Tax-deferred annuities are financial products that allow individuals to save for retirement while deferring taxes on the investment gains. Here's how they work:
1. Contributions: With a tax-deferred annuity, you make regular contributions to the annuity account. These contributions can be made on a pre-tax basis, meaning that you don't pay taxes on the money you contribute. This allows your investment to grow faster since you're not immediately reducing your investment amount by taxes.
2. Accumulation Phase: During the accumulation phase, the money in your annuity grows tax-deferred. This means that you don't have to pay taxes on the investment gains as long as the money remains in the annuity. The earnings on your investment compound over time, helping your savings grow.
3. Withdrawals: When you're ready to start receiving income from your annuity, you can begin making withdrawals. The withdrawals are taxed as ordinary income at your current tax rate. It's important to note that if you withdraw money before the age of 59 ½, you may be subject to an additional 10% early withdrawal penalty.
4. Required Minimum Distributions (RMDs): Once you reach the age of 72 (or 70 ½ if you turned 70 ½ before January 1, 2020), you are required to start taking minimum distributions from your tax-deferred annuity. These distributions are calculated based on your life expectancy and the account balance. The purpose of RMDs is to ensure that the government starts receiving tax revenue from your annuity.
Tax-deferred annuities can be a valuable tool for retirement planning, as they provide a way to save for the future while potentially reducing your current tax burden. However, it's important to consider the fees and expenses associated with annuities, as well as any surrender charges for early withdrawals. Consulting with a financial advisor can help you determine if a tax-deferred annuity is the right choice for your retirement goals and financial situation.