Which of the following best explains how annuities receive favorable tax treatment?

• A. Contributions to annuities are always tax-deductible.
• B. All annuity payments are completely tax-free to the recipient.
• C. Annuities are exempt from all state and federal taxes.
• D. Earnings within an annuity grow tax-deferred until withdrawn.

Answer: (D)

Verified step by step guidance

1. Understand the concept of an annuity: An annuity is a financial product that provides a series of payments over time, often used for retirement planning. Contributions to annuities are typically made with after-tax dollars unless part of a qualified retirement plan.
2. Clarify the term 'tax-deferred': Tax-deferred means that earnings within the annuity (such as interest, dividends, or capital gains) are not taxed in the year they are earned. Instead, taxes are deferred until the funds are withdrawn.
3. Analyze the options provided: Evaluate each statement to determine its accuracy. For example, contributions to annuities are not always tax-deductible unless part of a qualified plan, and annuity payments are not completely tax-free. Additionally, annuities are not exempt from all state and federal taxes.
4. Focus on the correct explanation: The correct answer is that earnings within an annuity grow tax-deferred until withdrawn. This means that the growth of the investment inside the annuity is not taxed annually, providing a tax advantage by allowing the investment to compound over time.
5. Conclude the reasoning: Tax-deferred growth is a key benefit of annuities, making them attractive for long-term savings and retirement planning. When funds are withdrawn, they are subject to taxation based on the recipient's income tax rate at that time.