As I noted in Part I, an annuity is a complex financial animal. It can be used as a tool to accumulate funds on a tax-advantaged basis. It can also be used efficiently to distribute funds in later years, which is my focus here in Part II.
This is the very definition of the word annuity. If I want that stream of payments, I can either purchase it from the annuity company, or I can annuitize an annuity contract I already have. In either case I make an irrevocable choice to turn over control of my principal to the annuity company in exchange for this stream of payments.
That I annuitize a lot of money, get hit by a bus, and the annuity company keeps the remainder. That is called the single life option, which yields the highest payout. To mitigate against this risk, I chose a payout option:
Another risk is interest rate risk. Say I annuitized a sum of money now. The annuity company will look at my life expectancy and the current interest rate environment to give me a quote. What would happen in, say, 5 years when current money rates might be up 5%? Nothing will happen; that’s the point. You will be paid out according to your contract. Someone purchasing a new contract with the same assumptions as yours might indeed have a higher payout.
Many people are uncomfortable with the irrevocably giving up control of a lump sum of money. Instead, they simply draw money out of the contract as needed. This can be done occasionally, or on a periodic basis. An annuity is not an investment account, however: each non-periodic withdrawal will require a form to be submitted to the annuity company, and it can be several weeks before you see your funds.
The taxation is different here: no exclusion ratio. The contract distributes all the gain first, fully taxable, and then the basis. For example, you have a contract worth $100,000. You’ve paid in $64,000 and have $36,000 gain in the contract. You decide to take $1000 monthly distributions. You will have 36 fully taxable $1000 payments (just to make the math easy, assuming no further earnings). With the 36th payment all the gain in the contract is distributed, so all remaining payments are free of taxation.
The annuity contact passes to your named beneficiary. There is no step-up in basis, however. An annuity contract is not capital gains-type property, so there is no step up. Your beneficiary will inherit not only the contract value but also your basis, and will therefore have an immediate tax issue.
This is sort of a high-class problem, as I see it. If dad wants to leave a sum of money set apart for a child, an annuity is a good place to put it – dad won’t have to pay any taxes on the gains. In this case the child who inherits the contract will pay the taxes. This is a very different tax situation from the investment account that dad opens, registered as a Transfer on Death to the Child. In this case dad will pay the taxes on the gains. These can be minimized by investing in non-dividend paying investments that would produce a lot of ordinary income, and by holding investments. If there are no sales, then no gains are realized, and the whole account value gets stepped up at dad’s death. Once again, this is another big trade-off.
Annuities are fairly complex products. If you have further questions feel free to get in touch with us at [email protected] Also follow us LinkedIn, Facebook, Instagram, and YouTube for more personal financial information relevant to you!