Many investors look to annuities as a way to invest in a tax-deferred vehicle outside of an IRA or other retirement account. However, annuities have different tax attributes from most retirement accounts. When you cash in an annuity, you have to be aware of the potential tax consequences. Below, you'll get a quick look at how various situations can affect your taxes.

The basic rules for annuity taxation
The first question in evaluating the tax consequences of cashing in an annuity is what you mean by cashing the annuity in. If you mean annuitizing the contract and starting to get regular payments, that's different from taking money out before you annuitize. Annuitized payments are divided into part principal and part earnings, with taxes on the earnings but none on the principal.

If you don't annuitize, then IRS typically treats withdrawals from annuities as being from earnings first. Therefore, you'll pay tax on every dollar until you're only left with your initial investment. After you've withdrawn all your earnings, you can then withdraw your initial investment free of tax.

Taking money early
The other major tax consequence has to do with the retirement-related nature of annuities. The IRS imposes the same penalties for early withdrawals from annuities that it does for IRAs and retirement accounts. If you take money out of an annuity before you turn 59-1/2 and you don't qualify for any exceptions to the general rule, then you will have to pay an additional 10% penalty on the withdrawal on top of the taxes that result from adding the withdrawal to your taxable income.

Tax-free exchanges
If you're thinking about cashing in your annuity solely to buy another annuity that you think is better, keep in mind that the tax laws allow you to make a tax-free exchange. If you follow the rules correctly, you can make an annuity switch without the usual tax consequences.

The catch, though, is that the money has to go directly from one annuity provider to the other without ever passing through your hands. The rollover options that you have with IRAs and 401(k) plan money don't apply here, and the direct transfer is your only choice. Still, the strategy is worth considering if your objective is to get a better annuity rather than getting out of annuities entirely.

Annuities can be complex, and tax consequences aren't always clearly stated when you buy an annuity. Nevertheless, there are ways you can control your tax liability and make the most of the annuity contracts you own.

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