Taxes and annuties: A bundle of strategies

Ah, tax season, the time of year when the Internal Revenue Service is no longer just the IRS, but rather the “(insert unprintable epithet here) IRS!” Wouldn’t it be satisfying to feel as if you and your clients got the best of the tax code rather than the tax code getting the best of you?

For advisors who deal in annuities, this is the season to put a premium on tax-efficient planning strategies involving annuities. Time to brush up on the intricacies of annuity taxation, from fundamental, long-standing considerations to new, more complex issues that may arise due to recent tax code changes.

From the obvious to the obscure, the insights, tips and tactics that follow are designed to help ensure that once April 15 comes and goes, you and your annuity-oriented clients stay in the tax collector’s good graces and without a reason to curse the IRS.

BASIC
Funds inside a deferred 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 among the most basic and compelling selling points for annuities, says Timothy J. McNeely CFP, CIMA, principal at McNeely Financial Strategies in Northridge, Calif.

“Annuities are what help us to avoid taxes. As long as you keep the money inside an annuity, the government isn’t going to tax the earnings.”

The tax-deferral benefit is especially beneficial to clients who don’t have–or are limited in their ability to use–a qualified IRA, adds Jeff Leib, an insurance and annuity specialist at Santiago Rodnunsky & Jones, an estate-planning law firm in Woodland Hills, Calif.

Annuity assets avoid probate and (to varying degrees in most states) are protected from creditors. These can be vital considerations for businesses and individuals alike; for those who want to pass assets to heirs privately, outside the probate process, for example; and for businesses that want to protect assets from creditor claims.

At distribution, 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, says Leib. “For those who don’t want income tax exposure, annuities may not be best. And when you factor in expense charges, that can make annuities more expensive than other investment options.”

There’s no step-up in basis with an annuity contract upon the death of the annuitant, unlike with other assets such as real estate, meaning heirs who inherit an annuity before it has been annuitized may be on the hook to pay both ordinary income tax on contract gains and estate taxes.

If an annuity owner envisions passing the annuity asset to heirs, it might be worthwhile to invest in an estate-enhancement rider on the contract, such as one that provides beneficiaries with an additional payment at the contract holder’s death to help cover taxes, or otherwise to consider vehicles other than an annuity to transfer wealth.

Beware the new Medicare tax on unearned income. Beginning in 2013, Uncle Sam will impose a new 3.8 percent levy on the unearned investment income of higher-income individuals. The so-called unearned income Medicare contribution tax, enacted last year as part of health care reform legislation, will apply to unearned income from a range of investment vehicles, including non-qualified annuities. Annuities inside qualified plans are exempt. The tax applies to couples whose annual income exceeds $250,000. The threshold is $200,000 for single and head-of-household filers, and $125,000 for married people filing separately.

Start planning now to reckon with the new tax, McNeely suggests, and if the new tax looks like it’s going to be burdensome, take action. How? Shifting the annuity contract into a trust or a qualified retirement plan may address the issue.