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.

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