To take full advantage, pick the right type of annuity and take
care to set up your beneficiaries correctly.
By KEN NUSS,
CEO / Founder | AnnuityAdvantage
December 11, 2019
Deferred
annuities offer powerful tax advantages. While annuity tax rules aren’t too
complex, understanding them and properly naming beneficiaries assures you’ll
get the maximum tax advantage.
Annuity
interest is not taxed until it’s withdrawn. With a deferred annuity, the owner
decides when to withdraw interest and pay taxes on it.
The
flexibility to wait until you need the income has many advantages for the
annuity owner, as well as the spouse and beneficiaries. Deferred annuities
include fixed-rate, fixed-indexed and variable annuities.
Other
interest-paying investments — such as money market accounts, savings accounts,
certificates of deposit and bonds (except tax-free munis) — create taxable
income unless they’re held in a retirement account. You must claim the interest
earnings as income on your 1040 form and pay tax even if you don’t withdraw or
use the income.
The Stealth Power of Tax Deferral
Compounding
occurs when interest is paid on previously earned interest. So, let’s suppose
you have a CD that’s paying 3.0%. All future interest will be compounded on the
total of principal and accumulated interest.
But,
unless your CD is in an IRA or another tax-qualified account, you’re not really
getting 3.0%. For example, if you’re paying 25% in combined federal and state
income taxes, you’d be earning only 2.25% net.
With a
deferred annuity, if you’re earning 3.0%, you’ll keep it all for compounding.
By allowing the annuity interest to remain untaxed and in your account, your
money will grow and compound faster than money in a taxable account earning the
same before-tax rate. At 3.0%, compounded annually, $10,000 will grow to
$13,439 in 10 years. At 2.25%, you’d have $12,492. The higher your tax bracket
and the longer you defer, the bigger the advantage.
Avoiding Taxable RMDs with the Right Kind of Annuity
Annuities
can be purchased with pretax funds or after-tax funds. You can place an annuity
within an IRA, Roth IRA, 401(k) or 403(b) plan. Such annuities are sometimes
called qualified annuities.
Nonqualified
annuities are purchased with funds that have already been taxed. In other
words, you hold it in a taxable account instead of within a retirement account.
Annuities
held in standard IRAs are subject to the required minimum distribution (RMD)
rules, just like other IRA investments. This rule requires you to take
withdrawals each year after you reach age 70½. Each withdrawal is fully taxable.
But
nonqualified annuities are not subject to RMD rules, and that’s a big benefit.
This lets interest continue to compound without tax until you withdraw it. For
instance, if your annuity earns $1,000 of interest and you withdraw $200,
you’ll only pay tax on $200. The balance, along with your principal, continues
to compound tax deferred.
The
interest credits and gains from all types of annuities are taxed as ordinary
income, not long-term capital gain income. But your original investment (the
principal) in a nonqualified annuity is tax-free when it is withdrawn, because
you bought the annuity with money that had already been taxed.
Be Careful to Name Your Beneficiaries Correctly to Maximize Tax
Advantages
If you’re
married, your spouse does not have to pay taxes on an annuity when you die if
you’ve named your spouse the primary beneficiary. Then, your spouse can assume
ownership of your qualified or nonqualified annuity at your death and continue
to earn tax-deferred interest. On the other hand, because children cannot
assume ownership of a parent’s annuity, they do pay taxes on inherited
annuities. So, it’s important to make the right designations when choosing your
beneficiaries.
Here are
two examples.
1. Jack
Hill and Jill Hill are married, and Jack has an annuity in his name. They
have three children. Jack would name Jill Hill – Spouse, as his primary
beneficiary. And he would then name their three children as contingent
beneficiaries.
If Jack
dies first, Jill will become the new owner of the annuity, and she would pay no
taxes on the annuity. Their children would then become the primary
beneficiaries. If Jill dies first, Jack continues as the owner and the children
become the primary beneficiaries.
2. Jack
Hill and Jill Hill are married and jointly own an annuity. The
primary beneficiary designation should read “surviving spouse” and the
contingent beneficiaries should be their three children.
Joint
annuity owners should not name their children as primary
beneficiaries. In this example, if the Hills had put their children down as the
primary beneficiaries, once either Jack or Jill passes away, annuity benefits
would be payable to their children rather than the surviving spouse. And the
accrued interest would be taxable.
Most
often a single annuity owner will name their child or children or other
relatives as primary beneficiaries. The next most common designation is to name
a living trust as the beneficiary and allow the trust language to govern the payout.
Pick the Right Payout Option, Too
Most
insurers let adult children beneficiaries choose their payment option. There
are three choices:
1. Taking a
lump sum payout means that all accumulated interest is taxable in one year.
2. Under the
five-year option, the beneficiary can take their share of the annuity over a
five-year period and spread taxes over five years. This often leads to a lower
tax payment.
3. The third
option is receiving benefits over the beneficiary’s life expectancy.
To see
the effect of this beneficiary decision-making process, let’s look at an
example. Consider a 50-year-old unmarried male beneficiary with taxable income
of $140,000, currently in a 24% federal tax bracket. As of 2019, his federal
tax rate increases to 32% on income above $160,725. He inherits a nonqualified
annuity with a value of $200,000 and a cost basis of $100,000.
Lump Sum
Payout: Must report $100,000 in additional taxable income.
Tax on
first $20,725 at 24% = $4,974
Tax on
balance of $79,275 at 32% = $25,368
Total
federal tax = $30,342
Five-Year
Payout: The $100,000 gain is spread out evenly over five years,
preventing him from exceeding the income limits of his current tax bracket.
Total federal tax paid over five years = $24,000 at 24%.
Lifetime
Payout: The $100,000 gain is spread out over his life expectancy of
approximately 30 years, reducing significantly the taxable amount each year.
Because most people experience reduced income and are in a lower tax bracket
after retirement, this option would likely produce the lowest total tax paid of
the three methods.
The Bottom Line
Tax laws
gives annuities tax advantages because they’re designed to help people save
more for retirement. These advantages also come with rules you need to follow
to get the most benefit, so take care to follow them. One last tip: withdrawals
before age 59½ may be subject to tax penalties. Annuities are meant for
long-term savings.
Retirement-income
expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of
fixed-rate, fixed-indexed and immediate-income annuities. It provides a free
quote comparison service. He launched the AnnuityAdvantage website in 1999 to
help people looking for their best options in principal-protected annuities.
https://www.kiplinger.com/article/retirement/T003-C032-S014-deferred-annuities-can-deliver-major-tax-advantage.html
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