Retirement planning often focuses on income streams, investment returns, and protecting against outliving assets. But just as important—and frequently underestimated—is the role of tax strategy. How and when retirees choose to access certain accounts can have long-term implications on their overall financial health. Annuities, when used wisely, offer a unique and often overlooked tax advantage: deferral. The ability to delay taxation on gains gives retirees more control over when they pay taxes and how much they owe. Understanding how to use this deferral properly, and when it makes sense to begin income, can be the difference between a good plan and a great one. Advisors like Mark Zayti of GreenLine Retirement often highlight this feature as a way to help clients manage their tax burden and structure retirement income with more precision and flexibility.
What Tax Deferral Really Means for Annuities
At its core, tax deferral means that the growth inside an annuity is not taxed until the money is withdrawn. Unlike taxable investment accounts, which generate annual tax bills on interest, dividends, and capital gains, annuities allow earnings to accumulate without immediate taxation. This gives the funds more opportunity to grow, since no portion is being siphoned off to the IRS year after year.
For retirees, this feature creates significant opportunities. It allows them to time distributions for when their income is lower, or when they can strategically manage their taxable income. For instance, someone in a high tax bracket today might choose to let the annuity grow untouched and wait to take income until they are in a lower bracket later in retirement. This flexibility is especially valuable when coordinating multiple income sources such as Social Security, pensions, and required minimum distributions (RMDs) from qualified accounts.
The longer the annuity is held, the more impactful the tax deferral becomes. It allows the earnings to compound uninterrupted, which can significantly improve outcomes over time. And because there are no annual taxes, the retiree can better plan when and how much to withdraw based on changing needs or tax conditions.
Non-Qualified vs. Qualified Annuities: Understanding the Difference
Annuities can be purchased with either qualified or non-qualified funds. Qualified annuities are funded with pre-tax dollars—usually from IRAs or 401(k)s—and distributions are fully taxable as ordinary income. Tax deferral in this case isn’t unique to the annuity itself; it’s a feature of the retirement account.
Non-qualified annuities, on the other hand, are purchased with after-tax dollars. The principal has already been taxed, but the earnings grow tax-deferred. When withdrawals begin, only the earnings portion is taxed, while the original principal is returned tax-free. This creates a key planning opportunity: the ability to spread out tax liability over time, rather than paying it all up front.
When income is drawn from a non-qualified annuity, it’s typically taxed using an exclusion ratio, which allows part of each payment to be considered a return of principal and part as taxable earnings. This results in lower taxable income in the early years of distribution. Over time, as the principal is exhausted, a greater portion becomes taxable.
Understanding this distinction is crucial. It affects how the income is taxed, how it interacts with other income sources, and how it may affect Medicare premiums, taxation of Social Security benefits, and overall tax planning in retirement.
The Impact of Smart Timing
The decision of when to take income from an annuity affects more than just cash flow—it shapes the retiree’s tax landscape. For those who don’t need immediate income, delaying annuitization or withdrawals can be a powerful strategy. Deferring distributions until later in retirement—when RMDs begin or when other income sources decrease—can lower overall tax liability and help manage the timing of income recognition.
In years when a retiree might otherwise cross into a higher tax bracket due to other income, they may choose to avoid annuity withdrawals entirely. Conversely, during low-income years—perhaps between retirement and age 73, when RMDs begin—it may make sense to begin withdrawing from a non-qualified annuity while the tax impact is minimized. This could also be coordinated with Roth conversions or other strategies aimed at controlling future taxable income.
The flexibility of tax-deferred annuities is especially helpful in filling income gaps. Retirees can plan withdrawals in a way that avoids sudden spikes in income that could trigger higher taxes on Social Security benefits or Medicare IRMAA surcharges. Because annuity income can be delayed and controlled, it serves as a buffer against the rigid distribution requirements of other accounts.
The Case for Laddering and Staggered Withdrawals
Many retirees choose to use more than one annuity to create a staggered withdrawal strategy. This involves opening several contracts with different time horizons. For example, one annuity may be structured to begin payments at age 65, another at 70, and another at 75. This not only provides income diversity but also distributes the tax impact across multiple years or even decades.
This strategy benefits from tax deferral by allowing each contract’s earnings to grow until needed. And because each annuity is drawn upon at a different time, the retiree avoids concentrating all taxable income in a single year. This form of annuity laddering can also be paired with varying product types—such as fixed indexed annuities and immediate annuities—to reflect shifting priorities over time.
In addition to spreading out the tax impact, this approach supports lifestyle needs that evolve over retirement. Early years may require more discretionary income, while later years may focus on healthcare or legacy goals. The tax strategy is built directly into the structure, providing a level of control that other income sources cannot offer.
Long-Term Tax Advantages
One of the most underappreciated aspects of tax-deferred annuities is the long-term benefit to estate planning. If an annuity is not annuitized and remains untouched at the time of the owner’s death, the value can be transferred to a beneficiary. While the gains are still taxable when distributed, the beneficiary can often choose to stretch payments over a period of time, spreading out the tax liability and avoiding a lump sum tax hit.
This becomes an appealing strategy for retirees who may not need the annuity for personal income but want to pass on a structured asset to children or other heirs. With proper planning, this can be a tax-efficient legacy tool that combines income control with asset growth.
There are also potential state-specific advantages, depending on how annuities are treated under local tax laws. Some states provide favorable treatment or creditor protection for annuity assets, making them a smart addition to a well-rounded financial plan.
When Deferral Should End: Annuitizing with Intention
Eventually, the decision to start taking income must be made. Whether through systematic withdrawals, annuitization, or required distributions, the tax deferral clock stops once money begins to come out. That’s why this decision should be timed carefully, based on income needs, tax exposure, and other planning goals.
Annuitizing the contract—turning the value into a stream of guaranteed payments—is a permanent decision. Once it begins, it can’t be undone. That’s why some retirees prefer to use income riders or systematic withdrawals instead, keeping more control while still enjoying guaranteed income features. Either approach should be evaluated in the context of total income sources, expected longevity, health status, and tax thresholds.
Ultimately, the goal is to begin taking income when the tax impact is least disruptive. This may be early in retirement to fill a gap, or much later, when other sources are depleted. Either way, the choice to defer gives retirees an edge. It allows them to avoid taxation on gains until they are ready—and that timing can be aligned with both life stage and tax strategy.
Making the Most of the Advantage
The power of tax deferral in an annuity is more than just a perk—it’s a cornerstone of flexible retirement planning. It allows retirees to grow their income base without annual tax erosion, manage the timing of taxable events, and maintain control over how their savings are accessed and taxed. When coordinated with Social Security, RMDs, Medicare planning, and Roth strategies, the tax deferral feature becomes a dynamic tool—not just a passive benefit.
As retirees face longer retirements and more complex financial environments, the ability to choose when income is taken—and how it is taxed—can offer meaningful advantages. The key is understanding the implications, working with a trusted advisor, and making intentional decisions that reflect both present needs and future opportunities.