Variable annuity contracts are sold as investment vehicles that can offer significant tax savings by deferring income taxes on any gains. You invest with after-tax money, and you pay no taxes on any interest, dividends, or capital gains until you begin taking withdrawals.
You are also allowed to transfer money between different types of investments within the annuity without incurring a tax when, for example, the proceeds from selling shares in one mutual fund are used to buy shares in another fund.
That sounds perfectly good to this point, but there are two tax-related problems with variable annuities that investors should be aware of. These problems could cause you or your heirs to pay more in taxes than you or they would have if you had used other investment alternatives.
Problem No. 1: Taxing Capital Gains as Ordinary Income
First, think of a variable annuity as 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 won't have to pay taxes on any accumulated interest or capital gains until you begin taking withdrawals.
Once you start taking withdrawals from your variable annuity, you are required to treat the earliest ones as gains (as opposed to principal). For example, if you invested $50,000 within a variable annuity, and the investment is now worth $90,000, you would pay taxes on the first $40,000 you withdrew. The remaining $50,000 could then be withdrawn tax-free.
The problem is that these gains, like those from IRAs and other tax-deferred investments, are taxed as ordinary income, not as capital gains, when they're withdrawn, and income tax rates are higher than capital gains tax rates. That means, despite the tax deferral, you may end up paying more taxes on funds kept inside the annuity than if you had invested in a lower-cost alternative, like an index mutual fund, that wasn't held within an annuity.
If you plan on owning a variable annuity for more than 25 years before taking withdrawals, the power of earning compound interest on tax-deferred income may enable you to come out ahead. But if you will need income from the annuity in only 10 or 15 years, you may not gain enough interest income to offset the greater tax hit on withdrawals.
One way of lowering your taxes on withdrawals is to annuitize your contract, which means the insurance company that sold you the variable annuity contract will give you regular payouts. Each payment you receive will consist of a mix of principal and gains, so part of the payout won't be taxed. The amount that's excluded from taxation is determined by dividing the premiums you paid for the contract by the number of years you're expected to receive payments.
Problem #2: No Step-up in Cost Basis for Heirs
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 invested $100,000 in a stock mutual fund 12 years before your death. Over the 12 years, the $100,000 doubled to $200,000.
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: $200,000. They can now sell their shares in the fund and pay no tax on the $100,000 of gain.
This step-up in cost basis does not apply to funds placed in variable annuities. Let's say you invest that same $100,000 in a mutual fund that's held within a variable annuity, and it also doubles in value to $200,000 by the time you die. Your heirs will have to pay taxes at their ordinary income tax rate on the $100,000 of gain. That could mean a tax bill of up to $37,000, depending on their tax rate.
If that all sounds complicated—and taxes on retirement investments typically are—you might want to consider seeking the help of a qualified financial planner. They can help you put together a retirement strategy that results in you and your heirs keeping as much of your money as possible.