Tax-deferred annuity: How it works and withdrawal rules

A tax-deferred annuity can help you build retirement savings by allowing earnings to grow without immediate taxation. Understanding how these contracts handle contributions, withdrawals, and beneficiaries makes it easier to compare them with other long-term savings options. 

Gainbridge believes in transparent terms and in helping people make educated decisions about the future. This guide walks you through the ins and outs of tax-deferred annuities, including their pros and cons so you can evaluate whether this type of annuity fits your financial goals.

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What are tax-deferred annuities?

A tax-deferred annuity is an investment with an insurance company. You fund the annuity with after-tax or pre-tax dollars, depending on the type of annuity you select. You pay income taxes only when you take withdrawals. 

There are fixed deferred annuities that offer a guaranteed rate of return for a set period. There are also indexed annuities that credit interest based on market performance.

How a tax-deferred annuity plan works

There are three primary stages to investing in tax-deferred annuities: 

1. Purchase/contribution: You enter the deferred annuity contract with an insurance company and make either a lump-sum payment or a series of routine contributions to the investment.
2. Accumulation: The account grows tax-deferred through interest, index credits, or market returns, and growth compounds over time.
3. Distribution: You withdraw either a lump sum or take regular payments from the account in retirement.

Pros and cons of tax-deferred annuities

Tax-deferred annuities are popular among retirement investors. They allow savings to grow without annual taxation, which can strengthen long-term results. But there are trade-offs to consider. Below, explore the pros and cons.

Pros

Tax-deferred annuities can be a safe, steady way to grow funds. Here’s why:

• Speed of accumulation: Because the funds you contribute to the annuity aren’t taxed during the accumulation period, your principal is higher, and your money can grow faster.
• Protection from creditors: In certain states, creditors can’t take funds from an annuity to resolve a debt. This protection safeguards your investment, even during a tough financial time. 

Cons

Deferred annuities aren’t the ideal investment if you want short-term gains for the following reasons:

• Liquidity trade-offs: Most contracts include a surrender period, often up to 8 years after the contract begins. This limits withdrawals in the early years, reducing flexibility and making your investment less liquid.
• Potential fees: Early withdrawals can trigger surrender charges and a 10% IRS penalty before you hit 59½ years of age. Qualified contracts also require minimum distributions at age 73, or you’ll face hefty fees. Many annuities also include ongoing costs like administrative fees.

How tax-deferred annuities are taxed

The basic rule of thumb for the taxation of a deferred annuity is you pay income taxes only when you take money out of the contract. But there are nuances to understand, depending on whether the annuity is qualified or non-qualified.

Qualified tax-deferred annuities

With a qualified tax-deferred annuity, you fund the contract with pre-tax dollars inside a 401(k) or IRA. Contributions may reduce your taxable income, and all withdrawals in retirement are taxed as ordinary income. 

While you aren’t taxed during the accumulation period, there is an exception: Early withdrawals may trigger a 10% IRS penalty, and the taxable portion of the withdrawal is subject to ordinary income tax. 

Non-qualified tax-deferred annuities

Non-qualified tax-deferred annuities use after-tax dollars to fund the account. You pay taxes only on earnings, not on your original contributions. 

For non-qualified tax-deferred annuities, withdrawals follow the IRS’s last-in, first-out (LIFO) rule. Earnings come out first and are taxed as ordinary income. The remaining principal comes out tax-free. 

How withdrawals from tax-deferred annuities are taxed

Taxation on a deferred annuity depends on how you take money out of the account. Any early withdrawals during either the surrender period or before you reach 59½ years of age are taxed as ordinary income and are subject to penalty fees. And when you’re contractually able to withdraw funds, the IRS taxes them as follows, depending on how you choose to receive returns.

Annuitized payments

Annuitization converts your investment into regular, scheduled payments, turning the money you saved into a guaranteed income stream. These distributions can last for a set number of years, your lifetime, or the lifetimes of you and a beneficiary. The IRS taxes qualified deferred annuity payments as ordinary income, meaning that 100% of each payment is subject to your tax bracket’s rate. 

For non-qualified annuities, the IRS uses the exclusion ratio to determine how much of each annuity payment is taxable. To calculate it, divide the total principal by the expected return. This ratio shows which portion of each payment is considered non-taxable.

For example, if you contribute $100,000 and the expected return is $200,000, the exclusion ratio is 50%. That means half of each annuity payment is tax-free, and the other half — which represents earnings — is taxed as ordinary income.

Lump-sum withdrawal

In a lump-sum withdrawal, you receive the entire amount of your savings in a single deposit. The full amount is taxed as ordinary income, so the year you receive the lump sum you could have a significant tax bill. It can also push you into a higher tax bracket. 

For a non-qualified annuity, the IRS follows the LIFO rule. The taxable amount only corresponds to interest earnings, and your principal is returned tax-free.

So, why choose a lump-sum withdrawal? While a giant IRS bill and higher tax bracket can be deterrents, this method may make sense for people with major expenses, such as paying off debt or buying property. 

Partial/discretionary withdrawals

Discretionary withdrawals, also known as free withdrawal provisions, are unscheduled funds the owner takes out from the account before annuitization starts. Many insurance companies allow you to take 10% per year without incurring fees. However, the IRS still taxes these funds as they would any other annuity withdrawal.

Inherited tax-deferred annuities: What beneficiaries need to know

Inherited annuities are subject to taxes. And the taxable amount is based on the annuity type and the beneficiary’s relationship to the owner. Here’s what you need to know.

Inherited qualified annuities

If the owner is a deceased non-spouse, all distributions to the beneficiary are taxed as ordinary income. The entire balance typically must also be withdrawn within 10 years. 

A spouse beneficiary has more flexibility. They can continue the contract and take payments based on their own life expectancy, or roll the remaining value over into an IRA. If no distributions have begun at the time of death, the spouse can treat the annuity as their own, delay withdrawals, or receive the total amount over a period of 10 years.

Inherited non-qualified annuities

When a beneficiary receives a non-qualified annuity, the tax rules are similar to those the original owner had. They’ll only pay taxes on the account’s interest earnings, not the principal. 

A beneficiary can select annuitized or lump-sum payments. Some contracts require the beneficiary to withdraw the total amount within five years of the death of the original account holder. 

Tax-deferred vs. tax-free vs. taxable accounts 

The language around annuity taxation can sometimes be confusing. Understanding the following can make it easier to compare types of annuities and other retirement accounts:

• Tax-deferred: You won’t pay taxes until you withdraw.
• Tax-free: Roth accounts use after-tax dollars and allow tax-free withdrawals.
• Taxable: Earnings are taxed each year.

You likely encounter these terms when seeking:

• Taxable brokerages: Interest, dividends, and capital gains from these accounts are taxed annually.
• Qualified retirement accounts: Common retirement account types like 401(k)s and IRAs offer tax-deferred growth and may reduce current taxable income.
• Non-qualified retirement accounts: There’s tax-deferred growth in these accounts, but they use after-tax contributions. You pay income taxes only on earnings when you withdraw. 

Explore deferred annuities with Gainbridge® 

Understanding the tax rules associated with your savings fund helps you make smarter investment decisions and avoid surprises. Deferred annuities can support long-term retirement income, but it’s wise to know the tax implications you’ll face before you sign up.

Gainbridge offers fixed annuities with guaranteed income features and straightforward terms. The platform highlights how long-term, tax-deferred growth can support retirement income planning with products like SteadyPace™. Explore Gainbridge today to see how modern fixed annuities are structured and to compare guaranteed rates.

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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. The Gainbridge® digital platform provides informational and educational resources intended only for self-directed purposes. 

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