The information contained in this website is not intended to be legal or tax advice. Please consult with your attorney, accountant or tax advisor for more information regarding your specific circumstances.)
Funds held in a tax-deferred annuity can accumulate free of current income tax because of Internal Revenue Code Section 72(e) which states that interest earned in an insurance contract (an annuity is an insurance contract) is not taxable to the owner until it is withdrawn. (For more information, visit the "Tax-Deferred
Annuity" link.)
When funds are withdrawn from an annuity before the owner is age 59 ½, the IRS imposes a 10% tax penalty (excise tax) for premature withdrawals. (Note: the penalty only applies to any interest withdrawn.)
Internal Revenue Code Section 72(t) (Pre-LERO) allows individuals younger than 59 ½ to receive distributions from their qualified retirement plans without paying the 10% penalty, as long as certain requirements are met. (For more information, visit the Pre-LERO section of the "Avoiding Penalties" link.)
Each annuity payment is part nontaxable return of principal and part taxable interest income. An Exclusion Ratio is applied to determine what percentage of the monthly payment is nontaxable. The Exclusion Ratio for each individual annuity is the ratio of the total investment to the total expected return. (For more information,visit the "Immediate
Annuity" link.)
The IRS has specified that all owners of qualified retirement plans such as IRAs (other than Roth IRAs), 403(b)s, 457s, etc., must begin receiving required minimum distributions no later than April 1st of the year following the year in which the owner attains age 70 ½ — even if he or she is not retired. If, however, no distribution is taken or if the distribution is not large
enough (as determined by using an age-based IRS distribution table), the IRS imposes a tax penalty equal to 50% of the amount by which the required minimum distribution amount exceeds the actual amount distributed.
In 2002, the IRS changed the rules governing required minimum distributions. The new rules establish much smaller required minimum distributions and allow individuals to maintain and maximize the benefits of their IRA by making it possible to "stretch" those mandatory distributions over the life expectancies of themselves and their beneficiaries. (For more information, visit the "Stretching
Your IRAs" link.)
With Roth IRAs, the contributions are made with dollars
after they have been taxed. But once these dollars are in a Roth IRA, they grow tax free. And then later, all distributions (from both contributions and earnings) are received completely free of all income taxes! (As long as the account has been established for five years and the owner is at least age 59 ½.) (For more information, visit the "Roth
IRA" link.)
Traditional IRA rules require that the owner start taking required minimum distributions no later than age 70 ½, or pay a 50% tax penalty. Roth IRA participants, however, can choose to never take a withdrawal from their plan for as long as they live. (For more information,visit the "Roth IRA" link.)
In some cases, an individual can transfer the full value of one deferred annuity to another deferred annuity without any tax penalties. With this method, a person will not have constructive receipt of his or her funds and thus the transfer will not be considered a taxable withdrawal. (For non-qualified deferred annuities the rules of I.R.C. Section 1035 are used. This exchange is allowed by
Revenue Ruling 73-124, Code Section 1035. This ruling does not apply to qualified plans.)
