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I had a client come to me with an annuity he had bought 14 years previously. He wanted to cash it in. He originally paid $110,000 for the annuity and the day he came to me it was worth about $200,000.
I told him when he surrenders the contract and gets the $200,000, he would owe taxes on the $90,000 gain. He responded, “No problem, it will be a long-term capital gain and I have losses I can offset it with.”
I had to tell him the bad news, “Annuities are not eligible for capital gains tax treatment. All of the $90,000 will be taxed as ‘ordinary income’.”
This extra $90,000 would put him in a higher tax bracket and increase his medicare premiums.
This story points out one of two tax traps that annuities have and are in my experience not fully explained when they are sold. During downturns in the stock market, annuities are presented as alternatives to stock investments. Annuities are insurance products and thus offer guarantees of minimum interest and income.
Annuity sales people tout “tax-deferral” of annuities but fail to explain that appreciation on any investment is “tax-deferred” until it is sold. Premiums/deposits are paid into an annuity “after-tax.” (Sometimes annuities are sold within a retirement account and then the premiums/deposits are “tax deductible.” There are other problems to this that will require another article to explain.) The growth within the annuity contract is not taxed until it is withdrawn.
The rest of the story about the tax-deferral is the part about it being taxed as “ordinary income” and not “capital gains.” If a person buys any type of investment, real estate, art, bonds, or stocks, the amount paid is called a basis and is subtracted from the gain pro-rata. So, if a person were to buy $110,000 worth of IBM stock and hold it for 10 years and the stock appreciates to be worth $200,000, the appreciation would not be taxed. (Dividends paid on the stock were taxed each year they are paid in, but most would qualify for capital gains taxation.)
Basically the $90,000 would be deferred for taxation purposes until the stock is sold. When it is sold, the gain is treated as a long-term capital gain and taxed at a rate of 0%—20% and can be offset by any long-term capital losses. This can make a significant difference to an individual’s portfolio.
My client asked if he just cashed out half of his annuity and took out only $100,000 would that lessen his tax payment? Unfortunately, no. Tax rules say that the gain in the annuity must be taken out first. This is referred to as the “First In — Last Out” rule. Of the $100,000 withdrawal, $90,000 of it would still be taxed as “ordinary income.”
Compare that with the IBM stock example. If you sold half of the stock, only $45,000 of the $100,000 sold would be taxed as long-term capital gains, the other $55,000 is just basis. There is no “First in-last out” rule on investments.
The second and worst tax trap of an annuity is the loss of the “step-up” in basis at death. All investments, real estate, a business, stocks, art, precious metals, give the heirs at death a basis “step-up” that upon the owner’s death the new owners (heirs) take a new basis in the investment equal to the investment’s value at the time of death. This is a very big benefit. “Step-up” in basis allows inheritances to be tax-free.
Annuities do not get a “step-up” in basis because it is an insurance contract, not an investment. Investments are subject to risk, they can go down in value, but an annuity contract has guarantees.
If my client in the story were to die, his children would have to pay the taxes as “ordinary income” on that $90,000 of gain. If instead it was IBM stock, they would get a new basis of $200,000 (value at death) and could sell it for no gain and no taxes. My client is in the 15%—22% tax bracket and his children are in the 32% bracket.
The two tax traps of annuities are:
- All gains are taxed as “ordinary income” not as capital gains; and
- There is no “step-up” in basis for annuities at death.
These two traps are almost reason enough not to use an annuity in place of an investment. Yes, an annuity comes with guarantees and you can never lose all of your money, but the guarantees have a cost.
These tax traps are that cost.
For my client, we were able to find a reasonable solution to spread the taxes out over lifetime payments (annuitization). It’s not exactly how he wanted to use the money, but it was the best he could do. Think twice before purchasing an annuity and consider getting a second opinion from a Certified Financial Planning Professional™.
Wes Shannon CFP® is a Certified Financial Planning Professional for Brazos Wealth Advisors.