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Financial Planning > Tax Planning

Annuities and Taxes: What Advisors Need to Know

By Roger Wohlner

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What You Need to Know

  • Annuities can offer another alternative in your retirement planning efforts for some clients.
  • However, annuities have some tax complexities that need to be considered in the context of your client’s overall retirement income strategy.
  • Annuities can be either non-qualified or qualified.

Annuities are a viable retirement planning vehicle for many clients. They offer tax deferral during the accumulation phase and the possibility of guaranteed lifetime income.

They also have a tax impact when distributions start. Like most aspects of retirement planning, and with most retirement planning vehicles, tax planning is an integral part of the process of using annuities.

Here are some of the key tax planning issues tied to annuities to consider when determining whether an annuity is the right choice for a portion of your client’s retirement savings.

Qualified vs. Nonqualified Annuities

When many clients and advisors think of annuities, they think of nonqualified annuities that are held outside of a retirement plan like a 401(k), IRA or 403(b) plan. However, qualified annuities are also an option in some cases for clients.

The taxation of qualified annuities will be in line with the tax rules pertaining to the type of retirement plan or account in which they are held. This is the same with other assets such as mutual funds and ETFs. Qualified annuities can be held in both traditional and Roth accounts.

Tax Benefits of Nonqualified Annuities

Nonqualified annuities offer a way for clients to invest and accumulate retirement savings that can grow tax-deferred. While contributions are made with after-tax premiums, the premium dollars grow inside the annuity with no tax impact until they are withdrawn either as a lump sum or via annuitization.

For clients who may have maxed out their 401(k) and IRA contributions, an annuity can offer another source of tax-deferred growth of their contributions for retirement. For clients who may be a bit behind in their retirement savings, an annuity can be another addition to their retirement savings with the benefit of tax-deferred growth.

Tax Issues to Watch

There are a number of tax issues connected with nonqualified annuities to keep in mind.

Early Withdrawals and Contract Surrender

You might encounter this issue in a couple of ways. First, it’s not uncommon to take on a new client and review their portfolio only to decide that changes are needed. One such change could surround an annuity they were placed in by a former advisor.

Perhaps the contract expenses are too high, or it just isn’t a good fit in your client’s overall retirement planning.

Surrendering the contract will result in a penalty, if they are within the surrender period, and income taxes if they are under age 59.5. The entire amount of interest included in the contract value will be subject to taxes.

If there are no surrender charges, a better solution for your client might involve looking for a more suitable annuity contract and doing a 1035 exchange into the new contract. This will avoid the taxes and penalties.

While an annuity may or may not be the ideal solution for your client, avoiding the taxes and surrender charges preserves those funds for retirement. If the contract has a surrender charge, you will have to weigh whether to wait until the surrender period is over, or whether your client is better off “eating” this charge and doing an exchange into another annuity contract.

Last-In, First-Out Taxation

Any lump-sum withdrawal from a nonqualified annuity will be taxed on a last-in, first-out basis. In other words, it will be assumed that the first money withdrawn consists of gains inside the contract. Once the gains are totally withdrawn, subsequent withdrawals will consist of the basis in the contract.

A withdrawal of the entire contract amount will be taxed to the extent of the gains withdrawn. The gains will be taxed as ordinary income, much like a withdrawal from a traditional IRA or 401(k).

Annuitization and the Exclusion Ratio

Payments from a nonqualified annuity will be taxed based on the contract’s exclusion ratio. The exclusion ratio states what percentage of each payment is considered gain and subject to tax.

The contract owner’s life expectancy is a major factor here. If they outlive the expected annuitization period, the entire payment could become taxable as gains inside the contract.

Types of Annuities

The tax element of the exclusion ratio needs to be taken into account in deciding when to annuitize and in determining what type of annuity product to suggest for your clients.

Immediate Annuities

With an immediate annuity, your client purchases the contract and annuity payments commence within a few months. This can be both a solid retirement income and tax planning tool.

From a retirement income planning perspective, the use of an immediate annuity can allow your client to determine when their income will commence based on when they decide to fund the contract. They can tie the timing of the payments to their income needs and also when these payments fit best within their tax situation.

Deferred Annuities

With a deferred annuity, your client pays their premium into the contract, but annuitization is deferred from 10 to 30 years. From a tax planning perspective, the premium dollars grow tax-deferred inside the contract.

The ability to defer annuitization can help with income planning later in retirement and can defer the taxation of the annuity until a period when your client might be in a lower tax bracket.

QLACs

QLACs, or qualified longevity annuity contracts, are a form of deferred annuity available inside of retirement plans like a 401(k) or an IRA. Your client can buy a deferred annuity of up to $200,000, and the commencement of the annuity payments can be deferred as far as age 85.

The $200,000 limit represents an increased amount under the Setting Every Community Up for Retirement Enhancement (Secure) 2.0 Act.

The tax benefit is that the amount of the annuity does not have to be withdrawn as a required minimum distribution until the contract is annuitized. This defers taxes on the RMDs for this amount, potentially until your client is in a lower tax bracket later in retirement.

Other Types of Annuities and Riders

There are many varieties of annuities to consider including variable annuities, indexed annuities and a host of others. They all have different properties that might affect your client’s taxes when they annuitize or take periodic withdrawals in retirement.

Plus, there are a host of riders, essentially contract add-ons, that can tailor the contract in terms of death benefits, living benefits, inflation protection and a number of other factors. Some of these riders can affect the level and timing of taxable income for your client, and this should be taken into account when purchasing the contract and the rider.

Qualified Annuities, Secure 2.0 and RMDs

Annuities can be purchased inside of a workplace retirement plan like a 401(k) or 403(b) in some cases. They can also be purchased inside of an IRA. From a tax planning standpoint, it’s important to understand that the tax rules of the retirement account govern the taxation of the annuity when annuitized or lump sums are taken.

Annuities can also be purchased inside Roth accounts, which can allow for tax-free annuitization or lump-sum payments if certain requirements are met.

The Secure 2.0 Act included several annuity provisions, such as higher limits on qualified longevity annuity contracts. For qualified annuities, the rules as to what does or does not violate the RMD rules for IRAs and qualified plans have been adjusted.

One key provision allows for an annual increase in the contract value of no more than 5% without violating RMD rules regarding benefit increases for annuities.

Also, the Secure 2.0 Act allows account holders to consolidate their RMD calculation between annuities held in the plan and distributions from non-annuity plan assets. Previously, these had to be done as two separate calculations.

If your client brings a qualified annuity to your relationship with them, it’s critical that you get your arms around the tax aspects of distributing the annuity and any RMD considerations. In deciding whether or not to add a qualified annuity, you will need to look at the tax ramifications as well as whether a qualified annuity is the best option for them.

Conclusion

Annuities can play a role in your retirement planning efforts for your clients. Like any other tax-advantaged retirement vehicle, tax planning for annuities as part of your client’s retirement planning strategy is critical.

You will want to balance the various income options available in an annuity with the tax implications. When considering whether an annuity is a good fit for your client’s retirement planning strategy, be sure to contemplate the tax implications of any annuity you are considering in the context of their entire retirement tax situation.

(Image: Adobe Stock)

Roger Wohlner

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