When it comes to retirement income planning, annuities can serve as a powerful tool to convert savings into a predictable income stream, either for a lifetime or a specific period of time. With that said, the decision about what assets to use when funding an annuity (i.e., in a taxable brokerage account, a traditional pre-tax IRA, or a Roth IRA) has important implications for tax efficiency, flexibility, and legacy planning. Each account type can trigger a different tax impact when purchasing and ultimately, beginning income payments from the annuity. Understanding these nuances can help retirees make more informed decisions.
Understanding How Fixed Annuities Work
There are various types of annuities, but the focus of this article is on annuities used for retirement income purposes, such as Single Premium Immediate Annuities (SPIAs), Deferred Income Annuities (DIAs), Qualified Longevity Contracts (QLACs), and other fixed products that offer lifetime income guarantees.
At its core, an annuity is a contract between an insurance company and the annuitant. In exchange for a lump-sum payment, the insurer provides a guaranteed income stream for a specified period or for the remainder of the insured’s life. The income from an annuity is subject to taxation based on the account type from which the annuity is purchased. That taxation affects not only your cash flow but also your adjusted gross income (AGI), which in turn can impact things such as Social Security taxation and Medicare premium surcharges.
Qualified annuities are purchased using pre-tax or tax-free Roth dollars. Pre-tax annuities will incur taxes when you make withdrawals, while tax-free annuities will be distributed without additional taxes applied. Non-qualified annuities are purchased with after-tax dollars from a taxable account, and taxation will depend on how and when you access your funds.
Non-qualified Annuities: Funding Using a Taxable Account
Non-qualified annuities are funded with taxable contributions, typically from a brokerage or bank account. These contributions establish a tax basis within the annuity that is nontaxable when the funds are distributed. Only the earnings generated within a non-qualified annuity are taxable as income at the time of a withdrawal or payment.
If you purchase an annuity using money from a regular brokerage or savings account, there are two potential tax treatments. If you withdraw money prior to annuitization, the funds are taxed on a “Last-in, First-Out” or LIFO basis. This means that your withdrawals will be fully taxable until the gains are depleted.
Once annuitization begins, your income will be a combination of taxable earnings and tax-free return of premium, allowing an “exclusion ratio” to be applied. This means a portion of each payment is considered a return of your original investment and is not taxed. The rest is taxed as ordinary income. Once you outlive your expected lifespan, the payments become fully taxable.
This structure can reduce your taxable income early on, but keep in mind that if you need to sell investments to buy the annuity, that sale could trigger capital gains taxes. Over time, as more of your payments become fully taxable, the early tax break may fade.
Qualified Annuities – Funding Using Pre-tax Dollars
Qualified annuities are contracts that have been funded with pre-tax money, usually through retirement accounts such as a 401(k) or IRA. Contributions into these accounts remain tax-deferred and will only be subject to income taxes in the year withdrawals or payments are received. All income from a traditional IRA, including annuity payments, is taxed as ordinary income. The benefit is that you can purchase the annuity without incurring upfront taxes. But it is important to keep in mind that there’s no extra tax deferral from using an annuity in a traditional IRA, since the account already defers taxes until you withdraw the funds.
A newer form of qualified annuities is called a Qualified Longevity Annuity Contract (QLAC), which is exempt from the Required Minimum Distribution (RMD) rules. With a QLAC, you can defer income until age 85, without being subject to RMDs. This may prevent you from getting bumped into a higher tax bracket, as well as potentially lowering your Medicare premiums. The extended deferral can be especially effective if you end up working into your later years.
Qualified Annuities – Funding Using a Roth Account
Annuities purchased with Roth dollars are still considered “qualified” even though the premium was paid with after-tax dollars. If your Roth account is at least five years old and you’re over 59½, the income and withdrawals from an annuity purchased within the Roth are completely tax-free.
That means you get guaranteed income for life that doesn’t count toward your taxable income. This can help keep your Medicare premiums lower and reduce or eliminate taxes on Social Security benefits. For retirees who aren’t concerned about leaving the Roth IRA to their heirs, this approach can be a highly effective way to generate tax-efficient income. The downside is that you’re using up Roth assets that could have been passed down tax-free to beneficiaries. And not everyone has a large enough Roth balance to make this strategy work.
Choosing the Right Account to Fund an Annuity
Assuming you have sufficient assets in various account types, choosing the account to fund your annuity depends on your overall retirement goals. If minimizing taxes is your primary focus today, using a Roth account may be the best fit. If you’re managing RMDs or have most of your assets in a traditional IRA or 401(k), that may guide your decision. And if flexibility and preserving Roth assets for heirs are important, a taxable account could be more appealing. It all boils down to what funding sources are available to you and what your priorities are. Part of the evaluation process should involve considering how much of your retirement income is already covered by Social Security, pensions, and other sources to understand the potential tax impact and value of adding an annuity.
There’s no universal answer; however, understanding how annuities work and how the income is taxed can help you make a more informed decision. With a clear view of your tax landscape and retirement goals, you can better align your annuity strategy to support the retirement you envision.
If you’re trying to decide which account type to use when funding an annuity (or just want a clearer understanding of how annuities work in the first place) this is exactly the kind of question we dive into in the Retirement Researcher Academy. Our Understanding and Interpreting Annuities Workshop walks you through how these contracts are structured, how they generate income, and how to make sense of the tax treatment depending on where the funds come from. These resources are designed to help you move beyond general advice and make decisions that are right for your specific situation.
Want to learn more? Listen to Ep. 187 of the Retire With Style Podcast.
