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Many retirees have discovered the apparent value of owning tax deferred annuities. However, the possibility of the gain being subject to state and federal income tax, the new Medicare 3.8 percent tax, and the possibility of Federal Estate Tax at the death of the contract owner (annuitant) have created a sizeable tax burden for surviving spouses and children.

There are significant tax advantages that lure retirees to invest in annuities. Normally, all growth and gains on the policy are tax deferred until the contract owner makes a withdrawal. The gain is taxed at the time at ordinary income tax rates. For most investors, these funds are not necessary to live on; therefore they realize many years of tax deferred growth.

The explosion in annuity sales is largely due to the popularity of “indexed” annuities which offer the investor an opportunity to earn a return that is correlated to the S&P 500 index (or other world indexes). The biggest benefit is that they offer downside protection. If the index drops 20 percent you would earn zero and reset for the following year.

Almost all deferred annuities are offered without front-end load but require the owner keep the policy a certain number of years to avoid early surrender penalties. Annual costs vary depending on options and riders selected. Long-term care, critical illness, guaranteed income and enhanced death benefit riders are some of the more popular choices for buyers today.

Investors are very interested in any opportunity to delay paying income tax. In California, a married taxpayer only needs to have $67,751 of taxable income to be in the States 9.3 percent income tax bracket (that goes all the way up to 13.3 percent for higher income earners). Having the ability to have a sizeable sum grow tax deferred for a long period of time has appeal. Couple that with no required distribution at 70 ½ like IRA’s and other qualified plans, provides the annuitant with unlimited “paper” growth.

The “end game” in annuity distributions has always been challenging. The design of these policies was for someone ideally in the 40-55 year old range that was in their peak earning years. Deferring income tax while you are in your top earning years makes sense. When you retire, you may be in a lower income tax bracket (not always of course) and could then withdraw the annuity earnings and hopefully pay income tax at a lower bracket while also having enjoyed the magic of tax deferred growth. Annuity income is treated as “gain out first” to the annuitant.

This model annuitant story does not always play out as illustrated above. Many new retires find that they do not need the income and do not want to have to pay tax if they do not need the money. These polices are also sold to wealthy retirees who have more to invest and would like to lighten their income tax burden on monies they do not need for the foreseeable future.

Both cases cause us to ask the question; when will you ultimately pay income tax (and potentially other taxes) and are there any other alternatives?

At age 60, Jim invested $250,000 in an annuity that has done fairly well over the last 18 years. It is now worth $1,000,000. Now at age 78, Jim is not in need of any additional income and does not want to have to pay more State and Federal tax. With $750,000 of gain, this is subject to the top California income tax of 13.3 (he has other income), the top Federal income tax bracket of 39.6 percent plus the new 3.8 percent Medicare tax and potentially Federal Estate Tax of 40 percent if his estate is over $5,430,000. I will let you and your CPA do all that math, but what you find is this was not a good tax scenario to build up all this gain.

He has a few options that he should consider:

  • Annuitize the money over your lifetime (and maybe a spouse’s lifetime). This involves the insurance carrier paying you back systematic payments of principal and interest over your lifetime. You still have to pay income tax but better to spread it out over a longer period of time.
  • Do the same as above, except take these after tax payments and consider buying a life insurance policy on you and or your spouse’s life. The benefit from the insurance will be Income and possibly Estate Tax free to your beneficiary and likely will be much more than the annuity could have ever grown to! This is a viable strategy up to age 85.
  • Wait until you die and let the beneficiary evaluate their options. Which are:
    • Pay tax on all the gain at your death;
    • Most carriers will allow an additional five years deferral by the beneficiary but then force distribution;
    • The beneficiary can annuitize the money over their lifetime. This might make a lot of sense for someone with a child or children that they want to provide lifetime income after they die.

As I hope you can see, deferred annuities have many great investment components and options but can turn into a tax time bomb if not planned for properly. You should consult your financial planner, CPA and estate tax attorney when deciding on this type of purchase.