Avoiding Tax Issues

Taxes on Annuities

Back a few months ago when stocks were soaring, investors ran into an interesting dilemma. Because of regulations concerning many types of funds (mainly mutual funds), companies could not apply dividends back into accounts, but rather had to pay them out to the investors. Stocks were making too much money, and many funds had made so much that the investment companies servicing these funds had no legal choice but to either send investors a check, or to put the money back in. However, the tax codes mandated that these dividends count as capital gains and these investors that presumed they would not have to pay taxes on their money until retirement ended up having to pay taxes on these gains. In some cases, the money went right back into the accounts and wasn’t directly seen. They still had to pay taxes either way.

This is not a big deal in the grand scheme of things, but it is a big inconvenience and quite annoying. Many types of annuities would have completely avoided this issue, and they would have served the same exact purpose that many of the affected fund owners were looking for. Mutual funds have long been a versatile way to save for the future, but they do have some drawbacks and this illustrates one of the big ones. Annuities are specifically geared for retirement and there are many safeguards built into them to make it very tough to get your money before you reach the age of 59 ½. If you take your money out before this age, you are given an immediate 10 percent penalty. Some annuities have tougher restrictions to encourage you to keep your money in even longer.

This doesn’t mean that annuities are inconvenient for retirement. There are ways around getting your money earlier. Assuming you retire after the age of 60, you will have access to your money right away the moment you decide to annuitize the contract. So, if you purchase a fixed annuity at age 55, and then in five years you want to get your money but the insurance company says you need to wait four more years before you can get full access to your cash, you can either wait those four years and get the whole sum back without penalty, or start receiving disbursements. These typically come in the form of a monthly check or direct deposit to your bank account and even if you haven’t fulfilled the surrender requirements (the extra time that the insurance company adds on for penalties for early withdrawal), you can skip this by annuitizing the contract. Not all policies will have this feature, but most do. Make sure to check with your agent before exercising this choice, of course.

Mutual funds do have benefits, but they are geared more heavily toward those individuals that want access to their money before retirement. But because they are easy to find and invest in, they are used more heavily than they should be. This stresses the importance of using the right tool for the right job. Annuities have a very specific purpose, and the tax benefits that they provide are a key part of your retirement planning. You can even combine an annuity with your IRA or Roth IRA investing to maximize the tax benefits and add another layer of safety to your money. These will require you to begin taking distributions at age 70 ½ if you go the IRA route, so do be aware of this before you begin your research on this. This is true even if you are still working at that age. For those that want some extra spending money later in life, this can be a nice little bonus for yourself.

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