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All types of annuities with insurance companies, offer guaranties that are based on the claims paying ability of the underlying insurance company. They are not guaranteed by FDIC or the US Government. Investors should review the insurance contract carefully before purchasing an annuity.  Death benefits and riders have additional costs and expenses.

Variable Annuities are long-term investments designed for retirement purposes.  They involve risk and are offered by prospectus only.  Investors should carefully consider the investment objectives, risks, charges and expenses of the insurance contract and its underlying investment options. The prospectus contains this and other important information and should be carefully read before investing.

 

 

What is an Annuity?

An annuity is a complex contract between an individual and an insurance company. The individual either makes a lump sum payment or series of payments and in return obtains regular income disbursements beginning either immediately or at some point in the future. The goal of an annuity is to provide a steady stream of income during retirement.

Annuities offer guarantees that are only as good as the claims paying ability of the insurance company. They are not guaranteed by the US Government. Make sure to review the prospectus before purchasing an annuity.

 

There are 3 different types of annuities:

  1. Fixed Annuities – These products have a fixed interest rate which does not change after the date of purchase. With inflation as high as it is now, these policies are not able to keep up with the high cost of living. Most of these policies are turned into immediate annuities. This means that the annuitant gives the money to the insurance company in exchange for a guaranteed income starting immediately. This is similar to a pension (fixed monthly income that generally doesn’t change over time).
  2. Indexed Annuities (sometimes called Fixed Equity Indexed or Equity Indexed) – These products are very popular among some financial professionals. They promise to potentially increase as the market grows and never go down when the market declines. Your momma told you, “if it sounds too good to be true it probably is.” Your momma was a very wise woman. In my opinion, they are oversold with unrealistic return expectations. They promise an elevated return, but the actual return is much closer to earth. These products do not require the sales person to hold a securities license. All that is required is an insurance license. Holding a securities license requires additional education and testing which in turn can allow for a better understanding of complex products.  These products often have high sales charges, long surrender periods and high redemption fees. These products can be highly lucrative for those who sell them. One can get a 7% to 10% (or more) commission for selling one of these products. Long surrender periods and high redemption fees. These products can provide income benefits which can be attractive.
  3. Variable Annuities – These products involved investing in actual securities through the use of sub-accounts. These sub-accounts are similar to mutual funds. The benefits of these products is that they provide a Death Benefit and/or Living Benefit. They also involve investment risk and can lose value when the market declines.  Another consideration is the fact that these investments often have high expense factors (expense ratios, rider costs, mortality and expense charges).  Some of these policies can have long redemption charge periods and high redemption fees just like the Indexed annuities. Other policies are much more reasonable in terms of redemption penalties and fees.

Learn more about investment vehicles in episode 081

 

How do annuities work?

It comes down to taxation, cost basis, and things like that. In the world of annuities, there are a lot of different ways to look at it. One way to understand annuities is to look at qualified vs non-qualified annuities

  • Qualified – One that is an IRA, 403b, retirement type account. Pre Tax account (contribution funded with pre-tax dollars). Inside a qualified annuity, the money grows tax deferred, and when you withdraw the money, it will be taxed as ordinary income. An annuity automatically provides tax deferral. 
  • Non-Qualified – After tax dollars contributed to an annuity. These annuities grow tax-deferred. Aside: The benefit of the tax deferral use of an annuity is to reduce capital gains taxes and the taxation of dividends that you would have if you invested into the stock market. You put in after tax dollars, it grows tax deferred, and when you withdraw your money, the income (growth) is taxed first, and is taxed as ordinary income (not capital gains). Aside: If it was invested in the stock market, it would be taxed as capital gains, and it wouldn’t all be gains. The first thing that comes out is your gain, and it is taxed as ordinary income. 
    • Example: If I put $10k in, it grows to $20k, I sell $5k. If its in the stock market mutual fund, that $5k is treated as half gain and half basis. If it was in an annuity, the $5k is treated as growth.Therefore, it is taxed as ordinary income at your highest income tax bracket.

 

What Happens at Death?

What is cost basis and how does it work?

  • Cost-basis is the value of an asset for which you have already been taxed. Example: You make $50,000 a year, and you decide to save $5,000 and invest it into Apple stock in a joint account between you and your wife. That $5,00 came from your paycheck. It has already been taxed! If the value of your stock goes from 5k to 50k, you don’t have to pay tax on the first 5k because you have already been taxed in it. You only pay tax on the gain. The 5k is considered your cost basis.

What is a Cost-basis step up?

  • Under current law (2023), if you die with an asset like a stock or a bond (not held in a retirement account), your cost basis jumps to the value of the asset as of the date of your death. This means that your heirs will not have to pay tax on the 5k to 50k change. They actually have the basis jump to $50k, saving them a HUGE amount of taxes. They are only responsible for the change of value from the date of death to the date of the sale.

 

Qualified – There is really no difference in tax treatment outside of an IRA or a qualified annuity. It’s treated the same. This podcast is not addressing qualified annuities.  Qualified annuities do not have a cost basis. Their cost basis is zero. You have not paid taxes on any of this money. 

Non-qualified – Here is where there is a HUGE difference. There’s an additional element that you need to know. When it comes to a non-qualified annuity, at death, there is no step up in basis. If it’s $100,000 and it grows to $200,000, all that gain (and the tax that comes with it) goes to your children. When you die you might be in a low tax bracket. But your kids are likely in a higher tax bracket. They will inherit a tax time-bomb because it will be taxed at their highest bracket. The non-qualified annuity has a cost-basis. But, it does not have a step up in basis at the date of death.

This is why we say, “if you die with an annuity, your kids will never talk to you again.” They are inheriting a tax time-bomb. 

It’s a double whammy. 

  1. It’s taxed as ordinary income
  2. You lose the step-up in basis.

 

My parents have a non-qualified annuity. What should I do?

This is where it helps to work with a tax professional to help manage (or create) a withdrawal /distribution plan from the annuity. There are a number of things we have to be aware of. Here are 3:

  1. Since all gains are taxed as ordinary income, distributions from an annuity may cause a greater portion of your social security to be added to your taxable income. Talk to a financial advisor or tax professional to prepare and create a distribution plan. 
    • It depends on how much income you have. When you are in retirement, if your income is below a certain threshold, none of your social security income is considered taxable. In 2023, that number is $25-34k/yr you may have to pay tax up to 50% of your benefit. For individuals, if you earn less than $25k of total income, none of your income is taxed. If it falls between $25k-$34k, you could be taxed up to 50% of your social security income. If you are married filing jointly, the numbers go from $25k-$32k, and $34k-$44k. 
  2. If you earn too much, it could impact (increase) your Meidcare part B premiums.
  3. For very low income people, additional distributions from an annuity may disqualify them from certain benefits they receive, such as medicaid benefits. Losing these benefits may disrupt your livelihood. However, if you look at it, and say it’s worth it to pay the taxes at your rate than to pass it on to your kids (for your tax rate should be lower), that’s where you have to be aware of the various tax entanglements, so you can create a plan to do your distribution.

 

Don’t Die with an Annuity 

  • TAXES: Dying with an annuity becomes incredibly complicated when it comes to taxes. It all comes down to the tax impact on your children or grandchildren. The tax impact that you might pay today could pale in comparison to the higher taxes that your children could pay if they inherit your non-qualified annuity.
  • Non-qualified annuities are fantastic at managing taxes for today (capital gains, dividends are not taxed when they occur). But, they are terrible at managing taxes in the future/during distribution.  All of the gains and dividends are taxed as ordinary income, which can move you to a higher tax bracket, which would cause you (or your heirs) to pay more in taxes in the end. 

 

Stewardship Application

  • Proverbs 12:15 – The way of a fool seems right to him, but a wise man listens to advice.
    • There may be some internal comforts that may direct you toward getting an annuity.  We understand that!  But, there are many questions that ought to be asked if you want to also be a future blessing to your kids and grandkids.  Annuities bring an element of comfort, peace and sleep…FOR TODAY.  But, as we just shared, they could be a complication and tax burden to your kids along with being a cash-cow for Uncle Sam.
  • Matthew 22:21 – Then he said to them, “Therefore render to Caesar the things that are Caesar’s, and to God the things that are God’s.”
    • As stewards, we are to pay our taxes and specifically, our fair and appropriate share.  But, with good planning, and wisdom from financial and tax professionals, you will only have to pay what is needed and not a penny more…and that would be for you…and those that will inherit any remaining assets!  If you work with those that know and understand taxation, in your estate plan you could be even more generous to your church and other ministries that you are passionate about, along with blessing your kids.
  • Proverbs 13:22 – “A good man leaves an inheritance to his children’s children.” (NKJV)
    • Plan well, and minimize any tax burdens for today and tomorrow, and you may even be able to bless your grandkids with an inheritance.

 

Next Steps

 

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The topics discussed in this podcast are for general information only and are not intended to provide specific investment advice or recommendations.  Investing and investment strategies involve risk including the potential loss of principal. Past performance is not a guarantee of future results.

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