as ordinary income, which should prompt a discussion with clients: Is it better
to pay capital gains taxes now or defer taxes until retirement? The answer
depends on your client’s retirement tax bracket, insurance, other income
streams, and his estate plan.
Deferred annuities are often sold to clients on the basis of their special
tax treatment: investment earnings are not subject to taxation until they are
withdrawn by the client. For clients who do not need immediate income from their
investment and would prefer not to pay income tax each year on reinvested
earnings, the tax savings can be substantial. Amounts that would otherwise be
paid out in taxes can remain in the contract to generate additional investment
earnings, thus magnifying the impact of compounded interest.
But tax-deferred is just that: deferred. And because annuities are long-term
holdings—contracts that are generally held for the rest of the client’s
life—clients need to have an idea about when, under what circumstances, and at
what tax rate the deferred taxes will become due. This information will enable
them to decide if an annuity is right for them, and if so, will help them
understand how to manage the contract for the best overall after-tax result.
Despite the controversy surrounding them, annuities are inherently neither
good nor bad. They involve tradeoffs just like any investment and are suitable
in some circumstances but not others. The advisor’s role is to present all the
information and lay out the tradeoffs so clients can decide for themselves if
the investment is right for them.
Ordinary income tax
One of the biggest tradeoffs in annuity taxation is that the investment
income—when it is eventually received and taxed—is subject to ordinary income
tax. This could result in a tax rate as high as 35% (plus state tax), depending
on the client’s tax rate at the time the income is taken.
This applies to beneficiaries as well as the original purchaser. Clients who
expect to be in a lower tax bracket when they start taking annuity withdrawals
must consider the possibility that they may never make it. Instead, their
beneficiaries may inherit the contract and be forced to pay taxes at a high rate
when they withdraw the income.
Withdrawing money from an annuity
There are two ways to get money out of an annuity contract. One is a partial
withdrawal, which is simply a request for a check, at any time and in any
amount. Most annuity contracts allow partial withdrawals up to a certain amount
each year without surrender charges. Partial withdrawals come first from
earnings and are fully taxable.
The other way to get money out of an annuity contract is to annuitize, or set
up a program of periodic payments. This is a tax-favorable strategy because a
portion of each annuity payment is tax-free return of principal. However, it
should be noted that annuitizing does not change the rate at which investment
income is taxed. All it really does is continue the tax deferral on the
investment earnings. The rate of taxation doesn’t change unless the client’s tax
bracket changes.
Fixed annuities are often compared to CDs, money market accounts, and even
bonds. Variable annuities are often compared to mutual funds or a diversified
portfolio of securities. Here the client has to weigh the tradeoff between
deferring the tax and eventually paying it at ordinary income tax rates (the
annuity) vs. paying tax each year on investment income but having some or all of
it be subject to the favorable long-term capital gains rate (securities and
other capital assets). When weighing the alternatives, clients should consider
their own individual objectives:
- When do they want to start taking income? A very long
deferral period could make up for the higher tax rate the income would be
subject to under the annuity. But if a client will be taking income relatively
soon—say, in 10 or even 20 years—the tax deferral may not make up for the higher
tax rate. It may be better to hold securities outside the annuity and pay taxes
at long-term capital gains rates. - What tax bracket do they expect to be in when they start taking
income? According to some very simple back-of-the-envelope,
likely-never-to-be-duplicated-in-real-life calculations shown in Table 1, a
client in the 35% tax bracket is almost always better off paying taxes year by
year at the 15% capital gains tax rate than deferring the income for as long as
30 years and paying at the 35% tax rate. For a 25% bracket taxpayer, it’s a
wash.Ordinary Income Tax Rates vs. Long-Term
Capital Gains Rates20-year deferral 35%
tax bracket25%
tax bracketLong-term
cap gains*Annuity value** $265,329 $265,329 Less taxes $57,865 $41,332 After-tax value $207,464 $223,997 $229,890 30-year deferral Annuity value** $432,194 $432,194 Less taxes $116,268 $83,049 After-tax value $315,926 $349,146 $348,563 Source: Elaine Floyd
* Long-term capital
gains investment, taxes paid year-by-year at 15%
($100,000 compounded at
4.25%—the after-tax return on 5%— for 20 years).
** Return assumptions on
both the annuity and the long-term capital gain investment is 5%.
Starting
value is $100,000.Clients should also be aware that this question is in some sense unanswerable
because our entire income tax system could change by the time they start taking
withdrawals. Also, the question becomes more complicated when you take into
account other parts of the client’s tax situation, such as the taxation of
Social Security benefits. If deferring income via an annuity makes Social
Security benefits tax-free, the deferral becomes more valuable. Furthermore, the
answer to this question depends on the answer to the next question. - Where would the money be invested if it did not go into the
annuity? You can’t compare ordinary-income investments such as CDs and
bonds with a capital-gains investment such as stocks. In other words, the
advantage of capital gains tax treatment outside the annuity is lost on a client
who would prefer the predictability and safety of a CD or other fixed-income
investment. In this case, a client who buys an annuity is not converting capital
gains income into ordinary income, but merely deferring the tax that would
otherwise have to be paid. For these clients, annuities may make sense. - How important are the death benefit and other guarantees?
This gets away from the pure tax question, but if you are comparing an
annuity with other investments, and if the client really likes the insurance
aspect of the annuity, this, combined with the tax deferral, may give the
annuity the edge.
What if a client already owns an annuity?
Let’s face it. Over the years many people have purchased annuities who
shouldn’t have. Or perhaps the purchase made sense at the time but has become
less desirable because of changes in annuity laws and the lowering of the
long-term capital gains tax rate. If you are doing a portfolio review for a new
client who already owns an annuity, how should you advise? If the annuity
compares less favorably to other investments you might recommend, can the client
get out of it? Once you factor in surrender charges, taxes, and other costs,
does it still make sense to bail out of the annuity? Here are the options.
- Complete surrender. If an annuity holder surrenders the
annuity and receives the complete surrender value available under the contract,
the holder must pay income tax on the difference between the amount he has
received and his basis in the annuity. Ouch. However, depending on the client’s
age and other objectives, he may want to take the hit now so he can invest the
proceeds in something else. Don’t forget to factor in the 10% premature
distribution penalty, in addition to taxes and surrender charges, if the client
is under 59½. - Section 1035 exchange. An annuity contract can be exchanged
for another annuity contract without tax consequence under Section 1035. This
preserves the tax deferral and avoids the 10% penalty but doesn’t avoid the
major drawback under discussion here, which is taxation at ordinary income tax
rates. Still, you may encounter a client who owns an annuity that is badly
designed or issued by a financially unstable carrier, in which case switching to
a different annuity is better than keeping the old one or surrendering it and
paying the tax all at once. The client’s cost basis in the new annuity will
generally be the same as the cost basis in the old one. - Gift. A client who wants to get rid of an annuity without
paying a large tax bill may want to give the annuity—and the tax obligation—to
someone else, such as a child, grandchild, or charity. Sorry, this won’t work.
An individual who makes a gift of an annuity contract that was issued after
April 22, 1987, is treated as having received an amount equal to the cash
surrender value of the contract at the time of the gift minus the annuity
holder’s investment in the annuity. The tax hit is essentially the same as if
the contract were surrendered back to the insurance company.
Annuities are complicated investments, and for that reason some advisors shun
them altogether. But advisors and clients who take the time to understand them
in relation to the client’s objectives and other comparative investments may
find that they do the job perfectly for a certain portion of the client’s
assets. Even if you decide never to recommend annuities to your clients, you
should be aware of how they work so you can properly advise clients and
prospects who may already own them. And it is always prudent to consult with a
tax advisor before making any decisions about annuities that clients may hold or
purchase. Tax law changes constantly, and the wrong decision can affect clients
and their heirs for years to come.
References
The Annuity Handbook, Darlene K. Chandler
The Annuity Advisor, John L. Olsen and Michael E.
Kitces
