Before choosing an annuity, know the tax implications

Guaranteed payments.

That's the allure of many annuities. But "guaranteed" doesn't mean tax-free.

Annuities come in many flavors and can cost a lot to set up. So when figuring out if one is right for you, you have to consider many factors, including the tax implications. The last thing you want is to be surprised by your tax bill when your goal is to have adequate income in retirement.

"An annuity is a tool. You have to use it wisely," said certified financial planner Mari Adam of Adam Financial Associates.

Qualified vs. non-qualified annuities

Although there are many types, annuities fall into one of two broad categories: qualified or non-qualified. And the payouts are taxed differently.

If you fund an annuity with pre-tax money, it's considered a "qualified" annuity. Payments from qualified annuities are fully subject to income tax because you weren't taxed on your contributions when they went in or on the growth of your money as it accrued, just like in a 401(k) or traditional IRA.

Qualified annuities are usually funded with money from an IRA, 401(k) or other tax-deferred account.

Related: One way to get retirement income for the rest of your life

If you buy an annuity with after-tax money, that's considered a non-qualified annuity. You'll only owe income tax on a portion of your payments, because you've already been taxed on the principal you invested.

What part of your payments will be taxable is determined by a so-called "exclusion ratio," said Mark Luscombe, principal federal tax analyst of Wolters Kluwer Tax & Accounting US.

The ratio is based on the principal you invested, the earnings on your principal and the length of your annuity. Your investment return may be fixed or variable, depending on which type of annuity you chose.

If your non-qualified annuity payments are based on your life expectancy and you happen to live longer than expected, that will affect the taxes you pay, too. Say you start collecting non-qualified annuity payments at 65 and your life expectancy is 85. Your payments from age 65 to 85 will be partially taxable based on your exclusion ratio. But if you end up living to 97, 100% of your payments from years 86 to 97 could be subject to tax, Luscombe noted.

There is one instance in which annuity payments could be tax free: if you bought an annuity within a Roth IRA or Roth 401(k). In that case, you use after-tax money to buy your annuity and, because it's a Roth, the earnings will grow tax free, as opposed to just tax deferred the way they are in most other annuities.

"Roths would qualify for a 100% exclusion if the timing and age requirements are met," Luscombe said.

Other tax issues to consider

There are plenty of other tax considerations that come into play with annuities.

For instance, depending on where you live, your state may tax annuity income somewhat differently than the federal government.

"It would probably be safest to check with the law of a particular state to see if annuities are treated in that state the same as for federal purposes," Luscombe noted.

Related: Should I buy an annuity or invest my savings on my own?

And don't forget potential tax penalties. With any annuity, check the rules for when you may start taking withdrawals or receiving regular payments.

Also consider the estate tax consequences. Say you're investing in a non-qualified annuity for the tax deferral on your investment gains, but you die before you start collecting payments. Your chosen heir will have to foot your tax bill, Adams said.

That's because, unlike with stocks or other investments, there is no "step-up in basis" for those who inherit annuities, Adam noted. A step-up simply means a person would owe no tax on any of the unrealized capital gains that accrued on an investment before they inherited it.

Since annuity products can be very complicated and expensive to set up, talk to a tax adviser about the tax implications before agreeing to buy one.

"It is also important to discuss the overall financial and investment implications of the annuity with someone other than the person selling the annuity," Luscombe said.

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