Beware: Tax-Deferral in Variable Annuities Might Cost You More in Tax

Variable Annuity Taxation May Cause You to Pay More in Tax

Variable Annuity Taxation
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Variable annuities are sold as an investment vehicle that can offer significant tax savings by deferring income taxes on the investment gain. You deposit after-tax money, and you pay no taxes on the investment interest, dividends, or capital gains, until such time as you take withdrawals. This means you can exchange between investment options inside the variable annuity without triggering taxation.

Sounds great…so what’s the catch?

There are two problems with variable annuity taxation. These problems may cause you, and your heirs, to pay more tax than you would pay if you had used other investment alternatives.

Problem #1: Taxing Capital Gains as Ordinary Income

First, think of a variable annuity like a container. The rules of the container trump the rules of the underlying investments.

For example, if you buy a bond fund that pays interest income, you will pay taxes on that interest each and every year. If, however, you own that same bond fund inside of the variable annuity container, you will not have to pay taxes on any interest or gain that accumulates until such time as you begin taking withdrawals.

It doesn’t matter whether the gain comes from interest, dividends or capital gains; it’s all deferred. This is the beneficial tax treatment of annuities, called tax-deferral.

Tax-deferral is great, until you start taking withdrawals. At the time you take withdrawals there are two problems.

  1. When you take withdrawals from an annuity, gain is considered to be withdrawn first. (Unless you annuitize your contract, which, simply put, means you trade in your lump sum of money for a guaranteed income stream from the insurance company.)
  2. All gain that is withdrawn from the annuity is taxed at your ordinary income tax rate.

Why is this bad?

Ordinary income tax rates are higher than capital gains tax rates. At the top tax bracket, you will pay 20% more tax on ordinary income than on capital gains.

This means, despite the tax deferral, when it comes time to access your money, you may end up paying more taxes on funds inside the annuity than if you had invested in a lower cost alternative like an index mutual fund.

If you plan on owning a variable annuity for over 25 years before taking withdrawals, then the power of earning interest on deferred taxes may have enough time to work. But many variable annuities are sold to people who will need income in 10 or 15 years, which may not be enough time for the tax-deferral to provide a significant benefit.

Problem #2: Heirs Do Not Receive a Step-up in Cost Basis

Upon your death, your heirs receive something called a step-up in cost basis when they inherit assets such as real estate, stocks, and mutual funds.

Suppose you invest $100,000 in a stock mutual fund 12 years before your death. Over the 12 years, the $100,000 doubles to $200,000 (assuming the investments average a return of 6% a year, net of all fees).

Upon your death, your heirs inherit the $200,000. Tax rules say their cost basis in the investment will be the investment’s value upon your date of death; in this case $200,000. They can now sell it, and pay no tax on the $100,000 of gain.

This step-up in cost basis does not apply to annuities.

If you invest $100,000 in a variable annuity, and it doubles to $200,000, upon your death, your heirs will have to pay taxes, at their ordinary income tax rate, on the $100,000 of gain. This could result in federal taxes of $15,000 - $35,000, depending on their tax rate.

No tax would be due if the investments had been placed directly in a mutual fund, instead of inside the variable annuity.

Unfortunately, when variable annuities are sold, far too few advisors explain that your heirs may pay thousands in taxes, instead of no taxes.

Does all of this sound complicated? Tax treatments of investment products are not easy to understand and with the complicated nature of annuities, it becomes very difficult for the average consumer to understand. That's why it's important to seek the help of a qualified financial planner to help you put together the best retirement strategy that results in you and your heirs keeping as much money out of the hands of the government as possible.