Annuities… is tax deferral really a benefit..? That depends.


When it comes to understanding annuities, complexity is not the only issue, it’s just downright confusing. As a consumer, more than one challenge is before you. Not only is it difficult to make heads or tails of what you’re buying, but sifting through all of the fine print making sense of details presents another set of obstacles. At best, it’s an exercise in futility.

As a result, your best ally becomes the salesperson trying to sell you the annuity. This being the case, it will serve you well to understand some of the basic features and tax laws surrounding the purchase of annuities. Knowledge is certainly power in this scenario and can keep you from making a poor decision.

A main benefit advertised regarding annuities is tax deferral. Tax deferral is a technique that can lead to an increase in wealth. But if tax-deferral is the only reason for purchasing an annuity then other options should be explored before signing on the dotted line.

To better understand, we’ll create a hypothetical person and call her Mrs. Smith. Let’s say Mrs. Smith has $250,000 not held in an IRA or any other qualified plan. If Mrs. Smith elects to place her money in an annuity the tax on growth is deferred until withdrawn. Not a bad idea. But what else should Mrs. Smith know before buying?

First of all, the growth of money in an annuity is taxed at ordinary income tax rates. If Mrs. Smith is a high income earner, then ordinary income tax is not the best, or only, tax rate available. As of writing, the top tier for federal long-term capital gains tax is 15-percent. The top ordinary income tax bracket is 35-percent, a whopping 20-percent more.

If deferring taxes is goal, an option to consider is a tax-efficient investment portfolio. Done properly, it can minimize current taxable income and offer lower the long-term capital gains tax rates. A side note: Anytime you invest money in the market you are exposed to risk. However, when you purchase an annuity from an insurer you have others risk exposures (I’ll cover this in another post).

If your not in a high ordinary income tax bracket then there is still a benefit to long-term capital gains over ordinary income gains. As of writing (2012), If filing taxes at the 10 and 15-percent ordinary income tax rates, long-term capital gains is zero. If filing taxes at the 25-percent or higher rates, the 15-percent federal long-term capital gains rate applies. In both cases your tax rate is 10-percent lower.

Simply put, long-term capital gains over ordinary income taxes can be anywhere from 10-percent to 20-percent lower when money is withdrawn from your account. Not a bad deal. Another side note. If you have an annuity and are under the age of 59 ½ you will be subject to an IRS imposed 10-percent penalty if you withdraw money.

Placing non-IRA money into an annuity treats the growth with the same penalty as you find in an IRA. The penalty applies to growth only in a non-IRA annuity, but none-the-less it’s a penalty.

Annuities are LIFO, meaning you must withdraw interest first before you can get to the original amount. So if you need money from your annuity before 59 ½ you become subject to an early withdrawal penalty on growth.

Another important issue with annuities deals with death. When an annuity owner dies and the named beneficiary receives the annuity death benefit, all growth in the annuity is taxable at the ordinary income tax rate of the beneficiary. In contrast, when an investment account passes at the death of the owner any capital growth in the account receives a fair market value step-up in basis.

Here is our hypothetical scenario: Mrs. Smith buys a $250,000 non IRA annuity. Fifteen years later her annuity value equals $450,000. Subsequently Mrs. Smith dies. The beneficiary is responsible for the tax on the $200,000. Furthermore, it is the beneficiaries ordinary income tax rates Rev. Rul. 79-335, 1979-2 C.B. 292, not Mrs. Smith’s, on which the taxes are calculated.

Compare this to a tax-efficient investment account with the same level of capital growth. At the death of Mrs. Smith, the one who inherits the investment account receives a step up in basis. The new owner of the account has no income tax issues if the securities are sold at the same value as the fair market value at date of Mrs. Smith’s death. A nice benefit compared to ordinary income tax liabilities.

So, if buying an annuity is under consideration know what tax benefits best meet your needs. Taking one benefit might cause you to sacrifice another and vice versa. A little pre-planning will do much.