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Annuity taxation primer - The good, the bad and the obvious

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As tax time looms, you’re confident that you have a handle on the tax ramifications – positive and negative – of annuities on those of your clients who own them. After all, there is little mystery and nothing especially new about how the tax code treats deferred annuity contracts, whether they’re of the fixed or variable variety.

However, as straightforward as annuity taxation might seem, there may be tax issues and angles that an advisor with clients who own annuities might not have thoroughly considered. From the good and the bad to the obvious, here’s a list of annuity-related tax matters worth considering before those client tax returns are signed, sealed and sent to the IRS.

GOOD: From a tax standpoint, according to analysis by PriceWaterhouseCoopers and the National Association of Variable Annuities, there are compelling reasons to use the life annuitization option offered with variable annuity contracts. Comparing the performance of variable annuity and mutual fund investments, the report indicates that “the after-tax payouts funded by the variable annuity investment [are] substantially larger than for the mutual fund.” The report also concludes “life annuitization (with or without a 10-year guarantee period) remains a more tax efficient payout option than systematic withdrawals.”

BAD: Unlike mutual funds and other equities such as common stocks, annuities do not receive a step-up in basis at the death of the annuitant, significantly diminishing their appeal and efficiency as a wealth transfer tool. Those who inherit an annuity before it has been annuitized may face the double-whammy of having to pay ordinary income tax on any contract gains along with estate taxes, if applicable. “That could make for a major hit for the taxpayer the money in that annuity is going to,” says tax expert Jim Ivers, JD, LLM ChFC, a professor of taxation at the American College. “That’s the price you pay for tax deferral. It’s what makes annuities a good wealth accumulation vehicle but not a particularly good wealth transfer product.”

To counter the lack of step-up at death, annuity providers are offering so-called estate enhancement benefit riders, which, for a fee, provide beneficiaries with an additional payment at the contract holder’s death to help cover the tax tab. These enhanced guaranteed minimum death benefit riders give beneficiaries a larger death benefit when the contract holder dies before annuitizing the contract. They can be well suited to people who have a health issue that makes obtaining a permanent life insurance policy for the purpose of wealth transfer prohibitively expensive.

While those riders may soften the tax blow in certain situations, Ivers suggests that advisors and their annuity-owning clients consider other wealth transfer and estate preservation tactics. “It’s generally a good idea for clients, when they reach a certain age, to start taking money out of the annuity to minimize some of those tax consequences.”

OBVIOUS (and good): Funds inside an annuity contract grow on a tax-deferred basis, so the contract holder owes no taxes on the income and investment gains from an annuity until contract withdrawals begin. This is the most fundamental and often the most compelling benefit clients reap from investing in a deferred annuity. “Generally speaking,” says Chris Grady, president of the retirement income division of Genworth Financial, a major annuity supplier, “the higher a person’s income tax bracket is, the more important it becomes for part of their portfolio to be tax-deferred.”

And, as Ivers points out, “The longer funds are allowed to accumulate within the annuity contract [without withdrawals], the more potential benefits the contract holder stands to get from tax deferral.”

GOOD: Annuities give contract holders the ability to transfer assets from one investment option to another within a variable annuity without triggering taxable events. “Everyone needs to rebalance their portfolios at certain times. The ability to rebalance one’s annuity assets over time is one powerful and often overlooked benefit [of owning an annuity],” says Robert Fishbein, vice president of tax and corporate counsel at Prudential, another major annuity provider. “If you do that with something like mutual funds, for example, you are likely to cause a taxable event.”

BAD: When distributed, earnings from a deferred annuity are taxed not as capital gains but at much higher ordinary income tax rates. The major disparity between ordinary income tax rates and capital gains tax rates makes this a huge consideration.

OBVIOUS (and good): In some states, assets residing in an annuity contact receive protection from probate and creditors.

GOOD: Income from an annuity doesn’t count toward income tallied for the purpose of calculating taxes on Social Security benefits. “This is a fairly significant benefit tax benefit for older taxpayers,” says Ivers, noting that even income a person receives from tax-exempt municipal bonds is used in calculating the level at which one’s social security benefits are taxed. That is not the case, however, with income from a deferred annuity. That’s an important consideration, he says, for advisors with clients who might be on the verge of having their social security benefits taxed at higher levels.

BAD: Using a commercial annuity contract as a gift to a person or charity can trigger a taxable event. Thus, says Ivers, a deferred annuity “is probably not something you want to use as an asset for a gift, because if there’s gain in the contract, there’s going to be a tax hit.” From a tax-efficiency standpoint, investment vehicles such as stocks and mutual funds make better gifts, he adds.

GOOD, BAD & OBVIOUS: Investing in an annuity contract in the context of a qualified retirement plan moots the tax-deferral benefits of the annuity, since assets in qualified plans are already afforded tax deferral anyway. Still, annuities offer other features that might justify using them within a qualified retirement plan.

“Critics frequently question the value of putting an annuity, which offers tax-deferral benefits, in another tax-deferred investment such as a qualified plan or IRA. However, this argument fails to recognize the great value that annuity insurance guarantees can offer,” says Mark Mackey, president and CEO of the National Association of Variable Annuities in Reston, Va. “Annuities offer consumers the option of insuring that the pre-tax dollars they have allocated for retirement are protected against downside market risk. They also offer beneficiary protection in the form of a guaranteed minimum death benefit, and the ability to convert retirement savings into a lifetime stream of income-all of which help ensure that their hard-earned savings will be there when they, or their heirs, need them most.”

GOOD: New combination products that bundle an annuity with long-term care insurance are poised to gain tax-favored status beginning in 2010 as a result of provisions of the Pension Protection Act enacted in 2006. Under the law, funds can be withdrawn from these so-called combo products on a tax-free basis to cover long term care expenses incurred by the contract holder. Funds that a combo annuity-LTCI contract pays out for long term care will be treated as insurance benefits, free from tax.

BAD (and obvious): Significant surrender charges and tax penalties loom for people who pull money from an annuity contract early in the contract’s accumulation phase. “If a client expects to have a need for liquidity earlier rather than later, a deferred annuity might not be the right product for them,” says Grady. “There are times when an annuity is not the right answer.”

However, taking all the above issues into consideration, the positive tax-related attributes of annuities in many cases overshadow the negatives, according to Ivers, “Annuities are good vehicles because, in the long run, the tax deferral they offer really can be beneficial enough to outweigh the disadvantages. You just have to be sure you plan carefully.”

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