At its most basic level, an annuity is a way to accumulate money for retirement over a long period of time, without having to pay any taxes on the accumulated returns – at least not until you access them
That is the main advantage that is at the heart of annuity investments. The sooner you start tax-deferred annuity savings, and the longer therefore you have until retirement to accumulate tax-deferred income – the better.
The other major advantage is that the money you use to purchase your annuity initially is in "after tax dollars" – because unlike when you invest in a CD or Money Market you can claim the entire amount you invested in an annuity as a deduction off of your income taxes.
How exactly you are eventually taxed on your annuity income all depends on how you elect to receive payments
Lump Sum Payout
If you decide to go with a lump sum payment from your annuity, you will be taxed on what is called a last-in-first-out, or "LIFO" cycle. In other words, picture your annuity as a building pile of cash. The money on the top (last in) is all earned interest, the money on the bottom your principal. When you begin drawing money out "you are taking it off the top" – or earned interest, and therefore it is taxable.
If you take only a partial withdrawal as a lump sum, depending on the total earnings, you may or may not have to pay income taxes on the entire withdrawal.
The LIFO method of accounting is true whether you have a variable annuity, a fixed annuity or an indexed annuity. There are additional penalties in the form of early withdrawal taxes of up to 10% if you take any funds out of an annuity prior to the age of 59 ½
There are circumstances under which the early withdrawal tax is waived such as because of disability or other, life circumstances. Check with the specifics of your particular annuity contract for these details and learn more about annuities on http://www.annuities.org.
Installment Payments
If you elect to take your guaranteed minimum benefits on an annuity contract in regular monthly or annual payments – these payments are also taxed on the LIFO model. So the payments you receive regularly will be taxed as income until you have gone through the "top layer" of gains, and then after that, your payments are considered a return of principal and will not be taxed.
Annuities can be complex investments, but they also can be key to a long and financially secure retirement, however it is important that you understand the taxation of annuities before making them part of your retirement plan.
