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The Problem with Annuities and How to Solve It

                It’s an issue that we see time and again.  Many of our senior clients have annuities that they purchased years ago.  In its simplest form, an annuity is an insurance contract into which you can reposition a lump sum to an insurance company and in return the insurance company will provide you with a stream of income.

                Immediate annuities begin making payments immediately with interest. Deferred annuities, however, allow the annuity owner to turn on the payments at a point in the future.  In the meantime, the original principal amount grows tax deferred.  In this way, annuities provide some of the same benefits as IRAs and other retirement accounts.  The investor does not pay tax on the growth until the money is withdrawn.  Similar to an IRA, there is a 10% penalty for withdrawing funds before age 59 and ½ but there is no requirement that you start withdrawing funds at 70 and ½ as there is under IRA Required Minimum Distribution (RMD) rules.  (I am specifically talking about annuities held in non-retirement account.  IRA annuities must still comply with RMD rules.)

                Annuities have been a way for people to get the same advantages of tax deferred growth as those who have IRAs and 401ks, which can be significant over time. They also provide for a steady stream of income for people who have small or no pensions to supplement their Social Security income in retirement, once they “annuitize” the contract.  They can guarantee themselves a steady income for life if they wish.  For conservative investors who are not comfortable with the ups and downs of the stock market, annuities can also be a way to grow their nest egg without investing in the market while getting a boost from the tax deferred nature.

                 Most contracts also allow the owner to withdraw money without turning on the income stream. These lump sum withdrawals, however, are taxed under a “last in first out” method.  This means that the growth is considered to be withdrawn first and thus is subject to income tax that has never before been paid because it was deferred.  Additionally, when the annuitant (the person on whose life the annuity payments are based) dies the annuity is part of the decedent’s estate for estate tax purposes and the beneficiaries must pay income tax on the growth.  It does not receive a step up in basis as does stock and real estate, which step up can wipe out all the unrealized gain and any tax that would have been owed on that gain.

                  Ok, so what’s the problem? The overwhelming majority of Americans who own annuities don’t ever turn on the income stream.   Instead, they leave them untouched for their beneficiaries to deal with the tax liability.  In other words, they don’t take full advantage of the positive features and leave their heirs stuck with the negatives.  Ideally, you want to leave as many of your assets to heirs tax free and withdraw from your tax deferred accounts in a way that can avoid the tax.

                   Is there really a way to do that?  Yes, there is and next week I’ll show you how.