“Taxes on Annuities are Complicated” – July 21, 2013


Reader Question: I have had an (non-qualified) annuity since 1980. Not needing the income from this annuity, the interest has been added back into the account. At this time the interest far exceeds the original principal. I am retired; however, I do not need this income for daily living expenses at this time. I realize that income tax will have to be paid on the accrued interest. My question is can anything be done with this interest that would lower the tax burden I will be required to pay and what is the best way to reinvest this money? O.V.S.
Answer: One of the big selling points for purchasing an annuity is that your interest earnings are not subject to current taxes and therefore the compounding of returns is magnified. But this is a knife with two edges. Once you decide to take your money out, typically during your retirement, income taxes must be paid. Here are a few of your options:
1.      Take withdrawals as needed. If you decide to take a partial withdrawal from your annuity, for income tax purposes, it will be treated as ‘first in; first out’ or FIFO in accounting jargon. What this means is that all such withdrawals will be treated as if you withdrew your original investment first (non-taxable) and this will continue until your cost basis is fully exhausted at which time all future withdrawals will be fully taxable. This rule is for contracts issued before August 14, 1982. Partial withdrawals from contracts issued after that date are treated as interest out first (fully taxable) or last in; first out (LIFO).
2.      Annuitize. Here you would elect to have your insurance company convert your lump sum into a stream of payments. Under this method, the payments to you will be treated as:
a.       Partially a return of your original investment (non-taxable) and
b.      Partially a return of earnings (taxable). 
This calculation is known as the exclusion ratio and is a formula that includes how much you invested plus your expected earnings.
3.      Leave your annuity to your beneficiary(s). This is the ‘kick the can down the road’ strategy where you let your beneficiary worry about paying the taxes. One advantage is that you will have deferred taxes for as long as possible. Based on my research, it appears your beneficiary could elect to ‘stretch’ the taxes over a variety of payment options.
A couple of strategies that you might be able to use to reduce the tax impact:
·         Charitable gift. In the year to take a voluntary distribution from your annuity, you could make an equal gift to a charity. For example, you take a distribution for $10,000 from your annuity knowing that you’ll have to report $10,000 of income. In that same calendar year, you also make a $10,000 gift to a qualified charity for which you’ll receive a tax deduction allowing one to offset the other. There are limitations on charitable deductions so be sure to coordinate this transaction with your tax advisor.
·         Contribute to a retirement plan. If you still have earned income you could use the taxable distribution from your annuity to contribute to your tax deductible retirement plan such as an IRA.
Some of the rules around annuities are complex so be sure to consult with a tax or insurance professional before making any significant changes.
Corrections and readers comments
In a recent column on long-term care (LTC) insurance, I discussed how insurance companies have aggressively been raising the premiums of existing policy owners in recent years. I went on to say that due to rising healthcare costs, I expected this trend to continue. LTC expert, Jack Lenenberg, J.D. (www.LTCPartner.com) correctly pointed out that rising healthcare costs is not a factor in the insurance companies decision since, with a LTC policy, what you are buying is a ‘block of money’ that once it’s used, the contract ends. What I intended to communicate was that with advances in healthcare science, people are living longer and therefore greater numbers of people may be qualifying for LTC benefits than the insurance companies had predicted. Jack further added that other important factors were unexpected low investment returns (low interest rates) and lower than expected policy lapse rates.
In my column about American expatriates, several physician readers pointed out the U.S. does not have “the best healthcare in the world”. One physician stated that, “We do have the most expensive healthcare system in the world…but overall the World Health Organization (WHO) ranks the overall quality of U.S. healthcare at #38”. Dr. Stuart Capper agrees. For nearly ten years he was chairman of UAB’s Department of Health Care Organization and Policy in the School of Public Health. Currently he holds an adjunct appointment as a full professor of public health at Emory. Dr. Capper adds that, according to the WHO, our life expectancy here in America is about the same as for the Czech Republic yet we spend three times more on healthcare. Italy, France, England, Greece, Australia and Canada all have longer life expectancy rates and lower infant mortality rates (we rank #25) while spending less than half of what is spent in the U.S. on healthcare. For a free twenty-six page report, “A Financial Guide for the American Expatriate”, email me at [email protected] and place ‘Expat White Paper’ in the subject line.