Are Your Annuities a Ticking Tax Bomb?

Lots of seniors have purchased fixed annuities for their safety, simplicity and income tax deferral. Yet some annuity owners are at risk to lose half of their annuity value, and most aren't even aware of this! The annuity tax can be significant.

Let’s take a look at how this happens with a hypothetical example. Mary, age 55, purchased a fixed annuity for $50,000 in 1991. She held it for 10 years and the interest accumulated nicely. The account doubled to $100,000 (a compound rate of 7.17% which coincides with fixed annuity returns over the 10 years ending 2001 per data from Annuity Shopper Magazine, Dec. 2001).

So far, Mary has been very happy with this safe alternative. She never gave much thought to what happens to the annuity at her death and the annuity tax due. She figured she would eventually withdraw the money and use it. The truth is, less than 10% of the annuity owners I meet make any withdrawals from their annuity. If the owner passes away, the policies can get hit with some very large annuity taxes.

In Mary’s case, here’s the picture at the time of death when the taxes are due. In the blink of an eye, Mary’s beneficiary loses $50,500, over half of the annuity value! Is there a remedy? YES! If they don’t plan to use the annuity themselves, there is a technique, which can offer your heirs a much richer estate and significantly reduce the annuity tax Here’s how it works.

Annuitize the annuity (be sure to check with your agent or the annuity company for deferred taxes or sales that may apply, or any potential tax penalty if under age 59). The annuity should be setup for a lifetime payout, but may or may not include a “period certain” guarantee. A “period certain” guarantees your heirs will receive payments throughout the contracted period if you die before the end of that time period. Thus it would guarantee a minimum inheritance.

Remember, this is money you don’t expect to need to live off of. This is money you have earmarked for inheritance by your heirs. Now shop for the universal or whole life policy that is going to offer the best death benefit for your age and anticipated monthly after-tax income, your life insurance agent should be able to do this for you. You then purchase a life insurance policy payable to your beneficiaries (You may also wish to do this within an insurance trust. If you do this, your money could escape estate taxes too, but that’s a different article).

Back to our example; based on Mary’s current age of 65 (and assuming she is a preferred nonsmoker female), this $700 ($585 after taxes) per month purchased her a $364,140 universal life policy. Now, instead of Mary’s heirs getting only $49,500 at her death (the amount that they would have received after the taxes on the annuity), the heirs receive $364,140 of life insurance death benefit, free of estate and income tax!

That’s seven times the legacy her beneficiaries would have otherwise received, over $300,000 more! Let’s say you begin the payments from the annuity as described. Each payment they receive from the annuity makes another premium payment for their life insurance policy. Even if you died right after the first premium on the life insurance, your beneficiaries would still receive the entire $364,140 death
benefit on the life insurance policy.

You have now found a creative way to reduce the potential annuity tax on holding annuities to death and you have increased the legacy you can leave to your heirs in the process!