The Taxation of Annuities

You have put your hard earned assets in one or more annuities. Do you how your money is taxed when you take it out of the annuity? Do you know how annuity withdrawals are taxed to your beneficiaries after you are gone? If you are like most of my clients with annuities, the taxation of your annuity was not fully explained to you by the annuity salesperson. Just this past week, I had a client who was very surprised when I explained how her annuity was going to be taxed.

As we have discussed in previous columns, annuities are among the highest commission financial products out there. According to industry disclosures, annuity salespersons typically get initial commissions of 6%-8% of the amount you deposit into the annuity, and continuing annual commissions of ½%-1% of the amount left in the annuity.

Chartered Financial Analyst Scott Fearon in his book Dead Companies Walking, stated: “As money managers, our customers trust us with their livelihoods…We charge them enormous amounts of money in fees…to safeguard that wealth and grow it as much as possible. But that’s not what happens. It seems like more and more people in my business see their clients’ money as a convenient pool of assets they can exploit to grow their own wealth.”

Also as we have discussed in previous columns, when you buy a deferred or variable annuity, your money is locked up for a certain period of time. Unless you meet some very limited and specific exceptions, when you take your money out of the annuity before the lock-up period is up, you pay a penalty. I have seen these early withdrawal penalty periods as long as 20 years and early withdrawal penalty rates as high as 50%. So now to the discussion about how annuities are taxed.

Deferral of income taxes with annuities.

With deferred and variable annuities, you put your money in the annuity and do not get taxed on any of the income earned until you pull the money out of the annuity. During your lifetime, when you take money out of your annuity, it will generally be taxed to you either to the extent of previously undistributed earnings in the annuity, or based upon the income accumulated in the annuity as a percentage of the total value of the annuity. The income tax on the earnings of the annuity is deferred so long as the earnings are not pulled out of the annuity. So the annuity contract is basically a tax deferral wrapper around an investment. Very often, the investment is in mutual funds.

The downside of this is that all of the income distributed out of the annuity is taxed as ordinary income, even if the distribution is due to the appreciation of the value of the mutual fund in the annuity or a capital gain distribution. If you held the mutual fund directly and not in an annuity, you typically only pay ordinary income taxes on the dividends and interest earned by the mutual fund. Gains upon sale of the directly owned mutual fund or capital gains distributions therefrom are taxed at capital gains rates, which top out at 20%, instead of the 37% maximum ordinary income tax rate.

Annuities are not necessary for deferral of income taxes on IRAs.

I’ve had a number of clients who have told me that they put their IRA into an annuity because the annuity salesperson told them they could defer the taxes on the IRA when it is put in the annuity. They were given the mistaken impression that they would have to pay taxes on the entire balance of their IRA unless they put it all into the annuity. However, IRAs by definition, are tax deferral vehicles.

For traditional IRAs, you put pre-tax money into the IRA and pay tax on the funds and their earnings when you take them out of the IRA. For Roth IRAs, you put in post-tax dollars; you can take your contributions out tax-free anytime, but after five years, all the earnings also come out tax-free. Why would you ever want to lock up your IRA and pay an annuity company up to 4% per year to either hold your traditional IRA tax deferred money in a second tax deferral wrapper, or hold your tax-free Roth IRA money in a tax deferral wrapper? I have yet to hear any justifiable reason to ever put IRA money into an annuity, other than to make money for the annuity peddler and the annuity company.

“Enhanced” death benefit 100% taxable as ordinary income to beneficiaries.

Some annuity contracts have a provision to pay an additional amount over and above your investment in the contract after your death. This is usually called an enhanced death benefit. The annuity companies are not giving this benefit for free. If your annuity contract has an enhanced death benefit, you are paying extra fees for this benefit.

Many of my clients who have annuities with an enhanced death benefit have said that they were told by the annuity salesperson that this enhanced death benefit is just like life insurance. Well, the enhanced death benefit is paid after your death, like life insurance. However, that’s where the similarity ends. Unlike life insurance, the annuity enhanced death benefit is taxable to your beneficiaries. Life insurance is paid to your beneficiaries completely income tax-free. On the other hand, an annuity enhanced death benefit is fully taxable to your beneficiaries at ordinary income tax rates. Ouch!

No step-up in tax basis on death with annuities.

If you own appreciated stocks or mutual funds, your beneficiaries get a step-up in tax basis upon your death. Upon the sale of those stocks after your death, your beneficiaries only have to pay taxes on the gain since your date of death. And they only pay the lower capital gains tax rates, not ordinary income tax rates. All of the appreciation before your death escapes all income taxation, forever.

However, there is no step-up of tax basis with annuities. All gains in excess of your investment in the annuity is fully taxable to your beneficiaries when withdrawn out of the annuity. In addition, the annuity appreciation that is fully taxed to your beneficiaries is taxed at ordinary income tax rates, instead of the more favorable capital gains rates.

So the next time an annuity salesperson tries to peddle an annuity to you, ask them the following questions:

  • How much money are you going to make and when?
  • How long is the early withdrawal penalty period?
  • What is the early withdrawal penalty rate?

What are the annual continuing internal fees and charges?

Published edited October 21, 2018 in The Times Herald newspaper Port Huron, Michigan as: Annuities can come with big tax bite.

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