Annuity Taxation: Are The Benefits Worth It?

Annuity contracts are complex, and we strongly suggest you consult a tax advisor if you are considering purchasing an annuity. Though the following shouldn’t be construed as tax advice, we hope these points about annuity taxation help you begin the conversation with your tax professional.

If you are considering an annuity for tax advantages, be wary. Even if you manage to eke out a small tax benefit, annuities can present disadvantages. Overall, annuity taxation is complicated and the tax consequences aren’t as clear-cut as some brokers and insurance companies might have you believe.

Annuities: A Quick Recap

Annuity contracts are financial products offered by insurance companies. When you purchase an annuity, you can fund the contract with one lump sum or a series of payments. 

All annuities have a similar two-part structure:

• Accumulation period. You deposit funds into an account and allow the investment to grow over time. Note that for immediate annuities, the accumulation period is very short as annuity payments must begin within one year.
• Annuitization. At a time defined in the contract, your investment is converted into a series of periodic payments for the rest of your life or a fixed period. At annuitization, your investment usually becomes the property of the insurance company.

There are three major types of annuities: fixed, variable and equity-indexed.

• Fixed annuities are like a watered-down, restrictive certificate of deposit. Insurers often offer “teaser” rates and then adjust them sharply lower. Does the tax deferral on a low-yielding instrument matter much if you aren’t on a path to meet your longer-term retirement goals?
• Variable annuities offer several mutual-fund-like subaccounts under the insurance contract. Variable annuity contracts can have complex fees, and the subaccounts may add an additional fee. These fees can hamper returns. How much are you willing to pay to reduce your payments to the IRS? What if the extra amount you are paying exceeds your would-be tax bill?
• Equity-indexed annuities are basically fixed annuities with fluctuating interest rates that typically tied to stock market index performance. There are many questions you might want to ask here: How is the rate actually calculated? Does the market index performance include dividends? Are there caps or limits on how much growth will be credited? Equity-indexed annuity performance cap calculations can limit so much upside return that the opportunity cost of owning the contract can exceed the value of the downside protection the contract may provide.

Weighing the Tax Effect

Some brokers may tell you the taxation of annuities offers an advantage over other investments. However, these benefits might not be worth it given annuities’ fees, their typical investment returns and other potential pitfalls.

An annuity’s tax structure depends on the account in which it is held.

• In a tax-deferred retirement account, like an Individual Retirement Account (IRA) or a 401(k), you may pay taxes on the annuity during your payout period. However, IRAs are already tax deferred, so annuities’ tax deferral really provides no additional tax benefit.
• If you hold an annuity in a Roth IRA, since you have already paid the income tax, taxes on the annuity won’t be deferred. This means you may not need to pay taxes when you reach annuitization.
• In a taxable account, your accumulated earnings get taxed but the principal doesn’t. With an annuity you pay tax to the IRS at your (usually higher) ordinary income tax rate, instead of the generally lower capital gains tax rate.

In addition, the tax consequences a beneficiary may face could differ from other investments. If you plan on passing your annuity to a beneficiary, your annuity gains won’t receive a cost basis step-up like many other investments would. This may create an additional tax burden for any beneficiaries.

Your age when you buy an annuity can also affect the taxation. And if you need to surrender the annuity before you reach age 59.5, you may pay regular taxes on the gains and an early withdrawal penalty.

Are Tax Deferrals Worth Potentially Higher Tax Rates?

If you buy an annuity in an after-tax account, your money grows tax-deferred. You won’t pay capital gains tax or taxes on dividend or interest income received in the annuity. The money grows without tax until you withdraw. At that point, however, you may experience an unpleasant surprise.

While annuities defer capital gains and dividend or interest taxation, when you withdraw the funds (typically by annuitizing them), all gains may be taxed at ordinary income tax rates. If your income tax bracket falls by the time you withdraw, many may argue you have won.

If you had invested that money in securities, however, you would be taxed annually on realized capital gains and dividends/interest, which may be taxed at less than ordinary income rates. Even if your income tax rate is lower after retirement, it will still likely be higher than the capital gains tax rate

Another benefit of investing in securities is offsetting realized gains with realized losses, should you have any. This practice is known as tax-loss harvesting. While selling losing positions may not be fun, the tax benefit can be a silver lining.

Taxes on Annuitized Payouts

Tax-deferred doesn’t mean tax-free. If your annuities are in a taxable account, you may pay taxes on the gains. If the distribution is annuitized and there are gains in those payments, then your annuitized payout is taxed in proportion to your percentage of gains.

Suppose you have a $200,000 portfolio that includes $100,000 in gains—50% of your account was a gain. This means 50% of your annuitized payout would be considered taxable income. Also, the future distributions from your annuity will be taxed at your then-current rate for ordinary income.

Know Before You Buy

Annuities are complex, and there are many other reasons to be wary of them beyond taxation. Fisher Investments is committed to helping investors better understand annuities. To learn more, please contact us or browse our educational annuity material today.