Variable annuities are sold as an investment vehicle that can offer significant tax savings by deferring income taxes on the investment gain. Annuity sales people tell you that you deposit after tax money, and you pay no taxes on the investment interest, or capital gains, until such time as you take withdrawals.
Sounds great…so what’s the catch?
Along with the tax deferral inside these variable annuities comes two problems that may cause you, and your heirs, to pay more tax than you would pay if you had used other investment alternatives.
Variable Annuity Tax Problem #1: Taxing Capital Gain as Ordinary Income
First, think of an variable annuity like a container. The rules of the container trump the rules of the underlying investments.
For example, if you buy a bond fund that pays interest income, you will pay taxes on that interest each and every year. If, however, you own that same bond fund inside of the variable annuity container, you will not have to pay taxes on any interest, or gain, that accumulates, until such time as you begin taking withdrawals.
It doesn’t matter whether the gain comes from interest, dividends or capital gains; it’s all deferred. This is the beneficial tax treatment of annuities, called tax deferral.
Tax deferral is great, until such time as you go to take withdrawals. At the time you take withdrawals there are two problems.
- When you take withdrawals from an annuity, gain is considered to be withdrawn first. (Unless you annuitize your contract, which, simply put, means you trade in your lump sum of money for a guaranteed income stream from the insurance company.)
- All gain that is withdrawn from the annuity is taxed at your ordinary income tax rate.
Why is this bad?
Ordinary income tax rates are higher than capital gain tax rates. At the top tax bracket, you will pay 20% more tax on ordinary income than on capital gain.
This means, despite the tax deferral, when it comes time to access your money, you may end up paying more taxes on funds inside the annuity than if you had invested in an alternative like an index mutual fund.
If you plan on owning a variable annuity for over twenty-five years before taking withdrawals, than the power of compounding deferred taxes may have enough time to work. But many variable annuities are sold to people who will need income in ten or fifteen years, and the adverse tax consequences are not explained upfront.
Variable Annuity Tax Problem #2: Heirs Do Not Receive A Step Up In Cost Basis
Upon your death, your heirs receive something called a step up in cost basis when they inherit assets such as real estate, stocks and mutual funds.
This is how it works: suppose you invest $100,000 in a stock mutual fund twelve years before your death. Over the twelve years, the $100,000 doubles to $200,000 (assuming the investments average a return of 6% a year, net of all fees).
Upon your death, your heirs inherit the $200,000. Tax rules say their cost basis in the investment will be the investment’s value upon your date of death; in this case $200,000. They can now sell it, and pay no tax on the $100,000 of gain.
This step up in cost basis does not apply to annuities.
If you invest $100,000 in a variable annuity, and it doubles to $200,000, upon your death, your heirs will have to pay taxes, at their ordinary income tax rate, on the $100,000 of gain. This could result in federal taxes of $15,000 - $35,000, depending on their tax rate.
No tax would be due if the investments had been placed directly in a mutual fund, instead of inside the variable annuity.
Unfortunately, when variable annuities are sold, no one explains that your heirs may pay thousands in taxes, instead of no taxes.
