If there’s one thing most retirees and pre-retirees agree on, it’s this: nobody likes paying more taxes than they have to. I certainly don’t.
The good news is that there are legal ways to reduce taxes in retirement, and annuities can sometimes play a role in that strategy.
But it depends on how the annuity is structured, what bucket the money comes from, and when you take income.
Let me walk you through a few ways annuities may help reduce taxes legally so you can decide whether it makes sense for your retirement plan.
Need help choosing the best annuity for your unique situation? Have questions about getting an annuity? If so, it’s best to speak with an annuity specialist. Watch this short video to see how I can help you do this (at no cost to you!)
Tip: See how much an annuity could pay you using my annuity calculator
How Annuities Are Typically Taxed
Before we talk about reducing taxes, we have to understand how annuities are taxed in the first place.
The key factor is which account the annuity is held in.
There are two main categories:
- Qualified annuities (IRA money)
- Non-qualified annuities (after-tax money)
If your annuity is inside a traditional IRA, every dollar that comes out is generally taxed as ordinary income.
So if your annuity pays you $71,500 per year, the IRS treats that the same as salary income.
For example:
- Annual annuity income: $71,500
- Tax bracket: 20%
- Taxes owed: about $14,000 per year
That’s why simply owning an annuity inside an IRA does not automatically reduce taxes.
But there are strategies that can change that.
Strategy #1: Using a Roth Conversion With an Annuity
One of the most powerful tax strategies I help clients explore is combining an annuity with a Roth conversion.
Here’s how it works.
You can:
- Purchase an annuity inside a traditional IRA
- Convert the IRA to a Roth IRA over time
- Take tax-free lifetime income later
Yes, the Roth conversion itself is taxable.
But once the money is in the Roth:
- All future withdrawals are tax-free
- Lifetime annuity payments can be tax-free
- The income doesn’t count toward taxable retirement income
For many retirees, the math often works best if the conversion happens over multiple years rather than all at once.
For example, you might spread the conversion over five years while waiting to start income, then enjoy tax-free payments afterward.
💡 Pro Tip: The break-even point for Roth conversions often occurs later in retirement (sometimes in your 80s). That’s why I always run the numbers first before recommending this strategy.
👉 Want help comparing annuity income strategies? Schedule a call with me and we’ll walk through the numbers together.
Strategy #2: Using Non-Qualified Annuities (After-Tax Money)
Another way annuities can reduce taxes is by using non-qualified funds.
This means the money you put into the annuity has already been taxed.
Examples include money from:
- Brokerage accounts
- Cash savings
- CDs
- After-tax investments
Because the money was already taxed, part of the annuity income is treated as a return of principal, which can be tax-free.
Let’s look at a simplified example.
You invest:
- $650,000 into an annuity
- It pays $71,500 per year
If the annuity had $33,000 in earnings, then:
- $33,000 of the income is taxable
- The remaining $38,500 is tax-free return of principal
So you receive the same income — but less of it is taxed.
Strategy #3: Taking Advantage of the LIFO Tax Rule
Non-qualified annuities follow a tax rule called LIFO (Last In, First Out).
That means:
- Earnings are withdrawn first
- Principal is withdrawn after
So when you receive a payment:
- Part may be taxable earnings
- Part may be tax-free principal
As the account balance changes over time, the taxable portion of payments can change each year.
In some years:
- More income may be taxable
In other years:
- Most of the payment may be tax-free return of principal
Over time, once the entire original investment has been returned, future payments become fully taxable.
But many retirees enjoy years of partially tax-free income first.
👉 Curious what your tax-efficient income could look like? Schedule a call with me and I’ll run the numbers for you.
Strategy #4: Timing Income to Avoid Higher Tax Brackets
Sometimes the biggest tax advantage comes from timing your annuity income properly.
I recently worked with someone who had:
- High income from bonuses this year
- Plans to retire next year
If he started annuity income immediately, it would push him into the 37% tax bracket.
So instead, we looked at:
- Using a non-qualified annuity
- Structuring early payments as return of principal
Because earnings aren’t credited until the first anniversary, his early payments were 100% tax-free return of premium.
That allowed him to:
- Start income now
- Avoid jumping into a higher tax bracket
Small adjustments like this can make a huge difference in retirement taxes.
When Annuities Can Help Reduce Taxes
Annuities aren’t magic tax shelters — but they can help when used correctly.
They may reduce taxes when:
- You combine them with Roth conversions
- You use non-qualified after-tax funds
- You time income strategically
- You structure payments to return principal first
But every situation is different.
The right strategy depends on:
- Your income sources
- Your tax bracket
- Your retirement timeline
- Your investment buckets
That’s why I always build a custom plan before recommending any annuity.
Conclusion
Yes — annuities can reduce taxes legally.
But the real key is how they’re structured and where the money comes from.
Used properly, they can provide:
- Guaranteed lifetime income
- Partial tax-free income streams
- Strategic Roth conversion opportunities
- Better control over retirement tax brackets
And that combination can make a huge difference in how much of your retirement income you actually keep.
Need help with finding the best annuity for your retirement?
Click here to schedule a call with me.
On the call, I can help you:
- Determine what type of annuity is best for you
- Find the highest paying annuities for your unique situation
- Answer any other questions you may have