A family member recently told me she was disappointed she had to pay tax on an inheritance last year. Knowing that her state has no estate tax and that the federal estate tax doesn’t kick in until $11.58M, I quipped that she should not have paid any tax. As we continued the conversation, I learned that she had inherited a non-qualified, variable annuity. Aha! I realized immediately what had happened.
Annuities are the worst asset to leave your heirs …
from a tax perspective.
A non-spouse beneficiary of an annuity has few options for managing the taxes owed on an inherited annuity. The beneficiary is not eligible for a step-up in cost basis, as they would be when inheriting investments outside of an annuity. There are only two options available to the heir; 1) take a lump sum distribution in the year that the owner died, 2) take distributions over a 5-year period.
Both options result in ordinary income taxed to the beneficiary. The beneficiary won’t owe tax on every dollar, only on the difference between your original investment and today’s value. Ordinary income tax rates are higher than the more preferable capital gains rates applied to inherited investments outside of an annuity.
If the deceased annuitant had already begun annuity payments, the beneficiary will be required to continue those annual payments based on the schedule and death benefit option chosen by the deceased.
My family member took a lump sum distribution from the annuity she inherited, probably without realizing that she could stretch the tax owed over 5 years. To top it off, the income reported on her tax return in 2019 made her ineligible for a $1,200 coronavirus stimulus check this spring when she otherwise would have been.
Don’t do this to your heirs!
So you already have an annuity. What should you do?
First, consider using the annuity for its main purpose. The insurance sales industry has marketed annuities as everything under the sun. Investors have lost sight of the primary use of an annuity contract, to provide a guaranteed stream of income. By “annuitizing” you receive an annual payment based on your life expectancy. You will owe income tax on the difference between your cost basis and the contract value as a proportion of each payment. The annuity income allows you to preserve more tax efficient assets to pass along to your heirs. Perhaps you could even use the annuity income to purchase a permanent life insurance policy to leave a tax-free death benefit instead!
If you do not need the income and find yourself in a high tax bracket, annuitization may not make sense. Some contracts allow for a 1035 exchange in to a non-qualified SPIA (single premium income annuity). A SPIA immediately begins paying an income stream based on your life expectancy, but the percentage of that income considered a return of principal, and not taxed, is higher for older annuitants. While a 50 year-old may owe tax on 50% of the annual payment, an 80-year-old annuitant might owe tax on only 20% of the payment. These are called exclusion ratios. The decision to purchase a SPIA is complicated and should be looked at as part of your overall financial plan, rather than as a single issue.
You also have the option of withdrawing from the annuity, either for income or to invest in stocks and bonds at a much lower cost that allows your heirs a step-up in cost basis at death. Before withdrawing funds, make sure that your annuity is past the surrender period where fees are charged. When taking withdrawals, you must take the growth first and pay income tax before withdrawing your cost basis. You don’t have to withdraw everything in one year. Instead, you can stretch the withdrawal, and the taxes, over a multi-year period.
If you own a complicated, opaque financial product such as an annuity, and you cannot remember the reason you originally purchased that product, it is time to work with your advisor to review your options. Rather than allow a seemingly small, non-qualified, variable annuity to sit untouched for decades and eventually left behind for your heirs to sort out, you may find there are better options to maximize the asset.
If your tax bracket is considerably higher than your heirs, leaving the annuity behind may still be the way to go. But you are better off better avoiding the purchase of annuities for the wrong reasons in the first place. Your savings will grow much faster by investing without paying the high fees associated with annuity products.
Post Script: Annuities are complicated. Qualified versus non-qualified, fixed, variable, or indexed, minimum income benefits, and a host of additional riders may apply. There are no blanket solutions, and the suggestions above may not work for your situation. Bottom line – talk to an advisor. Many thanks to my colleague Brian Rosen for his help with this post.