When considering investment options for retirement, two popular choices are annuities and real estate investments. Both can provide stable income streams, but they have very different tax implications that investors need to understand. This article examines the key tax differences between annuities and real estate when weighing these two common retirement investment vehicles.
Annuities and real estate investments like rental properties or REITs are taxed quite differently, especially when it comes to taxes on investment gains. Annuities allow you to defer taxes on investment earnings until withdrawals begin, while real estate investments generate taxable income each year. However, real estate enjoys preferential capital gains tax rates when sold after being held long-term. Conversely, annuity withdrawals are taxed at ordinary income rates. Estate taxes also differ, with annuities excluded from your taxable estate. Ultimately, the ideal option depends on your income needs and tax situation.
Annuities allow tax-deferred growth compared to annual taxes on real estate income
A major difference between annuities and real estate is taxation during the accumulation phase. Annuities grow tax-deferred, meaning no taxes are owed on interest, dividends or capital gains until withdrawals start. This allows faster compounding growth compared to taxable investments. In contrast, rental real estate and REITs generate taxable income every year. Rental properties produce taxable income after subtracting expenses like mortgage interest, property taxes, insurance, repairs and depreciation. REITs pay dividends that are taxed at ordinary income rates like bond interest. This can make real estate better suited for retirement investing when you need current income. But the annual taxes drag on long-term growth compared to tax-deferred annuities.
Annuity withdrawals are taxed as ordinary income, real estate gains get preferential rates
While annuities allow tax-deferred growth, all withdrawals are taxed as ordinary income based on your top tax bracket. This could be over 30% federal plus any state taxes. Capital gains from selling real estate held over one year qualify for preferential long-term capital gains rates of 0%, 15% or 20% federally. Any depreciation taken previously on rental property recaptures at 25%, but overall the effective tax rate on real estate gains is usually lower than ordinary income rates. An exception is a Roth IRA annuity where qualified withdrawals are tax-free. Inherited real estate also gets a step-up in basis to market value, avoiding prior capital gains. Beneficiaries of inherited annuities pay tax on all withdrawals.
Estate taxes apply to real estate but not annuities
For high net worth investors, estate tax planning is crucial. Lifetime annuity payments end upon death, so nothing is left to bequeath. Thus annuities are excluded from your gross taxable estate for estate tax purposes. However, real estate you own at death is included in your estate and potentially subject to estate taxes before passing to heirs. The federal estate tax exclusion is now over $12 million per person, but thresholds can be much lower in some states. Annuities allow you to accumulate substantial assets tax-deferred, receive lifetime retirement income, and avoid passing accumulated value to heirs that increases estate taxes.
In summary, annuities and real estate investments have significant tax differences that matter when choosing retirement assets. Annuities allow tax-deferred growth but withdrawals are taxed as ordinary income. Real estate investments generate taxable income yearly but qualify for preferential capital gains rates when sold after meeting holding period requirements. Annuities also avoid exposure to estate taxes, unlike real estate. Assessing your income needs, tax bracket and estate planning goals can help determine if an annuity or real estate better fits your retirement investment objectives.