Do Not Supersize Your Annuity
Fixed-rate and variable annuities provide a number of solutions for financial and estate planning. However, like any other investment vehicle, there are negative features to annuities, as shown in the table below. Each feature and consequence is detailed in the subheadings below the table.
All gains (appreciation + interest) eventually taxed
Withdrawals of gains always taxed as ordinary income
Order of withdrawals
Unless annuitized, all gains must be taken out first
Pre 59 ½ withdrawals
10% penalty on gains (no tax “credit” for penalty)
No step-up in basis for beneficiary
0% for fixed-rate but up to ~ 4% for variable annuities
You no longer own principal
All non-qualified annuities enjoy tax-deferred growth indefinitely. Contract owner decides when to trigger a tax event by making a withdrawal. Deferred taxation can last as long as either spouse is alive plus an additional five years. The surviving spouse must be the sole beneficiary of the annuity if indefinite tax deferral is to continue after owner’s death.
For example, Mr. Smith owns an annuity he paid $100,000 for; on his date of death, the annuity was worth $180,000. Mrs. Smith is named sole beneficiary of the contract. Mrs. Smith can take over this $180,000 contract and not have to pay any taxes on the $80,000 gain or any future gain while she is alive. She will not trigger a tax event unless she makes a withdrawal.
Mrs. Smith dies 11 years after Mr. Smith; at the time of her death, the annuity is worth $305,000. The annuity lists her son as beneficiary. When son inherits the $305,000 he can enjoy tax-deferred growth for up to five years. Son could also opt for annuitization and receive some tax-advantaged income (detailed later).
For income tax purposes, all growth in an annuity must be withdrawn first; the only exception is annuitization (described below). In the example above, Mr. Smith, Mrs. Smith, the son, or whoever is the current owner can make withdrawals at anytime. As long as remaining account balance is > $100,000, withdrawal is 100% taxable as ordinary income (since $100,000 is the cost basis).
For example, suppose son inherits the $305,000 annuity and then takes out $205,000 (fully taxable). Once he starts receiving principal (the last $100,000), 100% of those checks will be tax free.
Order of Withdrawals
The IRS will not let any annuity owner deem certain distributions as principal and others as growth—all growth (fully taxable) must come out first, unless contract is annuitized. In the example above, suppose Mr. Smith withdrew $23,000 when his contract was worth $150,000. Mr. Smith cannot claim the $23,000 is principal; since remaining principal is still > $100,000, the distribution is fully taxable.
When the annuity was worth $150,000, suppose Mr. Smith withdrew $53,000. In that case, the first $50,000 would be fully taxable and the final $3,000 would be tax free (since the final $3,000 was a partial return of his principal).
Pre-59 ½ Withdrawals
Withdrawals of growth prior to age 59 ½ from non-qualified annuities are subject to a 10% IRS penalty. There are some exceptions to the pre-59 ½ penalty: owner’s death, disability, or annuitization. The penalty is in addition to any income tax liability.
For example, Mr. Smith’s $100,000 annuity investment is now worth $124,000. Mr. Smith, age 56 and in excellent health, decides to take out $25,000 and use the money to buy a car he desperately needs for work. In this example, the first $24,000 will be subject to a $2,400 penalty (10%); the entire $24,000 is also subject to ordinary income taxes. The final $1,000 is coming from his principal and therefore is not subject to the 10% penalty or income taxes.
Annuity Owner Age 56 and Not Disabled
Original Investment (several years ago)
$25,000 is now withdrawn
$2,400 penalty + ordinary taxes on $24,000
Mr. Smith is in a 30% tax bracket
$24,000 x 30% = $8,000 taxes due
Total tax and penalty liability on $24,000
$8,000 + $2,400 = $10,400
Note: final $1,000 of withdrawal is return of principal (no taxes or penalty)
There is no step-up in basis when an annuity owner or annuitant dies. Any subsequent sale of the annuity likely means there will be a gain taxed as ordinary income.
For example, Mr. Smith’s $100,000 annuity investment is worth $180,000 on his date of death. His sole beneficiary is his wife, Mrs. Smith. She also inherits $90,000 of stock from Mr. Smith; the stock cost Mr. Smith $73,000 and purchased by Mr. Smith a couple of weeks before he died. A few days after Mr. Smith dies, Mrs. Smith decides to sell the annuity (for $180,000) and the stock (for $91,000).
Mrs. Smith will pay ordinary income taxes on the $80,000 annuity gain. However, she received a 100% step-up in basis in the stock. By selling the stock for $91,000, her taxable gain is just $1,000 ($91,000 - $90,000 step-up). Moreover, the entire $1,000 will be taxed as a long-term capital gain. It is irrelevant when Mr. Smith bought the stock or when it is sold by Mrs. Smith—capital gain assets inherited automatically qualify as “long-term,” regardless of anyone’s holding period.
Annuity Owner Dies
Original Investment (several years ago)
Value on owner’s death
Taxes if 100% liquidated
$80,000 taxed when received by any heir
Taxes if partial liquidation
All gain taxed as ordinary income
Minimize taxes w/o annuitization
Higher withdrawals in low tax bracket years
Note: Tax deferral can continue indefinitely if sole annuity beneficiary is surviving spouse
Fixed-rate annuities are like bank CDs: they have no upfront or annual costs. Few variable annuities have an upfront cost, but all variable annuities have ongoing costs. These ongoing costs range from ~ ½% a year up to ~ 4% a year. The range varies depending on the annuity issuer and features selected by contract owner.
For example, a “bare bones” variable annuity (VA) through Fidelity or Vanguard may have total annual costs of well under 1%. Another VA may have a living benefit and/or an enhanced death benefit rider. The M&E, management fee, and rider costs could be in the 3% range or even in the low 4% range per year.
Virtually all annuities will allow contract owner to annuitize their investment. Most of these same companies will also allow partial annuitization. Partial or complete annuitization provides:  an income stream guaranteed to last for a specified period, and  tax-advantaged income for all non-qualified contracts.
For example, Mr. Smith invests $100,000 in an annuity now worth $160,000. Mr. Smith decides to annuitize $80,000 and let remaining $80,000 grow tax deferred. Mr. Smith wants guaranteed income for his life and the life of his wife. He selects joint life annuitization—payments remain level as long as either spouse is alive.
Since Mr. Smith is annuitizing $80,000; his monthly payments will be based on the $80,000 plus his life expectancy and his wife’s life expectancy. Suppose the annual payments are going to be $5,000. Since he has a 60% gain ($100K grew to $160K), ~ 60% of each $5,000 will be taxable and ~ 40% will be tax free (due to the exclusion ratio). Mr. Smith and/or Mrs. Smith will receive $5,000 a year for as long as either one is alive; the amount will not decrease when one dies.
The exclusion ratio (~ 40% in this example) continues until principal portion of each check (~ 40%) cumulatively totals $80,000 (the principal annuitized). After that, 100% of any remaining checks are fully taxable (since he has now received back all $80K principal).
If 40% of each annual payment is principal (40% of $5,000), Mr. Smith is getting back $2,000 of principal each year. After 40 years, he (or his wife) will have received back all principal ($2,000 x 40 = $80,000). In the 40th or 41st year, 100% of future checks will be fully taxable. It seems unlikely either spouse will live that long unless annuitization began when one or both were in their 40s or maybe 50s. For someone who annuitizes a contract at age 60+, eventual “loss of the exclusion ratio” would be highly unlikely.