How do annuities receive favorable tax treatment and tax benefits?

Annuities are one of the few products that can provide both guaranteed income and favorable income tax treatment in retirement. Earnings can accumulate without annual taxation, which can help strengthen long-term compounding and can give you more control over when income becomes taxable. Depending on how you fund the contract, and the type, an annuity can also help manage current taxes or shape your retirement income strategy.

This article breaks down how types of annuities are given favorable tax treatment and how they can fit as part of a comprehensive investment strategy.

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Why annuities receive favorable tax treatment

With annuities, favorable tax treatment means three core built-in advantages: tax-deferred earnings, control over when income becomes taxable, and the exclusion ratio for certain payout structures. These benefits don’t eliminate taxes. They just change when you owe them. Understanding these features sets the stage for the following core advantages. There are non-tax deferred annuities so make sure you understand your contract before committing.

Tax-deferred growth

This means you don’t pay income tax on interest, index credits, or market gains until you withdraw funds or start taking annuity payouts. This allows your balance to compound without an annual tax on earnings. Over long periods, this can create a larger account value than a comparable taxable investment.

Tax timing control

With annuities, you typically have control over when taxable events occur. You can delay taking withdrawals until retirement — when your tax bracket might be lower. You can also schedule withdrawals to stop from moving into a higher tax bracket.

Exclusion ratio

For non-qualified immediate or deferred annuitized contracts, the IRS calculates an exclusion ratio to split each payment into two parts:

• A tax-free return of your principal
• A taxable portion, which is the earnings on your investment

This ratio can help reduce your annual taxable income in retirement by spreading the taxes you pay on earnings out over time rather than making you pay upfront.

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Qualified vs. non-qualified annuity taxation

Annuities are taxable, but the tax treatment depends on whether they’re treated as qualified or non-qualified. Qualified annuities are funded with pre-tax dollars inside retirement accounts, such as a traditional IRA, 401(k), or 403(b) plans. Because contributions reduce taxable income upfront, every dollar withdrawn later is taxed as ordinary income.

Non-qualified annuities use after-tax dollars. Only the earnings are taxable, while your original premium is returned tax-free. This creates tax diversification because you control when taxable income appears.

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When annuity income becomes taxable

Typically, annuities are not taxed while accumulating. Taxes apply when you take money out through withdrawals or convert the annuity contract into a guaranteed income stream (annuitization). The timing and amount of tax depend on the type of annuity, how you funded it, and how you choose to access your funds.

The IRS uses the last-in, first-out (LIFO) method to tax non-qualified annuity earnings prior to annuitization. Withdrawals come from earnings first. If you withdraw money prior to turning 59-½, the IRS might charge you a 10% early withdrawal penalty.

Once you annuitize, taxation works differently. Non-qualified annuities use the exclusion ratio. Qualified annuities are fully taxable. If you take a lump-sum distribution — the entire annuity value all at once — any gain in a non-qualified annuity is taxed immediately, while the IRS taxes the entire qualified annuity payout.

For qualified annuities held inside IRAs and 401(k)s, you must eventually take required minimum distributions (RMDs). This rule prevents you from putting off paying taxes on distributions forever. The IRS taxes RMDs like ordinary income.

When a beneficiary inherits an annuity, they only pay taxes on earnings received for non-qualified annuities. With qualified annuities, they owe ordinary income tax on the entire distribution.

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Is an annuity right for your tax strategy?

If annuities align with your broad retirement planning, they can make sense thanks to their favorable tax treatment. Advantages like tax-deferred growth and control over the timing of taxation can make them ideal for investors who seek predictable retirement income, while carefully managing the tax they pay each year.

A fixed annuity might be a strong addition to your investment strategy in these scenarios:

• You have maxed out IRAs or 401(k)s and are looking for predictable growth: If you’re contributing the maximum to your retirement accounts, a non-qualified annuity can extend tax-deferred growth without the confines of income limits or contribution caps.
• You want better tax visibility in retirement: The flexibility annuities can provide help optimize tax planning. You can delay withdrawals, stagger payout dates, or model annuitization ahead of time to get a strong sense of how much income you’ll receive and when it will hit come retirement.
• You want a diversified income stream: Deferred annuities can give retirees predictability. You know what to expect with your annuity payments. This contrasts with other types of retirement income sources subject to market conditions like dividend-paying stocks, real estate investment trusts, or bond-ladder interest.

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Using annuities to gain tax advantages

Annuities can provide investors with meaningful tax advantages, such as tax-deferred growth and control over the timing of taxation. They can make sense when you want to reduce your tax liability now, secure predictable retirement income, or diversify your drawdown strategy for later in life.

Gainbridge gives you a straightforward way to review different annuity options and compare how each one handles growth, access, and taxation. Compare annuities side-by-side to determine which product aligns with your goals and how it fits into your broader retirement plan.

Gainbridge SteadyPace™ offers a straightforward, tax-deferred solution to grow your savings with guaranteed interest rates and predictable growth. Earnings aren’t taxed until you take withdrawals, so more of your money can stay allocated and compounding over time. Explore Gainbridge today to see how our SteadyPace™ annuity can strengthen your long-term plan and support a more efficient retirement tax strategy.

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FAQ

What should I know about tax-deferred annuity growth?

With tax-deferral, you don’t pay income tax on interest, index credits, or market gains until you take withdrawals. This can allow your earnings to compound more efficiently without the burden of annual taxation. Tax deferral can be especially attractive if you think you’ll be in a lower tax bracket when you begin taking distributions.

What tax mistakes should I avoid with annuities?

Common mistakes include taking withdrawals prior to age 59-½, which can trigger the IRS 10% early withdrawal penalty. You should also avoid taking a lump-sum distribution that pushes you into a higher tax bracket.

Another mistake is not understanding the difference between qualified and non-qualified annuities or overlooking how RMDs impact taxation if you own your annuity inside a retirement account, such as an IRA or 401(k).

What can I do to make the most of annuity tax advantages?

You can optimize annuity tax benefits by coordinating withdrawals with other expected retirement income from pensions and Social Security. Consider staggering annuity payout schedules, using annuitization, and investing in non-qualified annuities to amplify retirement planning after you max out IRAs and 401(k)s.

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This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The GainbridgeⓇ digital platform provides informational and educational resources intended only for self-directed purposes. Guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company.

Withdrawals of taxable amounts are subject to ordinary income tax and if made before age 59½, may be subject to a 10% federal income tax penalty. Distributions of taxable amounts from a nonqualified annuity may also be subject to an additional 3.8% federal tax on net investment income. Under current law, a nonqualified annuity that is owned by an individual is generally entitled to tax deferral. IRAs and qualified plans—such as 401(k)s and 403(b)s— are already tax-deferred. Therefore, a deferred annuity should only be used to fund an IRA or qualified plan to benefit from the annuity’s features other than tax deferral. These include lifetime income, death benefit options, and the ability to transfer among investment options without sales or withdrawal charges.

SteadyPace™ is issued by Gainbridge Life Insurance Company, a Delaware-domiciled insurance company with its principal office in Zionsville, Indiana and is licensed and authorized to do business in 49 states (all states except New York) and the District of Columbia. Products and/or features may not be available in all states. Please visit gainbridge.com for current rates, full product disclosure and disclaimers and additional information.

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