Retirement Planning > Retirement Investing > Annuity Investing

The tax man commeth

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With tax time just around the corner, the savvy advisor knows how to make the proper plans to help clients deal with (or entirely avoid) the tax repercussions of their valued annuities. Here are five life-saving strategies to discuss.

You are destined to generate a steady stream of kudos and referrals from your clients by consistently showing them creative ways to minimize their taxes. But to be a crowd-pleaser around tax time, you have to know the tax nuances associated with the various insurance and financial products you’re likely to come across in client portfolios, including annuities.

With the filing deadline looming, here are five steps advisors can take to help clients maximize the tax efficiency of their annuity holdings and avoid landmines that lurk in the tax code:

1. Discuss the fact that annuities do not receive a step-up in basis at the death of the annuitant, and because of that, why it might be worthwhile to invest in an estate-enhancement rider, such as a non-reducing death benefit guarantee, if they intend to pass on the annuity contract to an heir.

The lack of step-up is one reason deferred annuities “are generally not a great wealth transfer vehicle,” says Jim Ivers, JD, LLM, ChFC, professor of taxation at the American College. With no step-up, heirs who inherit an annuity before it has been annuitized may have to pay ordinary income tax on any contract gains, along with estate taxes.

However, one way a wealth-transfer-minded annuity owner can directly address that issue is by investing in a rider to the annuity contract that guarantees the death benefit from the annuity won’t be reduced or one that provides beneficiaries with an additional payment at the contract holder’s death to help cover taxes. One maneuver to consider, says Robert E. Vashko, JD, AAMS, director of the retirement and wealth strategies group at Jackson National Life Distributors, is to put a deferred annuity with such a rider inside a Roth IRA. Not only does that guarantee the annuity’s death benefit remains intact, he explains, but because the contract is inside a Roth, the death benefit should transfer tax-free to heirs, allowing the annuity to function much like permanent life insurance would, but without the underwriting requirements. Such a maneuver should have appeal as a means of wealth transfer, particularly to “clients who are too old or have had too many health issues” to qualify for a permanent life insurance policy.

2. Weigh your client’s “stretch” options. So-called stretch rules allow heirs both spousal and non-spousal who inherit assets (including annuity contracts that haven’t been annuitized) inside a qualified retirement plan to stretch distributions over their lifetimes, meaning they can dodge the heavy tax burden that accompanies a one-time, lump-sum distribution of a death benefit. But what about when the inherited annuity contract resides in a non-qualified retirement account? In those cases, says Vashko, it may be worthwhile to consider a specific type of annuity contract that comes with a non-qualified stretch feature. Such products are available from some, but not all, annuity manufacturers (including Jackson), he notes, so advisors should shop around. When putting such a product on the table for discussion, it’s also wise, he says, for advisors to involve the client’s heirs in the discussion, since the decision about whether to “stretch” distributions from the annuity ultimately will be theirs.

3. Discuss the distinctions between, and the ramifications of, spousal and non-spousal beneficiaries and owners, and act accordingly. In situations where one spouse owns a deferred annuity of which the other spouse is beneficiary, and the owner dies, the surviving spouse can simply elect to continue deferring distributions from the contract. However, the tax code doesn’t provide non-spousal beneficiaries such a luxury, according to Ivers. Transferring the death benefit to them may trigger a taxable event, an important estate planning distinction. Similar rules apply to joint non-spousal ownership of a deferred annuity contract, notes Vashko. “The moral of the story,” he says, “is that in many cases, non-spousal ownership [of an annuity contract] does not make sense.” Permanent life insurance can be a more tax-efficient wealth transfer tool in such cases.

4. Be heady about gifts from the heart. Think twice before giving an annuity contract as a gift to a person or charity, because as well-intentioned as the gift may be, it can trigger a tax double-whammy, says Vashko, where the person giving the gift may be obligated to pay taxes on capital gains within the contract while the recipient is on the hook to pay gift taxes. In the same vein, Vashko recommends against using non-qualified money to buy an annuity contract for the purpose of putting it inside an UTMA or UGMA custodial account to fund the college education of a child or grandchild. Potentially steep penalties for early withdrawals and a lack of control over how the recipient uses the funds once he or she hits age 18 make such an arrangement less appealing than alternatives such as the 529 college savings plan, he says.

5. Help clients dodge unnecessary redundancies. Income tax deferral is an inherent trait of the deferred annuity. Since assets in qualified plans are also afforded tax deferral, “if you’re going to place a deferred annuity inside any tax-exempt or tax-deferred vehicle such as an IRA, you should have some other compelling reason, besides income tax deferral, for doing so,” contends Ivers. Accessing annuity guarantees on lifetime income, death benefit and principal may be considered compelling reasons, he notes.

Similarly, it may be redundant to put a deferred annuity inside a living or irrevocable trust for the purposes of protecting those assets from probate and regulating income distributions to an heir, says Vashko. “Those are things [annuity] contracts can handle without a trust.”