Use Caution and Know The Tax Implications Before Purchasing an Annuity

January 9, 2023

By ldraper on January 9, 2023

For many investors approaching retirement, the promises offered by some annuity advertisements can sound alluring: claims of steady long-term income, easy return on investment and peace of mind from the markets. 

But there are potential drawbacks as well, and RMB’s advisors recently noted that investors should be aware of the risks and tax implications before considering an annuity. 

“Annuity contracts are generally complicated.  If you don’t understand how the product works, consider that is usually by design of the annuity company,” said Janelle McCreary, wealth advisor in RMB’s Denver office. “Annuity companies often charge high up-front fees, lock up capital for a number of years by charging penalties for accessing funds, offer limited investment choices, and produce limited gains even in years when the market is up.”

Beyond this complexity, Sarah Tims, partner and senior wealth manager in RMB’s Chicago headquarters, said that annuities bring with them a bundle of tax questions, as well. 

“Gains on non-qualified annuities are taxed as ordinary income in retirement,” Tims noted. “Whether that happens as a pro-rata percentage of monthly annuity payments or as a lump-sum from a withdrawal made prior to annuitizing the investment, folks buying annuities should know that they’re not avoiding tax, just deferring it.  Given today’s preferential tax rates on long term capital gains and qualified dividends, plus the availability of tax-exempt income from bonds, a more tax efficient strategy may be available by investing after-tax dollars outside of an annuity.”

The biggest tax difference occurs between qualified and non-qualified annuities, said Brian Klein, wealth advisor for RMB in Milwaukee. 

“A qualified annuity is funded with pre-tax dollars and grows tax deferred. Upon distribution the amount is taxed as ordinary income. A non-qualified annuity is funded with after-tax dollars, money you have already paid tax on,” Klein said. “Upon retirement the non-qualified annuity will be made up of your initial investment (money that is already taxed) and the earnings (growth on your initial investment that is tax deferred).”

Tims explained that this distinction can be misunderstood by investors. 

“It’s important to remember that investing in an annuity within any kind of qualified account like an IRA or 401(k) doesn’t give you additional tax benefits beyond what the qualified account itself offers.”

McCreary, who was quoted in a recent Forbes article on the topic of annuities, suggested that if investors must consider an annuity, a no-load version should be where they start their research. 

“No-load annuities have lower fees than a typical annuity and can have shorter surrender periods,” she said. “Because the investment companies don’t have to pay a huge commission to an agent, your dollars are locked up for a lesser period of time.”

All three RMB advisors said that investors also need to be aware of any early withdrawal penalties an annuity product might charge, and reminded everyone to consult their financial advisor, a CFP® or other fiduciary before considering whether an annuity might be right for their financial goals. 

While there can be benefits to annuities for investors in certain financial situations, in the end those come with concessions and potential tax liabilities, all of which need to be known up front before making any financial commitment.  


The opinions and analyses expressed in this communication are based on RMB Capital’s research and professional experience and are expressed as of the mailing date of this communication. Certain information expressed represents an assessment at a specific point in time and is not intended to be a forecast or guarantee of future results, nor is it intended to speak to any future time periods. RMB Capital makes no warranty or representation, express or implied, nor does RMB Capital accept any liability, with respect to the information and data set forth herein, and RMB Capital specifically disclaims any duty to update any of the information and data contained in this communication. The information and data in this communication do not constitute legal, tax, accounting, investment, or other professional advice. An investment cannot be made directly in an index. The index data assumes reinvestment of all income and does not bear fees, taxes, or transaction costs. The investment strategy and types of securities held by the comparison index may be substantially different from the investment strategy and types of securities held by your account.

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