Withdrawal Fees – If your Fixed or Fixed Index Annuity is still within the surrender period, your Annuity contract will typically state a maximum annual withdrawal limit without penalty. It is called “Free Withdrawal” and with most (not all) 10% per year of the accumulated value. If you withdraw more than the free withdrawal, you will be subject to penalty fees. If you are no longer within the surrender period, then your Fixed Annuity will enable you to withdraw all money without any penalties or fees.
IRS Early Withdrawal Penalty – The IRS will charge you a 10% penalty tax if you withdraw on your Annuity before the age of 59 1/2. However, an Immediate Annuity (SPIA) has an IRS exception to this rule and the penalty is waived. Transfers/Rollovers are not subjected to this penalty and there is no taxable event.
Interest Income Not Taxed As Capital Gains – Compounded interest growth in an annuity is tax-deferred, but once you begin receiving payments from an Annuity, your interest income is taxed as ordinary income. It is not taxed as a capital gain.
When you withdraw money from an Annuity before 59 1/2 years of age, the IRS will levy a 10% tax penalty on your withdrawn money. With non-qualified funds, the 10% penalty is in addition to the regular income tax rate you would pay on your interest income. In most cases, this represents a large portion of your interest earnings in the Annuity. However, it is important to remember that the ordinary income tax rate and 10% penalty only applies to your interest earned in the Annuity. Your initial investment amount withdrawn from the Annuity is not taxed. If qualified funds, meaning they have never been taxed, the entire withdrawn amount is subject to taxation. Before withdrawing funds before age 59 1/2 it is advised to seek the advice from your tax professional.
There are occasions that the IRS, Age 59 1/2 penalty can be avoided:
Transfer from one Annuity to another Annuity (1035 exchange)
Rollover from 401k, 403b, 457 accounts, and transfer from IRAs
Death of the annuitant
Certain cases of disability of the annuitant
Annuitization (Begin an income stream using non-qualified funds)
Fixed and Fixed Index Annuities are a tax-deferred investment. This means the interest you earn on your initial investment is allowed to compound and grow tax-free until you withdraw the money. Eventually, you will have to pay taxes on the interest income. This is why the investment is considered tax-deferred, and not tax-free. When you do begin withdrawing from your Annuity, your income will be taxed at your ordinary tax rate. Since Annuities are taxed at your ordinary income tax rate, they have a tax disadvantage compared to other investments like stocks and mutual funds because those investments are taxed as capital gains. In some instances, depending on your income it is possible the capital gains tax of 15% could be substantially lower than your ordinary income tax rate. However, there are instances when the higher tax rates on Annuities are easily overcome by the advantages of an Annuity:
Continued Tax Deferral – Taxes can be deferred even if one spouse dies. If that spouse has the other named as a beneficiary, the Annuity will pass to the other spouse tax-deferred. It will continue to be tax-deferred until the surviving spouse withdraws the money. Also, the surviving spouse can pass the Annuity on to his or her heirs, and the monies can remain tax-deferred for up to 5 years.
Take Withdrawals at a Lower Tax Rate – Many retirees drop in tax bracket when they retire. Because you can decide when to exercise your Annuity withdrawals, you can choose to take your withdrawals during your retirement years when your tax bracket is likely to be lower.
Compounded Interest Grows Faster Tax-Deferred – When given a longer time frame (10-20 years), compounding interest that grows tax-deferred can grow much larger than the interest that is taxed on an annual basis. Investments that are taxed at the lower capital gains rate, but taxed annually, do not have the advantage of having all the interested earned for that year, compound year over year.
Roth IRA Option – Certain Annuities can be designed as a Roth IRA. In these instances, all withdrawals and payments remain tax-free. To learn more about Roth IRA options within an Annuity, please speak to your licensed Annuity Advisor.
Aside from the free withdrawal, most Annuity products feature a withdrawal penalty fee for receiving money from the Annuity during the surrender period. The withdrawal fee will be reduced as time passes throughout the surrender period. For example, a selected Annuity may feature a 5 year surrender period schedule that imposes a 5% fee in the first year, a 4% fee in the second year, 3% in the third year, 2% in the fourth year, and 1% in the 5th year. Starting in the 6th year, you could withdraw as much as you like free of incurring any cost, fees, or penalties. Be aware that although most Annuities have a withdrawal fee during the surrender period, most still allow for a certain amount of annual withdrawals without incurring a cost. Typically, this is a free withdrawal and is usually up to 10% of the accumulated value after the first year. This feature gives your Annuity product a level of liquidity. The other common ways to avoid early withdrawal penalties are:
Death of the Annuitant
Requires Nursing Care
Terminal Illness
It is important to keep in mind that Annuities are meant to be long-term commitments. The best way to avoid early withdrawal fees is to allocate money that you do not need access to for the surrender period. Liquidity in the remainder of your investment portfolio is critically important. Deciding on the best Annuity for your retirement need requires expert advice. Connect to a licensed Annuity Advisor in your area now.