Much like the fees from an unexpected trip to the mechanic, unforeseen taxes can significantly impact your wallet. Although an emergency fund provides peace of mind and much-needed relief, it isn’t realistic for every household. Wouldn’t it be easier if you could predict your financial future instead? Aside from recurring expenses, including utilities, mortgage, homeowners insurance, unexpected repair bills, medical bills, and more can bring added stress along the way. Taxes during retirement, for example, are just one of the expenses you may not have considered. Most retirees failed to consider the income they’d be earning from retirement account distributions, Social Security benefits, investments, etc. In terms of retirement planning, you can’t avoid the details of how annuity income impacts your taxes during retirement and planning for the amount you will be required to pay. While annuities, for example, grow tax-deferred, you will have to pay taxes once the distributions are received. However, as long as investment gains aren’t withdrawn, you won’t pay any taxes until payments are made. It’s essential to understand how your annuity is taxed, with qualified annuities taxed differently than non-qualified annuities. Considering qualified annuities are purchased with pre-taxed dollars, your investments are made free from taxation. However, it is essential to note that just because you invested with pre-tax money, you are still required to pay taxes once the funds are withdrawn, just as you would with regular income. This is particularly true if you withdraw from your annuity early, which imparts a 10% penalty on top of your taxes. However, this is not true for non-qualified annuities, where taxes are owed on investment gains, not contributions. Non-qualified annuities consist of annuities purchased outside of the realm of your average employment benefits. Because the transferred funds were already taxed, you don’t pay upon the dispersal of funds – enabling an annuity to grow tax-deferred. A non-qualified annuity includes certificates of deposit, inheritance accounts, mutual funds, non-IRA accounts, and savings accounts. Aside from zero contribution limits, non-qualified annuities do not carry a mandatory distribution age, either. This enables you to transfer funds between policies with no consequences through a 1035 exchange. When you purchase your annuity, the insurance company will require a lump-sum payment to get the ball rolling. You won’t be responsible for paying income taxes on a portion of individual payments when you receive the annuity. Because it is a principal return and the principal was paid with after-tax money, you won’t be taxed again by the IRS. An exclusion ratio of 50% on a $100 investment, for example, means the annuity would pay out $200 through $20 installments. The first half of your payout, being $10, would not be taxed as it is a collection of your initial investment. With this in mind, how would you go about calculating your annuity’s taxable amount? By determining the amount of future owed taxes, you can plan appropriately for your retirement budget. When your annuity payments begin to arrive, only a portion of your payment will be taxed every month. To properly utilize the exclusion ratio method or the pro-rata method, you can refer to the IRS General Rule 939. Begin by measuring the income tax on periodic payments against the expected return spelled out in your contract. Then, the percentage used is multiplied by periodic payments, with the remaining recurring payments taxed in the same manner as for regular income. There are a few reasons the IRS would tax you more than you’d expect, so it’s essential to speak with a financial advisor to discuss your options. For example, if your life expectancy exceeds that included in your annuity, you withdraw early or inherit an annuity, among others. Remember, you will begin owing income taxes on any annuity payments you receive (subject to early withdrawal fees).
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