The Annuity Tax Trap

If you already own or plan to buy annuities, this article is a must-read.

An annuity is an insurance product that pays out income. Generally, you invest in an annuity, and then it makes payments back to you in a lump sum at some future date or in installments over a series of dates. Most insurance companies offer a variety of annuity products, each a bit different from the others. There are literally thousands of options, but the type chosen most often is the deferred annuity, which delays payments of income until the investor chooses to receive them.

The reason so many people buy deferred annuities is that they are charmed by the salesperson’s standard industry pitch, which highlights the fact that earnings on the money invested in an annuity are tax-deferred. This means that no tax is due on any increase in value of the annuity account until those profits are withdrawn from the account.

This sounds great, but the realities that will haunt you as the buyer of any deferred annuity are these: You bought a lousy insurance policy, and you created a tax trap for yourself.

According to Ken Fisher, who has been writing Forbes magazine’s Portfolio Strategy column for 30 years, “The vast majority of annuities are really complicated insurance policies that make it very difficult to fully understand the implications and unintended consequences. And once you buy into an annuity, it can be a very difficult 
and potentially very costly investment decision to reverse.”

Here, we will explore the two sad realities, one at a time.

The Lousy Insurance Policy
Joe (a healthy 60 year old) buys a $500,000 deferred annuity. Statistics indicate that more than 90 percent of all deferred annuities are held (never annuitized) until the owner’s death. By the time Joe dies, his annuity has increased in value to $960,000 (a profit of $460,000). The beneficiary of Joe’s annuity is his son Sam. However, the entire $960,000 is part of Joe’s estate and therefore subject to estate taxes. In addition, the $460,000 profit is taxable as income in the year Joe dies.

If Joe had used that $500,000 to purchase a life insurance policy instead of the deferred annuity, the death benefit to Sam would have been in the $2 million range. And it would have been free of income and estate taxes.

The Tax Trap
Here’s another example: Scott purchased a $730,000 annuity that has a current value of about $2.01 million—a deferred profit of about $1.28 million. Scott, too, did not annuitize his annuity before his death. Annuities are subject to a top unearned income tax rate of 39.6 percent and an additional “surcharge” of 3.8 percent. That amounts to a total tax of 43.4 percent on the $1.28 million in deferred profit. This means the income tax burden for this annuity is about $555,520.

But there is even more to this tax horror story. Even after the income taxes have been levied against this annuity, its now-diminished value is further subject to a 40-percent estate tax. In the end, the double-tax liability on an annuity that had grown to about $2.01 million is about $1.14 million—more than half its value! And these tax liabilities would only have gotten worse as time went by and the value of the annuity continued to grow. Simply put, deferred annuities are a tax trap.

How to Escape the Trap
Escaping from the tax consequences of a deferred annuity is a simple two-step process:

Step 1. Annuitize the annuity. In other words, convert it into income. Let’s say that Scott had taken these steps prior to his death, and his deferred annuity still had grown in value to about $2.01 million. The insurance company from which the annuity was purchased agreed to convert it to an annual annuity and pay Scott about $171,000 every year for as long as he lives.

Step 2. Use the income to pay for life insurance. Of course, the payments from Scott’s now-annual annuity are subject to income tax. He used the after-tax annuity payment, which amounted to about $123,000, to pay the annual premium of a new $2.68 million life insurance policy on himself. This insurance policy actually is owned by an irrevocable life insurance trust, however, so its death benefit will not be subject to income or estate taxes.

Thanks to these two steps, Scott’s beneficiary will receive a $2.68 million insurance benefit, rather than a paltry after-tax payout from the deferred annuity of just over $875,000. That’s a difference of a whopping $1.8 million. Because anyone who is in the 43.4-percent income tax bracket and 40-percent estate tax bracket must earn more than $2.9 million in order to leave his or her family $1 million, this increase of $1.8 
million offers the same after-tax results as earning about $5.4 million. 

The overall lesson to be learned here: Stay away from double-tax situations like 
deferred annuities.