Tax Breaks for Annuity Owners and Their Beneficiaries

Annuity owners get a "good news, bad news" saga from their financial planners and tax advisors. The good news might be that their investment has risen in value; the negative information is that once they pass away, their heirs will have to pay income tax on that growth. There's nevertheless, a way to eliminate the "bad news" part of this story and pass much more dollars to your loved ones with tax breaks.

Let's consider Ruth, age seventy-five, a widow with a daughter. After her husband passed away, 8 years ago, Ruth sold her residence and invested a part of the proceeds in a variable annuity.

It was smart tax planning as she didn't require money for living expenses and simply wanted to have those funds appreciate without generating extra yearly income tax. Additionally, her intention is to not use these funds and leave the account to her daughter, Susan.

Ruth's annuity has almost doubled in value over the past 8 years. However, she has recently been reminded that Susan, who is in the 35% tax bracket, may ultimately have to pay income tax on those benefits. Clearly, one available tax break with an annuity is to always have the taxpayer in the family in the lowest tax bracket pay tax on the benefits. This is simply done by naming the low tax-bracket family member as the beneficiary.

Because Ruth does not require income from her annuity at this time and leaving the account to Susan would result in high taxes. A tax break available is for Ruth to begin withdrawals from the annuity and pay taxes as she is in a low tax bracket. Specifically, Ruth could gift the withdrawals to her daughter in order to purchase a life insurance policy on Ruth's life. This will permit the proceeds of the life policy to pass income tax-free to Susan. As we see, just a little thinking about a financial circumstance can reveal a simple-to-implement tax break.

To pay for the policy, Ruth will annuitize her variable annuity. She'll get a lifetime income and have the ability to gift her daughter enough money to make the life insurance premium payments. Any of the distributions that Ruth doesn't spend, might be spent to supply for her future needs.

Note the tax breaks harvested. At the age of 75, annuity withdrawals may have a relatively high exclusion ratio which means that most of each payment is a tax-free return of principal. Better yet is the fact that Ruth is living on a fairly modest income and it is in the 15% tax bracket. Therefore, by her harvesting the annuity, tax on the income will be paid at 15% instead than allowing the annuity to become inherited by her daughter who would need to pay tax at 35%.

Tax planning and tax breaks, the thinking in advance of ways to best handle the annuity to cut back taxes, can save significant tax dollars for the loved ones.