Annuities can be a great retirement funding vehicle, but they are not without drawbacks. An article in The Wall Street Journal in July pointed out that many people cash in annuities without understanding the consequences and subsequently are surprised by stiff tax liabilities and surrender charges.
What are annuities and how can you avoid their downside?
An annuity is a contract between you and an insurance company. The company agrees to pay a set income for a predetermined number of years during your retirement. You fund your annuity with a lump sum or with regular payments to the insurer.
In general, annuities come in two forms. Traditional annuities grow based on the general interest crediting rate of the issuing insurance company. Variable annuities hold underlying stock and bond mutual funds. With variables, the cash value may increase or decrease depending upon the performance of the underlying investments. A common feature of both forms is the insurance charge, which tends to be a drag on performance compared with a similar investment in nonannuity form.
Annuity options
Annuities offer several payout options. For example, you can elect to receive income for your lifetime or your lifetime and that of a designated beneficiary. If selecting payments for your life only, your income stream will be higher than if you elect a beneficiary to continue receiving payments after your death.
Annuities offer the added benefit of tax-deferred growth, with ordinary income tax due only upon withdrawal. The same 10-percent tax penalty that applies to early withdrawals from qualified retirement accounts also applies to annuity distributions made before age 59 1/2. There is also the added incentive of being able to contribute unlimited after-tax amounts, something you may continue to do even after retirement.
Annuities also offer several estate-planning benefits. When you name family members as your beneficiaries they can (in most cases) receive benefits directly, without the usual wait for your estate to go through probate. When you name your spouse as beneficiary, he or she also has the option of maintaining the annuity and enjoying the tax-deferred growth on earnings.
Dealing with the downside
Investors who surrender an annuity can be surprised by the hefty tax bite. An annuity that has been untouched for 30 years, for example, typically has appreciated significantly. The payout received is considered ordinary income, even though the underlying investments may represent capital appreciation in stocks and funds that otherwise would be taxed as capital gains. Hence the stiff tax bill.
If you are contemplating cashing in an annuity, shop around, both with the issuing insurer and also with the secondary market. Some annuities can be sold to a third party, giving you another option.
Consider taking advantage of a key annuity attribute: A lifetime payout that you cannot outlive.
Planning for the long term
An annuity can generally be “annuitized,” with the issuing insurance company committing to a lifetime monthly payout. This shifts the risk of extended longevity to the insurance company. Using an annuity as a core monthly retirement income source is an underused feature.
There are other options: Leaving the annuity to your heirs or a charity. Unfortunately, designating your heirs as beneficiaries does nothing to avoid the deferred income tax. Unlike many other investments, annuities do not receive a fresh tax cost when they pass through an estate. Accordingly, all of that income will still be taxable to your heirs when they cash in the annuity.
Charitable transfers, of course, fare better. If an annuity is transferred to a charity during your lifetime, you are liable for the deferred income at the time of transfer. But an offsetting charitable deduction is allowed for the full proceeds of the annuity that moves to the charity. Generally, this should produce a charitable deduction that is larger than the income by the sum of the owner’s investment in the annuity contract.
Another option is to pass the annuity to charity after your death by naming a charity as the beneficiary. For those who desire to leave some amount to charity as a bequest, using an annuity is a tax-efficient choice. The charity is not subject to any income taxes when it receives the proceeds. Other assets with no deferred tax liabilities can then be left to your heirs.
Smart handling of annuities can be tricky. They offer many fine advantages but also some serious tax and estate-planning concerns. •
Molly McShane Kelly, CPA, is a tax manager at Tofias PC, and can be reached at mmcshane@tofias.com. The firm, which has offices in Providence, Newport, New Bedford and Cambridge, Mass., provides accounting, tax and consulting services. This has been a general discussion and is not intended as advice.
