Although annuities may help in providing income protection, they also have downfalls, mostly tax- and fee-related. For this discussion, we will talk about annuity taxation and the handicap it may create down the road.
Qualified Versus Non-Qualified Annuities
When an annuity is held inside of an independent retirement account (IRA), it is called “Qualified.” When an annuity is held as a non-IRA, it is called “Non-Qualified.”
Non-Qualified Annuities get special tax-deferral treatment which makes them attractive to some investors due to the ability to kick the income tax can down the road. However, any gains built in over the long haul will not be taxed as capital gains (currently 0%, 15%, or 20% depending on one’s Taxable Income and Adjusted Gross Income). Gains of an annuity will instead be taxed as ordinary income. Many retirees may actually never end up annuitizing their annuity and may see their annuities accumulate more wealth.
Under current tax laws, a couple living in a community property state could pass on their taxable investments and real estate holdings with minimal income taxes to their heirs. This is due to the step up in basis rules.
For example: If a couple owned a stock that was originally purchased for $30,000.00 (cost basis) and is worth $300,000.00 at the date of death, the beneficiaries would receive a step up in cost basis (now $300K instead of $30K). The beneficiaries could thus turn around and sell the stock immediately and pay minimal capital gains taxes. On the other hand, an annuity would not qualify for this treatment and would still have built in gains that would be taxed at the taxpayer’s highest marginal tax bracket (up to 39.6%).
This is why tax planning is not just to be made with short-term decisions (annually) but also needs to take into consideration the long-term financial plan.
Work with a Tax Planning Team
Maximize your individual and family savings with a tax planning team. At Chatterton & Associates, our tax advisors work alongside wealth managers and estate planning attorneys to provide our clients with tax-advantageous strategies – all under one roof! Contact us today to receive a complimentary financial review.