Tax-deferred Financial Products
Interest inside an annuity is not subject to income tax and grows on a tax-deferred basis. However, tax-deferred does not mean tax-free. Interest withdrawn from the annuity is subject to income taxes in the year it is received, and upon death of the annuity owner, all interest earnings are taxable (the IRS assumes that taxable interest is always withdrawn first from an annuity; principal is not taxed). In addition, interest withdrawn from an annuity before age 59 1/2 is subject to an additional IRS penalty, unless the distribution meets certain exceptions. Taxes or penalties do not apply on the principal.
Almost all tax-deferred annuities charge a surrender cost if you cash in the policy prior to the end of the specified period. Depending on the policy selected, surrender periods vary in length from one to over twenty years. Surrender costs do not usually apply if the policy is cashed in due to death of the owner or if the policy is annuitized. Why are there surrender costs? There are expenses involved in issuing an annuity, and the insurance company wants to ensure that these costs are recovered if the annuity buyer cashes in. The surrender penalties and liquidity provisions should match your liquidity needs.
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