It's The Income, Stupid by Philip Romero Riaan Nel

Author:Philip Romero, Riaan Nel [Philip Romero, Riaan Nel]
Language: eng
Format: epub
Publisher: PP
Published: 2017-02-21T16:00:00+00:00

Annuities and Taxes

But annuities’ principal protected death benefit and tax deferral come at a price. (In the world of investing everything has tradeoffs.) Since the IRS sees these products as retirement vehicles they have certain tax features like retirement accounts and plans. In exchange for the tax deferral you have to deal with a premature withdrawal tax penalty of 10% if you take money out of an annuity contract before age 59 ½—just like an IRA. Furthermore, if you “surrender” the annuity contract (withdraw the contract value as a lump sum), any gains are treated as ordinary income and taxed at the investor’s marginal income tax bracket. Money invested directly in mutual funds, not indirectly through annuity contracts, are taxed at a different (and most of the time lower) tax rate for dividends and capital gains.

These are important disadvantages. The issue of premature withdrawals is essentially a non-issue for smart investors using this product as part of the envelopes approach we propose, since the smart investor will make sure she is older than 59½ before accessing these contracts for income. If an investor needs the proceeds from, say, a fixed annuity in Envelope 1 before age 59½ then the smart investor will either use a contract with a longer term as part of Envelope 2, or not use an annuity contract at all. This tax penalty does not apply to SPIAs. Variable annuities we propose for use in Envelope 2. Only a minority of investors are privileged enough to retire so early that they will access Envelope 2 before age 59½.

Another reason the premature withdrawal issue is no big deal when using our envelope approach is because we prefer to use variable annuities in Individual Retirement Accounts. The tax character of annuities in IRAs are the same as for annuities held outside of IRAs. Money distributed from IRAs are taxed as ordinary income just like annuity contracts. All other investment-related taxes inside IRAs are avoided as long as the money stays in the IRA. The same holds true for annuity contracts.

The tax treatment of annuity contract assets is a very important factor requiring planning. Let’s return to the hypothetical investor who invested $100,000 in a variable annuity contract using four funds. Most years these funds will have capital gains distributions, dividends, or interest income which inside a variable annuity contract are just reinvested in the funds. Also, if our investor switches from one fund to another and the fund being “sold” or switched out of had a gain, that gain is now also reinvested in the new fund. While all of this activity takes place within the variable annuity contract, no 1099 tax form is generated at the end of each calendar year and the investor owes no taxes. This is the same tax treatment IRA and other retirement arrangement assets receive. If the same four funds were held outside of the variable annuity contracts a 1099 form would be issued by each fund and the investor would have to pay taxes each year.

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