Annuities are probably one of the most misunderstood and misused financial instruments of all time. An annuity is a financial product sold by financial institutions designed to accept and grow funds from an individual. Then, upon annuitization, an annuity pays out a stream of payments to the individual either immediately or later. That seems simple enough until you consider all the different types and variations.
There are two kinds of annuities: immediate and deferred. An immediate annuity is one that starts paying out income immediately on an annuitization schedule. A deferred annuity means the contract has not been annuitized yet. The date of annuitization has been deferred. Many people mistakenly believe a deferred annuity implies that it is tax-deferred. While the income is not currently taxed and is indeed deferred until the contract is annuitized and the income is withdrawn, that is not the meaning of a deferred annuity.
Deferred annuities can also be divided into two categories: fixed and variable. Many people believe a fixed annuity is one that pays a fixed rate like a CD. While this is often the case, the annuity is called fixed because it is always denominated at a dollar. This means the value will be worth what you put into it plus any interest that is credited. Variable means the value can fluctuate above and below a dollar. Variable annuities are often invested in mutual funds called sub-accounts, which rise and fall based on the financial markets.
There have been books written on annuities and strategies that use them. I want to focus on the common mistakes that people and their advisers make with annuities. Specifically, the rest of this article will focus on the errors made by taking living benefits. Our next article will address the mistakes made by taking death benefits.
Annuity Traps Part I – Living Benefits
Tax-Deferral: Annuities only receive tax-deferred treatment if a natural person owns them. Income earned in an annuity owned by a trust, partnership, or other entity is taxed each year, just like a bond or mutual fund. The exception to this is if the trust has a natural person’s beneficiary, and the beneficiary can exercise ownership rights as the trustee. In this case, the annuity is deemed to be owned by a natural person. The trap we find most often is when Mr. Smith makes his living trust the annuity owner. He has all the rights and privileges as a trustee to qualify for tax deferral. When he dies, his trust becomes irrevocable, and the rights of the surviving beneficiary are now restricted. All the deferred income that has accumulated in the contract is now taxable in the year of death.
Gifting: When you gift stock to someone, they receive the stock with the same cost as the donor. Therefore, if you paid $10 per share for the stock and it is now worth $100 per share, when you gift the stock to your son, his cost is also $10 per share. He will pay capital gains tax when he sells the stock. When you gift an annuity, the recipient gets a step-up in basis to the current value. They also get a tax bill for all the deferred appreciation. Giving an annuity triggers taxation of all the deferred earnings.
Early Withdrawals: You must wait until age 59½ to withdraw earnings from an annuity to avoid the 10% IRS penalty. The penalty is waived in the event of death, disability, and agreeing to take distributions of substantially equal periodic payments, which is also known as 72(q) distributions. The fourth exception is when you annuitize the contract within one year of purchase. This only applies to the purchase amount of the original contract. You cannot exchange an existing contract for the one you’ve held for several years and annuitize it within a year to avoid the early withdrawal penalty.
Pledging a contract for a loan: Another transaction that triggers deferrals’ taxation is when a contract is pledged as collateral for a loan. All deferrals will become taxable in the year the contract was pledged.
Distributions: You can begin taking distributions penalty-free after age 59½ without annuitizing the contract. Some insurance carriers may have their penalties, so you should review your contract before requesting distributions. Periodic payments from the contract are considered earnings first and return of principal last for all contracts issued after August 13, 1982. Withdrawals from contracts issued before this date are deemed principal first, and earnings last. Distributions from contracts that are annuitized are considered a combination of principal and interest based on the pro-rata amount of principal applied to the term of the distribution. For example, if you invested $100,000 into a contract and then annuitized it over 20 years, $5,000 per year of the distributions would be considered a return of principal, and the balance would be taxable as earned income.
Contract losses: Variable annuities fluctuate in value based on the underlying investments and could be worth less than the amount invested. Losses incurred in an annuity contract are considered ordinary losses, not capital losses. The contract has to be surrendered to take the loss. Some annuity contracts may be subject to a penalty that is deducted from the proceeds. The amount of penalty is not considered part of the loss. For example, John and Mary have an annuity with an original investment of $100,000 that is now worth $80,000 and is still in the penalty period. They surrender the contract and receive $80,000 less a $4,000 surrender charge. The loss they report is $20,000 even though they lost a total of $24,000.
The amount of the loss is claimed as an itemized deduction and is subject to the 2% of Adjusted Gross Income (AGI) exclusion. John and Mary have an AGI of $100,000 in the year they claim the annuity loss. They will be able to take $18,000 of the loss as an itemized deduction.
Some advisers say Revenue Ruling 61–201, 1961–2, CB46 allows annuity losses to be deducted under “Other Gains/Losses” on the tax return. This approach allows a taxpayer to deduct the entire amount as a loss because there is no 2% of AGI limit. The “Other Gains/Losses” category is also not impacted by the Alternative Minimum Tax.
Annuities held in IRAs: A qualified annuity, which is nothing more than an annuity held inside an IRA, follows the rules for an IRA with one notable difference. Variable annuities often contain a death benefit provision in the event the contract value is less than the amount invested on the date-of-death. They sometimes will include a death benefit that automatically increases. Effective January 1, 2006, the contract value and a present value calculation of the death benefit (and any additional living benefits) are divided by the age-related factor to determine the required minimum distribution (RMD) for those age 72. The exception is when the present value is not more than 20% of the contract value, and withdrawals reduce all benefits pro-rata. Beware – the guarantees associated with these additional living benefits may create a greater value than the contract value and require higher RMDs.
Roth Conversions of Annuities held in IRAs: This same issue applies to variable annuities in an IRA when they are converted to a Roth IRA. The taxable amount of the conversion will include the current contract value plus a present value calculation of any death benefits or other living benefits. This amount could be significantly higher than the current contract value resulting in higher income taxes due to the Roth conversion.