Tax strategy: annuities and income
Annuities: turning a large sale into predictable income
After a big sale, the question often changes from how to save tax to how to live on the money. An annuity turns a lump sum into payments you can plan around, and lets the money you do not need yet grow without tax on its earnings until you draw it.
Two kinds
Income now, or income later
Income now
An immediate annuity converts a lump sum into a stream of payments that starts right away, for a set period or for life. Part of each payment is treated as a return of your own money and is not taxed, under the exclusion ratio of IRC 72(b).
Income later
A deferred annuity lets the money grow first, with earnings untaxed until you withdraw them, then turns it into income when you choose. Fixed, indexed and variable versions differ in how the growth is credited.
How they are taxed
The rules in IRC Section 72
Annuity earnings get tax deferral, but they come out as ordinary income, not as capital gain. That trade is worth understanding before you buy.
| Rule | Source | Effect |
|---|---|---|
| Tax-deferred growth | IRC 72 | Earnings inside the annuity are not taxed until they are withdrawn. |
| Withdrawals taxed as ordinary income | IRC 72(e) | Earnings come out first and are taxed at ordinary income rates, not capital gains rates. |
| Early withdrawal | IRC 72(q) | Earnings withdrawn before age 59 and a half generally carry an additional 10 percent tax, with limited exceptions. |
| Exclusion ratio | IRC 72(b) | For annuitized payments, the part that returns your investment is tax free; the rest is taxable. |
Before you buy
What to weigh
- Any guarantee is only as strong as the insurance company that issues the contract.
- Surrender charges usually apply if you take out more than allowed in the early years.
- Fees, especially on variable contracts and optional riders, reduce what you receive.
- Income payments are fixed by the contract and may not keep pace with inflation unless it says so.
Where we fit
Income that fits the rest of the plan
We hear you out on how much income you need, when, and what you want left for your family. If an annuity fits, we connect you with a partner firm that works with these contracts, and make sure it sits alongside whatever you are doing about the sale gain.
- Income needs first, product second.
- The issuer's strength weighed as carefully as the terms.
- Paired with a deferral approach where one fits.
Questions
Annuity questions
Does buying an annuity defer the tax on my sale?
No. If you sell an asset and use the proceeds to buy an annuity, the gain on the sale is taxed in the usual way. What the annuity defers is tax on its own earnings from then on. Owners often pair it with an approach that does defer the sale gain, such as a 1031 exchange or an installment sale, and use the annuity for the income side.
Why would someone who just sold something want an annuity?
To turn a large lump sum into income they can plan around, without having to manage investments, and to let the money that is not needed yet grow without annual tax on the earnings.
Are annuity payments guaranteed?
Payments are a contractual promise by the issuing insurance company, so they depend on that company's financial strength and ability to pay. That is why the issuer matters as much as the contract terms.
Can I get my money out if I need it?
Usually some of it, each year, without a charge. Taking more in the early years typically triggers a surrender charge set by the contract, and earnings withdrawn before 59 and a half generally carry an additional 10 percent tax.