The Real Story Behind Annuity Taxes
Annuities can be purchased in both qualified and non-qualified investment accounts. Qualified accounts such as Traditional or Roth Individual Retirement Accounts (IRA), Simplified Employee Pensions (SEP) or Defined Benefit Plans like a 401(k) are tax-deferred and typically come with an age restriction for penalty-free withdrawals. Depending on the type of retirement account the annuity is purchased in and other considerations, funds withdrawn before 59.5 or earlier can have a 10% penalty in addition to any taxes owed. Non-qualified accounts such as savings, money market, and inheritance accounts are not tax-deferred, funded instead from after -tax income resulting in only interest or capital gains being taxed. However, variable annuities are unique as they provide tax-deferred benefits within non-qualified accounts. The Financial Industry Regulatory Authority (FINRA) says holding a deferred annuity within a traditional IRA provides no additional tax advantage[i]—yet in recent years the majority of variable annuity assets have been held in qualified retirement plans[ii], which demonstrates the complexity of the product and the misunderstanding many investors may have with it. FINRA recommends most investors take maximum advantage of all other available tax-advantaged accounts before considering annuity products [i]—we agree.
More: Download Annuity Insights: Nine Questions Every Annuity Investor Should Ask
Another often overlooked disadvantage of annuities is the tax rate payable on earnings. While equities held for over a year can get a preferable capital gains tax rate on price appreciation depending on taxable income, as well as a less favorable ordinary rate on dividends, annuities are taxed entirely at the typically higher ordinary income rate. If an investor's income tax rate is higher than the long-term capital gains tax rate, an annuity may not be advantageous from a tax standpoint. If investors have a large income stream outside of their annuity, this could leave them potentially paying higher tax rates throughout their retirement—when their income payments matter most. Moreover, annuities don't receive a step-up in cost basis on the death benefit value—potentially leaving estates or heirs with a large tax bill. This is not the case with inherited equities in taxable accounts—the cost basis is readjusted to market value at the time of the decedent's passing. Lastly, like other investment losses, annuity losses may be tax deductible; However, the appropriate method for doing so has not been clarified by the Internal Revenue Service (IRS)—another reason we recommend you consult a tax advisor.
Annuitization can affect the taxes paid on the contract. If annuitized, withdrawals will generally consist of both principal and earnings amounts, keeping taxable income (on earnings only) more manageable. However, if distributions are made without annuitization, gains are withdrawn first—leaving an investor with more taxable income and a higher tax bill in the early years of withdrawal period.
Once purchased, investors can continue to defer taxes through a 1035 Exchange (replacing one annuity with another). This option can also leave investors with another costly problem—a new surrender penalty period of up to 10 years before penalty free withdrawals can be taken.
Understanding tax implications is one important element in helping to achieve financial goals in retirement. Failing to plan ahead can prove costly. In our view, learning the relative strengths and weaknesses between various investment products can make the difference between a happy, healthy retirement—and taxes are an integral piece the puzzle.
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[i] Source: Financial Industry Regulatory Authority, Inc., Variable Annuities: Beyond the Hard Sell (FINRA, 8/31/2009).
[ii] Source: Insured Retirement Institute (IRI) Factbook 2015, 14th Edition, page 153, Figure 13-10.