“I want to keep my tax burden low and my monthly income high.” That’s a goal we hear often when it comes to planning for retirement. After all, all of those retirement accounts that most people have used to save for retirement are tax deferred. That means when you start taking out money, the IRS is going to be looking for its cut.
In the first few years after retirement, this can create a pretty big tax burden. That’s why you may want to consider using fixed-index annuities for their tax-friendly status.
How Fixed-Index Annuities Are Taxed
The first thing you need to know is that fixed-index annuities come in two taxable forms. A qualified annuity is paid for with pre-tax dollars, like through an IRA or 401(k). A non-qualified annuity is one you purchase with money that’s already been taxed. These are treated very differently for tax purposes.
In a both types, you get the benefit of having all the taxes deferred. This allows more money to go toward the premium, which can help increase the payout later. When you withdraw funds, they’re taxed as ordinary income. As the annuity pays out periodically, this can help manage a tax burden when compared to the taxes that would be due on a lump sum. Because the payments from the fixed-index annuity are predictable, you can ensure that you don’t accidentally wind up in a higher tax bracket by withdrawing too much at once or at the wrong time. On qualified annuities, all distributions are taxable since the money has never been taxed.
On the other hand, a non-qualified annuity purchased with after-tax dollars is taxed to the extent that there is interest earned using a LIFO (last in, first out approach).
In either case, whether it’s qualified or non-qualified, a fixed-index annuity is going to have benefits over other index-based products, like stocks, bonds, and mutual funds. When you see gains on stocks, bonds, and mutual funds, you must pay capital gains on those funds. On some managed products, like mutual funds, you can be responsible for interim capital gains prior to selling a position if the internal sales of the holdings within a fund generate a tax consequence that falls on the shoulders of the fund investors.
In addition, if you want to sell one stock and buy another one, again, you’re going to have to pay tax on the gains you made after you sold the stock. While you get the benefit of better gains in the stock market, you’re going to have a more complicated tax bill in the end.
Many people turn to fixed-index annuities because of their simplicity. Gains on a fixed-index annuity are based on a stock index but not directly invested in one. They simply use that index as a benchmark for crediting interest to the account. They also use the overall performance of the index and not individual stocks and bonds. Finally, they’re more simplistic from a tax standpoint because you only pay taxes as you receive your income payments. If you defer income, there is no IRS form 1099 to contend with and your money will grow unencumbered by taxes.
But there’s an additional advantage to these types of annuities because there is a tactic you can use to avoid paying taxes at all.
Using a Roth IRA with a Fixed-Index Annuity
A Roth IRA can be a very valuable tool for limiting taxes and expanding your retirement funding options. A Roth IRA is an after-tax retirement account that you can use in conjunction with a fixed-index annuity to get a source of completely tax-free funding.
Here’s how it works. You use funds within a Roth IRA to purchase a fixed-index annuity and that annuity is characterized as Roth money. If you maintain the account for five years prior to taking payments and have reached the age of 59½, all the funds that come from the annuity within that account are withdrawn tax free. It’s a means of creating a tax-free stream of income that can continue paying out for your entire life.
On top of that, unlike IRAs or regular qualified annuities, Roth IRA funds have no required minimum distributions. You can hold onto that Roth IRA for life if you want and even use it as a means of estate planning because it can also be passed on to heirs tax free.
Of course, this solution isn’t right for everyone. One tricky thing about annuities is that they can be difficult to get out of during the deferral period without incurring a surrender penalty. When leveraged correctly, they can be used as a means of creating ongoing tax-free income and even a tax-free estate plan for beneficiaries.
The fixed-index annuity allows you to potentially get a higher interest return based on the stock market, while also eliminating market-based risk. These annuities also have some tax advantages that can reduce or eliminate your tax bill if properly structured. For more information on creating tax-friendly income in retirement, contact a Howard Kaye advisor at 800-DIE-RICH.
