Annuities

Annuities are especially attractive to retirees because they assure an income for life. They’re often held as deferred annuities as a back up for those later retirement years as a supplement to other retirement income or when savings become depleted. But many retirees will die before tapping their deferred annuity. What are the tax consequences to the annuity beneficiary and should other options be arranged?

A deferred annuity offers a distinct tax-benefit. It’s earning grow tax-deferred. For the same annual return as a taxable investment, a tax-deferred investment compounds faster because none of the earnings are taxed away each year. However those tax-deferred earnings will eventually be taxed upon withdrawal, whether by you or the annuity beneficiary. Your contributions to the annuity, though, will not be taxed. This is the case in ‘nonqualified’ annuities which are funded with after tax contributions.

Annuitant’s taxation
If a partial withdrawal is made, the IRS presumes that earnings come out first – so that these are completely taxable. But under regular monthly payments – a portion of each payment is not taxed but treated as a return of your nontaxable contributions. An exclusion ratio calculated by the insurance company designates that untaxed portion. When, after some number of payments and you’ve received all your contributions, all future payments will be fully taxed as income.

Beneficiary taxation
After tax contributions made by the deceased owner will remain  untaxed when received by the beneficiary. And of course, all those tax-deferred earnings within the annuity will be taxed as ordinary income to the beneficiary.

Usually, if the annuitant had begun receiving lifetime payments, no benefits would be left for the annuity beneficiary. But if the contract called for a fixed term guaranteed payments, the beneficiary would received those remaining payments taxed at the deceased’s exclusion ratio.

If the annuity owner died before beginning annuitization, provision may be made for either a lump sum distribution or a series of payments. For the lump sum payment, the beneficiary would only pay tax on the earnings portion.

But in the case of a series of guaranteed payments, the beneficiary would not be required to pay taxes on any of the payments until the deceased owner’s contribution were fully received. Any payments beyond that would be fully taxed as ordinary income.

An annuity beneficiary, who earns a substantial income already, can lose a lot of that taxable portion of the annuity as he’s pushed into a high tax bracket. So, if annuity owner decides not to annuitize, he may use his annuity’s value to switch to another option better suited to his beneficiary.

Note: Annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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An investment’s return is what most people analyze each year. However, what really counts is how much you hold on to after taxes. After all, that’s what you get to spend. If you’re shopping around for CDs, you may want to look at an alternative idea that will let you keep more of what you earn.

Suppose that you are considering a five-year jumbo CD. The certificate’s earnings may push your provisional income over the government’s threshold (provisional income is the income calculated by IRS to determine if and how much of your Social Security income becomes taxable). The result is that more of your Social Security check will become taxable when you add interest from CDs. 

The solution could be an immediate annuity that will pay you an income for five years (five-year certain). Part of that income will be taxable, while the rest considered a tax-free return of your investment. At the end of five years, the payments stop. To replace the funds you put into the immediate annuity, you would invest in a five-year fixed annuity. Interest earnings on the fixed annuity are tax-deferred, and not counted towards the government’s threshold of taxation of Social Security income.
  
The result is that you would have one investment that is partially taxable and another that is tax-deferred, therefore your provisional income should go down. With the right planning, you may possibly reduce it to the point that you would not have to pay income taxes on any of your Social Security benefits. Additionally, a decline in your adjusted gross income will lower the floor on medical expense deductions, and miscellaneous itemized deductions.

When the five years are up, you could remove funds from the fixed annuity, pay the income annuity tax, and purchase another immediate annuity. Or you could annuitize the fixed annuity for lifetime payments.
Much of this strategy depends on your current tax bracket, itemized deductions, exemptions, and income requirements. Therefore, in order to make sure this is an appropriate solution for you, we would need to include these factors in your analysis.

Ask your retirement advisor to give you an analysis of a split annuity.

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