Many investors use annuities as part of their overall financial planning, and these insurance-company products come with some interesting tax benefits. However, along with those benefits, you also have to keep in mind some rules you have to follow that can lead to some unexpected surprises if you're not aware of them. Let's look more closely at how annuities get taxed.

No up-front deduction for contributions
Annuity contracts offer no up-front tax break when you first buy the annuity. Some annuities are available for purchase within IRAs or qualified plans like 401(k) accounts, but in those cases, it's the plan contribution that gives you the tax break, not the purchase of the annuity in particular.

Tax deferral for annuity money
Once the money is in the annuity, though, it gets the same tax deferral that IRA and 401(k) money gets. You don't have to worry about paying tax on the income the annuity generates, and you can make exchanges between different annuities without realizing any capital gains tax on the appreciation in the contract.

How withdrawals get taxed
When you take money out of an annuity, how it gets taxed depends on where it is. If you take money out of an annuity that you hold within an IRA and have your financial institution pay it to you, then the distribution will get taxed like an IRA distribution. Typically, that means you'll pay income tax on the entire thing.

If you hold an annuity outside an IRA or qualified plan, then you'll get tax credit for your contributions. However, the IRS imposes a last-in, first-out method, which means that you'll have to pay income tax on all your profits first before you can get tax-free treatment for your initial contributions.

Watch out for early withdrawal penalties
In addition, the IRS treats annuities like retirement accounts for purposes of imposing early withdrawal penalties. If you take money out of an annuity before you reach age 59 1/2 and you don't qualify for one of the exemptions, then you'll have to pay an additional 10% penalty on the amount you take out.

Payments to heirs
If you die before taking money out of your annuity, the person you name as beneficiary will have the rights to the proceeds. Those payouts are still subject to tax on the deferred income of the annuity, and if the death benefit is higher than the account balance, that increase is also subject to income tax on the heir's tax return.

Annuities can be useful as retirement savings vehicles, but they don't have all the benefits that IRAs and 401(k)s do. Make sure you understand all the pros and cons before you buy an annuity.

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