One of the reasons why investors choose annuities is that they carry some favorable tax traits. Even if you don't hold an annuity in a qualified retirement account like an IRA, some of the tax laws that apply to annuities closely resemble how retirement money gets treated. The fact that the IRS largely treats non-qualified annuities in a similar manner to tax-favored retirement accounts has some pros and cons.

The benefits of non-qualified annuity taxation
The biggest benefit of an annuity is that your investment can grow on a tax-deferred basis. As long as your money remains invested in the annuity contract, you don't have to pay any taxes on any income or gains that the annuity produces. Because annuity contributions aren't eligible for any sort of tax deduction, the tax treatment of an annuity most closely resembles a nondeductible traditional IRA.

In addition, the tax laws allow you to make transfers from one annuity to another without recognizing any tax. So-called Section 1035 exchanges cover the trading of life insurance policies and annuity contracts, and the tax-law provision allows such exchanges without having to recognize capital gain.

Downsides of non-qualified annuity taxation
Investors face a trade-off with non-qualified annuities. Just like a retirement account, withdrawals from a non-qualified annuity result in taxable income in the year in which you take money out of the contract.

Exactly how much of your withdrawal is subject to tax can get tricky. For most annuities, if you just take a withdrawal, it will be deemed to have come first from earnings, meaning that the entire amount is taxable until the value of the annuity contract falls below the total of the premium payments you initially invested.

However, special provisions apply if you elect to annuitize your annuity contract. In that case, the amount of each regular payment you receive will be divided into two parts, one representing your initial contribution and the other representing earnings on your investment. As a result, only the portion of each payment representing earnings will be added to your taxable income.

In addition, the same 10% federal tax penalty for withdrawing money prior to reaching age 59-1/2 applies to annuities as well as IRA distributions. That penalty is in addition to any regular tax liability stemming from the withdrawal.

Non-qualified annuities have interesting tax characteristics that can make them desirable for some taxpayers. However, it's also important to know the potential downsides of annuity taxation before making a final decision about whether annuities are right for you.

The $15,978 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. In fact, one MarketWatch reporter argues that if more Americans knew about this, the government would have to shell out an extra $10 billion annually. For example: one easy, 17-minute trick could pay you as much as $15,978 more... each year! Once you learn how to take advantage of all these loopholes, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how you can take advantage of these strategies.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at knowledgecenter@fool.com. Thanks -- and Fool on!

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.