Except in rare instances, you should never buy an annuity.
An annuity is an insurance product that pays out income. You buy the annuity, and it eventually makes payments to you at intervals and in amounts that you determine, either for the rest of your life or for a predetermined number of years.
Most insurance companies offer a plethora of annuity products, each a bit different, so there are thousands of possibilities. Yet, there are only two basic types of annuities you can buy: immediate or deferred.
Immediate annuity (IA). With an IA, you begin to receive payments soon after you make your initial investment. For example, suppose Joe (age 56) buys an IA for $500,000 from ABC Insurance Co. The IA will pay Joe $30,000 per year starting immediately and continuing every year for as long as he lives.
The money Joe invested in the annuity is not taxed; however, part of the payments he receives will be. Part of the payments is considered a return of the $500,000 capital and is not subject to ordinary income tax. The IRS has a table that determines how much of the $30,000 Joe receives is tax-free. The balance is taxed as ordinary income. If Joe lives long enough, the tax-free portion of all his annual annuity payments will total the $500,000. But every penny of the future $30,000 payments are fully taxable as ordinary income. Ouch.
Deferred annuity (DA). With a DA, your initial money is invested until you are ready to begin receiving payments. If Joe buys a $500,000 DA instead of an IA, he should be able to annuitize it anytime he elects to do so. The longer Joe waits, the larger the annual annuity will be. However, once started, the annuity payments are subject to the same tax rules as an IA. Worse yet, when Joe dies, the value of the annuity is double-taxed. Here’s how: Say Joe’s $500,000 DA is worth $580,000 when he dies. The $80,000 gets socked for income taxes, and the full $580,000 is subject to estate taxes.
Most people buy DAs instead of IAs because they like the idea that the earnings are not subject to current income tax (thus the name “deferred” annuity). The years go by, however, and 90 percent of the time, the DA is never annuitized. Ultimately, the buyer dies. It works out that when that buyer bought the DA many years earlier, he inadvertently ended up buying a life insurance policy, because his beneficiary will get its value as a death benefit. This is a wrong and very expensive way to buy life insurance.
Avoiding the Annuity Tax Trap
So, based on the crazy tax rules, how can an annuity, whether an IA or DA, be good for
someone like Joe or his heirs? After 50-plus years in practice, I have yet to have a client subject to the estate tax who was happy with his or her annuity investment.
If you already own a DA that has not been annuitized, is there a way out of the annuity tax trap? About 81 percent of the time the answer is “yes.” We have a proprietary strategy that we have used successfully dozens of times. It simply requires that the client be insurable.
The strategy plays out in this example: A married couple, aged 63 and 64 years old, uses the annual payments from a $1-million annuity to pay the premiums on a $3.75-million second-to-die (survivorship) life insurance policy that will ultimately be paid out to their children, tax-free.
This strategy turns the tables on the IRS without any additional out-of-pocket costs. It can even be used by just one of the spouses in situations when the other spouse is not insurable.
One reason people purchase annuities is because their investment grows tax-deferred. Some use them as a means for securing steady cash flow during their retirement years. But they can have devastating tax implications. Money invested in the annuity is not taxed, but those payouts are. And even if you do not receive the annuitized payments and therefore manage to defer the taxes during your lifetime, your heirs eventually will have to face them.
If you own $250,000 or more in annuities that have not been annuitized, and you and/or
your spouse is insurable, have an insurance expert review your situation to help you avoid
the annuity tax trap with a strategy such as survivorship insurance.