Tax Deferred Annuities have become a very popular investment vehicle over the last ten years. With interest rates at twenty year lows annuities are highly competitive. Owners received safety, tax deferral (for interest which is not withdrawn) and an asset which passes outside of the probate system in all fifty states. Newer products
have exciting features like nursing home waivers (ability to avoid surrender charges) and interest rates linked to the stock market’s performance. You can literally defer thousands of dollars in income taxes using deferred annuities, so what’s not to like?
Plenty perhaps, or maybe nothing. Like anything else it depends on the individual situation. However the enormous annuity marketing engine stops short of forcing you to analyze complex tax questions before selling you an annuity. The concept behind tax deferral is based on the concept that you will probably be in a lower tax
bracket when you need the money than you are during the accumulation phase. For many people this is true, for others, the annuity itself actually forces them into a higher bracket.
The reason I use the term time bomb is twofold:
1. You don’t have control over when it goes off
2. There is a loud bang
Annuities in review
It probably makes sense backup and talk about annuities in general. There are many new types of annuities with new features including annuities which convert into Long Term Care Policies if the owner becomes disabled. The two broad categories of annuities are fixed and variable. Fixed simply means that the insurance company backs the annuity with their general assets, where variable means that the funds are invested in “side accounts” which are identical to mutual funds and carry market risk. The purpose of this book is not to differentiate between types of annuities, but to call into question their use. In some situations, annuities are not the right investment. The ratings of annuity providers is also beyond the scope of this article because the topic of insurance company ratings is quite involved. If you are interested in this subject please call our office to speak with a financial advisor. Moving on, I want to touch on the appropriateness of annuities and alternatives to annuities.
The Picture Begins to Blur
It is a known fact that 70% of all annuity owners will NEVER touch the interest that is building up. This means the owner may never pay taxes on the accumulated
interest –an outstanding feature. If you manage to consume the interest during your lifetime, then you will avoid the time bomb. Odds are you won’t however.
Therefore, your beneficiaries (other than your spouse who can continue the annuity) will have to figure out how to best pay the taxes. If they choose a payout to
spread out the taxes, their investment return will go down to around 2% For example, if you die and leave $100,000 annuity to your heirs (not your spouse) they have one of two choices at your death. 1. They can pay taxes all at once, or 2. they can take a payout over a period of time to defer the taxes due over the longest possible period. This process is called “annuitization”. Insurance companies love this because the interest rate they are paying is around 1 to 1 1/2 %.The IRS is not benevolent. They don’t allow people to defer billions in taxes because they are nice. They allow it because they know that they will eventually get their money, maybe more than if they didn’t allow it.
Lets discuss IRA’s and 401(k)’s as an example. It’s easier to illustrate this concept because both the principal and earnings have never been taxed and therefore anything withdrawn is taxed. If you have, for example $100,000 in an IRA, you should know that only $70,000 of that belongs to you, the other
$30,000 belongs to the IRS. The account may be in your name, you may be able to move it around, but you will never be able to get at the other $30,000! Whether you take the money out slowly, all at once or die, no one will ever see the $30,000 of the IRS’s money. They will let you manage it and watch it, but they won’t let you have it. Its not yours and never was yours. It would be simpler if banks and brokerage firms would show on your statement your portion and the IRS’s, but they don’t.
Annuities Can Actually Increase Taxes Consider that it is entirely possible that your kids or heirs will be in a higher bracket than you and pay more taxes than
you would have. This could happen either because they are working and have to report IRA distributions on top of their other income, or Congress may raise the top tax bracket by the time your heirs inherit the money. In other words, if you have money in annuities and you are in the 20% bracket and your heirs may be in the 39% bracket. Other problems are that heirs may lose current tax deductions because the income from annuities is considered “ordinary income” which is added to their adjusted gross income. Since certain deductions are based on your adjusted gross income, it is possible that an inheritance of an annuity could cause a deduction to be disallowed. Medical expenses, moving expenses, professional fees, and many other types of deductions are only deductible to the extent they exceed 2% of adjusted gross income. Therefore, the higher AGI, the lower the amount of deduction. So the bottom line is that your heirs may not only pay 39% of your annuity income is taxed, but the cost may go much higher due to the reasons mentioned above.
Annuities and Trusts Don’t Go Together
One of the benefits of annuities is that they are not probate-able, meaning the balance is paid directly to beneficiaries. However this means you can’t protect the assets
in a trust. Well you can name a trust as the beneficiary but you will almost certainly force immediate taxation of the deferred interest. The fact that something is not probated is not necessarily a good thing. Leaving assets in trust could provide a lot more benefit than the tax deferral aspect of annuities. In summary, a lump sum may be used to fund a trust but will create an immediate tax bill, or the trust could receive annuity payments to spread out the taxes, but then the beneficiary doesn’t have access to the principal. The estate planning aspects of annuities are quite complex and require delicate care. Unfortunately, most insurance agents don’t possess the technical expertise to navigate the tax and legal options. Why Would you Want to Leave Funds in Trust? There are dozens of reasons why it is advisable to
leave money in trust instead of outright. For now, I will mention a few of the most important and most frequently observed reasons:
1. A minor or disabled person cannot inherit money
directly.
2. Beneficiaries get divorced, sued and have other financial
problems. For example a child who is a doctor
or in another high-risk profession, they should not inherit
money directly because it would be available to
creditors.
3. Beneficiaries may need help managing money and
should not receive it directly.
4. Beneficiaries may lose all sorts of government and
other benefits if they receive money directly. If money
is left in trust, they may not be disqualified.
The decision to own annuities involves a number of important issues. For example, your income needs, tax situation, your heirs' needs, your health, and your entire
estate must be considered together before deciding if annuities make sense –even if you already own them.
What Are the Alternatives?
We’ve seen that annuities have many benefits and several disadvantages, mainly that if you don’t manage to spend the money, you are saving a tax bill for your heirs. We also discussed that your heirs may pay much more taxes that you would have and the inheritance could cause all sorts of other side effects. Fortunately
there are a number of good alternatives to annuities depending on the likelihood that you may need the money. If you truly believe you will consume the interest, or
could care less about the tax consequences on your heirs ,stick with annuities. The other important issue is whether you already own a long term care policy or have done other planning. If you haven’t done any planning and you do wind up in a long term care situation, there may not be any assets left to worry about. This article will focus on two alternatives to annuities:
1. Single Premium Whole Life – Life Insurance is and has always been tax free to the beneficiaries. This is one of the true remaining freebies offered by the government.
Regardless of when you die or how much you leave, the entire amount is income tax free to your heirs (but it is part of your taxable estate). You do have to
reasonably healthy to qualify for this type of product, however there are certain companies that have abbreviated underwriting and liberal standards. These products
do accumulate interest and you can still get to your cash. They don’t pay as much as annuities, but your heirs will thank you. Most of these products have a new feature
called “accelerated death benefit”. This means that if you are diagnosed with a terminal illness to last less than 12 months, you may get at the death benefit, not
just the cash value – tax free. In certain cases a loan against the cash value is not taxable – another option not available through an annuity. The death benefit can be
made payable to a trust without any adverse tax consequences.
2. Modified Endowment Contract – This is part annuity and part life insurance. Any withdrawals (certain exceptions apply)taken during your lifetime are taxed
like an annuity, but the entire value passes tax free at your death. Most of these polices also have an option to access the death benefit in the event of a long term
care need – defined as being unable to do 2 out of 6 activities of daily living (eating, dressing, bathing etc.). These payments may also be tax free. This is a great
parking place for cash in case you do have a long term care need or other need but whatever you don’t spend passes tax free and may be made payable to a trust.
The key to making the right decision is taking a complete look at your situation and weighing the tax and practical consequences of different options. Being licensed
to sell insurance and being competent in estate planning are two different competencies.
For more information, contact David Disraeli at 512-464-1110 or david@pcfo.net