Your Turn: What’s on Your Mind?
Reader Question: “I am the beneficiary of a fixed annuity owned by a relative who has allowed the interest to accumulate, without taking withdrawals, so that he could put off paying taxes. However, inheriting this annuity will leave me with a significant tax problem since it appears that my only withdrawal options are taking a lump sum or a payout over five years. Is there some other way I can extend the withdrawal period or some other investment which could shelter me from taxes in the short term?” – Tony
David’s Response: Thank you for your excellent question, Tony. The situation you have described is a very good example of why tax planning needs to be integrated with investment and retirement planning decisions. Although nobody ever reads the fine print, there’s a reason why annuity brochures usually say something like, “neither the insurance company, nor its agents, give tax advice. Consult your own tax advisor.”
The Situation: As you have discovered, a key feature with all three versions of deferred annuities (fixed, index, and variable) is that earnings are not subject to income taxation until they are withdrawn. I’m going to inject some more specifics so we can use your question as a working example: let’s assume that “John” is the owner of a $100,000 fixed annuity that has grown to $150,000 over time; that means he has $50,000 of tax-deferred earnings. If and when John takes a withdrawal, the tax treatment is LIFO (last in, first out), so the $50,000 has to come out first (and be taxed) before he can get to the $100,000 that he already paid tax on. As the $50,000 is taken out, it will be added to his other “ordinary” income (not capital gains) and be taxed accordingly. If John dies while these deferred earnings remain in his annuity, his beneficiary will be essentially in the same tax situation, but there won’t be an option to defer those earnings indefinitely; usually a lump sum or five-year payout is required. I am not aware of any options to defer taxation of earnings beyond five years.
A Solution: One of the best strategies I’ve found is to have a candid conversation about your, and the annuity owner’s, income and tax rates. Then you can decide who will incur the lower tax upon drawing the deferred earnings. You can also “straddle” a few tax years to keep the withdrawal from spiking your taxable income all in one year (e.g., make a withdrawal in December and in January). Sometimes it makes sense to pay income taxes before you are required to in order to keep your overall tax bill lower, especially if you think tax rates are likely to go up in the future.
David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show at 9AM on AM1380 Ormond Beach, AM1230 New Smyrna Beach and AM1490 Deland. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.