A Hidden Tax on Annuities Lurks in the Health Care Reform Law

retirement saving and annuities
retirement saving and annuities

The Obama administration is trying to encourage people to buy annuities

to ensure that they don't outlive their savings. But a little-noticed provision of the new health care reform law will slap a 3.8% tax on payouts from annuities purchased by high-income earners outside their workplace. And, not surprisingly, the life insurance industry isn't happy about that.

Life insurers, which have sold approximately 15 million so-called "nonqualified" policies containing some $710 billion in assets, hope to get this particular provision of the Health Care and Education Reconciliation Act of 2010 repealed. The health care reconciliation bill made amendments that House wanted for the Patient Protection & Affordable Care Act, which President Obama signed into law on March 23.

"This is a countermand to all that this administration has been doing since they took office in encouraging saving for retirement and using annuities as guaranteed lifetime income," says Catherine Weatherford, president and chief executive officer of the Insured Retirement Institute (IRI), a Washington, D.C., trade association that represents the annuity industry.

A Plea Fell on Deaf Ears

To help pay for the $940 billion health care reform measure, the administration and congressional Democrats included a 3.8% Medicare payroll tax on single people who earn more than $200,000 a year and couples earning over $250,000 a year. Starting in 2013, the tax will be applied to annuity distributions, interest, dividends, capital gains, rents and royalties. While there are no estimates of how much the annuity portion of the tax may raise, all of the investment taxes are expected to contribute $210 billion over the next 10 years to Treasury's coffers.

"We've got a retirement spike coming," Weatherford says. "Saving for retirement using this vehicle will give them that paycheck for life."

The IRI along with the American Council of Life Insurers, the National Association of Insurance and Financial Advisors and the National Association for Fixed Annuities co-signed a March 24 letter that urged the Senate in vain to leave the annuity provision out of the bill. As defined-benefit pensions continue to vanish from the workplace, "Individual annuities are an important tool used by millions of Americans to accumulate retirement savings and to secure lifetime retirement income," the letter said, noting that 78 million working Americans lack access to a workplace retirement plan.

The 3.8% Medicare tax on income received from individual annuities "would serve as a disincentive to save in a product that uniquely allows an individual to accumulate retirement savings and to guarantee that savings can never be outlived," the letter said, and it concluded: "In today's savings-poor environment, policy-makers need to create incentives for retirement planning."

An Inconsistent Strategy

Insurers also point out that the Obama administration has taken steps to try to promote annuities in other areas. The administration's Middle Class Task Force report issued in January included a call for "promoting the availability of annuities and other forms of guaranteed lifetime income, which transform savings into guaranteed future income, reducing the risks that retirees will outlive their savings or that . . . retirees' living standards will be eroded by investment losses or inflation."

The Labor and Treasury Departments have issued a request for information to look at possible impediments to the use of annuities and other types of lifetime guaranteed income in employer-sponsored plans and Individual Retirement Accounts. In his fiscal 2011 budget, President Obama also included a provision that would make it easier for holders of nonqualified annuities to take partial payouts without having to exchange their annuity contracts.

"The inclusion of annuities in the [Medicare] tax flies in the face of what we're trying to achieve here on lifetime security," comments Alane Dent, vice president of federal affairs for the American Council of Life Insurers.

Maintaining "Favorable Tax Treatment"

The administration disagrees that the tax will discourage people from choosing annuities. In a March 23 letter to the IRI, Michael Mundaca, acting assistant Treasury secretary for tax policy, said the tax is "not a proposal that is designed to or should discourage individuals from saving through purchasing annuities." The tax "does nothing to alter the favorable tax treatment of annuities inherent in deferring taxation of annuity earnings until annuity payments are made and then treating a portion of each payment as a return of the previously taxed funds used to purchase the annuity," he wrote.

Mundaca also noted that the tax applies only when an annuitant's income exceeds the $200,000 or $250,000 annual threshold.

But nonqualified annuities aren't typically sold to low-income people, say Diane Boyle, director of federal government relations for the National Association of Insurance Financial Advisors. Such plans usually aren't suitable for lower-income earners, who may not have the funds to purchase annuities, she says. Moreover, the income threshold "isn't that high for areas like Washington, New York and [Philadelphia]," where two-earner middle-income couples easily make that much, she adds.

"The financing of health care reform should not be paid for on the backs of individuals who are planning their retirement," Boyle says. Even if it affects only high-income people, "It does have a chilling effect any time you begin taxing lifetime income," the IRI's Weatherford says.

Coming Back for More?

Complicating the tax is that while it's fashioned as a tax primarily on annuity payouts from nonqualified plans, income from employer-sponsored plans such as 401(k)s will also be hit. While annuity income on qualified plans above the threshold amounts won't be subject to the 3.8% tax, allannuity income, including income from qualified plans, is considered in calculating income to meet the tax threshold, Dent of the American Council of Life Insurers explains.

And the insurance industry fears that this won't be the last time it's eyed for new tax proposals. "We're concerned this is a Congress that is looking for ways to finance different initiatives and programs," Boyle says. "They're looking at all areas of the tax code to find revenue. It's concerning that they're finding it in investments and programs that are designed to assist people with their long-term financing for retirement."

Weatherford pledges to try to get the tax repealed: "We think this is so important, we are going to continue to work with this administration and Congress to see if we can look toward repeal of this provision."

Originally published