Deferring income using annuities

Annuities are well suited to providing retirement income for some clients. They are most often used as a supplement or alternative to other sources of retirement income. An annuity contract can provide for an immediate annuity (the first annuity payment is due after the initial or single premium is paid) or a deferred annuity (the first annuity payment is due a specified number of years after the initial or single premium).

A commercial individual annuity contract may be purchased through many brokerage firms, banks, and mutual fund companies or by paying premiums directly to an insurance company. Payments may be made over time or with a single premium. Earnings on the invested premium accumulate tax-free until the annuitant begins withdrawals. The investor may choose to purchase a fixed-rate annuity, which will earn a rate of return set by the insurance company, or a variable annuity, which allows the investor to choose how premiums are invested, potentially maximizing return.

The tax-deferred accumulation of earnings within an annuity is similar to an individual retirement account (IRA). Individuals who (1) have made maximum contributions to their 401(k) plans through their employer; (2) are not eligible to make deductible contributions to traditional IRAs or contributions to Roth IRAs; or (3) want to set aside amounts in excess of the annual IRA limitation may find annuities particularly attractive. In addition, most annuities allow the investor to choose among several payout options.

Taxation of annuity distributions

Variable annuities

In reality, variable annuities are mutual funds with an insurance wrapper that shelters income from current taxation. A typical variable annuity allows the investor to put funds in stock, bond, and money market portfolios (called “subaccounts” by the insurance companies that sell the annuities). The investment is limited only by the flexibility of the insurance company.

One advantage of a variable annuity is its tax-deferral feature. Ultimately, though, the portion of any annuity payout that does not represent a return of capital is subject to tax as ordinary (rather than capital gain) income. In addition, the benefit of the tax-deferral feature is at least partially offset by the high expenses often associated with the annuity (compared with a direct investment in a mutual fund). An annuity’s earnings are normally not taxed at the point they are earned (Sec. 72). Thus, the ability to defer tax makes annuities an attractive investment. However, several disadvantages offset the annuity’s advantage of tax deferral, including:

• Investment risk is borne by the investor in a variable annuity;
• Management fees limit net investment performance;
• Surrender charges may be imposed by the insurance company on early withdrawals; and
• Withdrawals before age 59½ are subject to the early-withdrawal penalty of Sec. 72(q). However, Sec. 72(q)(2) provides several exceptions, including distributions allocable to investments in the contract made before Aug. 14, 1982, and when contracts are annuitized.

Cash withdrawals (as opposed to annuity payouts) from an annuity contract entered into after Aug. 13, 1982, are taxable as income first, then principal. Cash withdrawals allocable to a pre–Aug. 14, 1982, investment in a contract are treated as a recovery of principal first, then income (Sec. 72(e)). In addition, a gift of an annuity before maturity results in taxable income to the donor to the extent the cash surrender value of the contract exceeds the donor’s basis (Sec. 72(e)(4) (C)).Most annuities offer several payout options. Some of the more common ones include:

• Life only: Payments are made only over the life of the annuitant; nothing is paid to the annuitant’s estate or heirs. This option provides the annuitant the maximum income from a given principal amount.
• Joint and survivor: Payments continue over the lives of the annuitant and a surviving joint annuitant. The amount of each payment under this option will be smaller than under the life-only option.
• Life and period certain: Payments are made for the life of the annuitant or a specified period, whichever is longer. For example, if the annuitant dies one year after payments begin on a 10-year payout, payments will continue to be made to the annuitant’s beneficiary for nine years. The annuity payment under this option would be less than under the lifeonly option because the insurer has guaranteed payments for a term that could extend beyond the annuitant’s life.
• Installment refund annuity: Payments to the annuitant or the annuitant’s estate or heirs continue until the payout at least equals the amount paid to purchase the annuity. This option will also result in an annuity payment that is less than the annuity under the life-only option.

Variable annuity payouts (like fixed annuities, discussed later) are taxed partly as income and partly as a return of principal. The recovery of principal is excluded from income. The annual exclusion amount for a variable annuity is calculated by dividing the investment in the contract by the number of years over which it is anticipated the annuity will be paid (based on the annuitant’s life expectancy or the number of payments under a fixed-term contract). The life expectancy divisor for post– June 30, 1986, contracts can be found in Table V (for straight-life annuities) or Table VI (for joint and survivor annuities) of Regs. Sec. 1.72-9.

A death benefit received by a beneficiary when the annuitant dies before the annuity starting date is normally subject to income tax to the extent of the gain (i.e., the death benefit minus the net premiums paid) (Secs. 72 and 1014(b)(9)(A)). However, this rule does not apply to variable annuities purchased before Oct. 21, 1979, because they acquire a step-up in basis at death (Rev. Rul. 2005-30).

In addition to income tax, distributions received from an annuity contract before age 59½ are generally subject to a 10% penalty tax. Exceptions to this rule include payments attributable to the nontaxable recovery of principal in the contract, payments made as a result of the disability or death of the annuitant, payments made as a series of substantially equal periodic payments for the life or life expectancy of the taxpayer or the joint lives or joint life expectancies of the taxpayer and beneficiary, and payments allocable to pre–Aug. 14, 1982, investment in the contract (Sec. 72(q)(2)).

Fixed annuities

A fixed annuity contract is also taxed under the rules of Sec. 72. The purchaser of a fixed annuity contract obtains a tax basis (or cost) in the plan. Technically, this is the participant’s investment in the contract. Because the participant has already paid income taxes on the investment in the contract, the law provides a series of formulas whereby the participant excludes from gross income a portion of the investment (basis) in the plan (Sec. 72(b)).

Stock index mutual funds as an alternative to variable annuities

Investors are often drawn to fixed and variable commercial annuities because of the tax-deferred accumulation of earnings they offer. This deferral of tax makes annuities a valuable retirement savings vehicle for many investors, whether it be a supplement for those with other qualified plan benefits or a sole retirement arrangement for those without access to qualified plans.

But, as pointed out in the previous discussion, annuities have a number of disadvantages that must be considered. These include (1) higher costs due to mortality, administrative, and investment management fees; (2) the 10% early-withdrawal penalty on withdrawals before age 59½ that do not meet one of the penalty exceptions; and (3) surrender charges imposed by many insurance companies on early withdrawals. Despite these drawbacks, annuities can be suitable investments for many individuals, from both a tax and investment standpoint.

Stock index mutual funds generally

Before purchasing an annuity, however, investors should consider stock index mutual funds as an alternative. Index funds may be a better choice for some investors, particularly those who (1) are considering variable annuities; (2) have a relatively long-term investment period; and (3) intend to invest in the same type of equity fund (e.g., large growth or international) for the duration of the investment period. Because equity index funds are, in general, highly tax-efficient, they can somewhat replicate annuities without many of the restrictions and drawbacks of annuities. The table “Stock Index Funds Versus Variable Annuities,” below, summarizes relative advantages and drawbacks.

Stock index funds are not actively managed stock funds. Instead, they typically invest in and attempt to replicate a particular securities market benchmark. These benchmarks range from broad market indexes, such as the S&P 500, to more specialized segments of the securities market, such as utility stocks or real estate investment trusts.

Index funds have low portfolio turnover rates because they generally sell securities only when funds are needed to redeem shareholders. Thus, gains on the fund’s stock holdings normally are not realized, so the shareholder’s returns are generally in the form of unrealized gains that are not taxed until the shares are redeemed.

This discussion focuses on stock index funds, but the same rationale will generally also apply to tax-managed stock funds. Like index funds, tax-managed funds generally have low portfolio turnover rates and a primary objective of minimizing taxable distributions to shareholders.

Depending on an investor’s objectives, risk tolerance, and investment time frame, index funds may be a better choice than purchasing a variable annuity. This is more likely to be the case if the investor has a relatively long time horizon (e.g., 10 years or more) that will reduce the effects of the stock market’s volatility. The following factors favor index funds over variable annuities:

• Index funds’ lower fees and charges, which increase long-term returns;
• Much of the investor’s income is taxed as capital gain rather than ordinary income; and
• Redemptions before age 59½ are not subject to the 10% premature distribution penalty.

Gain from the sale of index fund shares held more than 12 months is taxed at a maximum capital gains rate of 23.8% (20% + 3.8% net investment income tax (NIIT)). On the other hand, annuity distributions are treated as ordinary income taxed at rates as high as 40.8% (37% + 3.8% NIIT) for some taxpayers. Of course, the capital gains rates and ordinary income rates may change between now and when a taxpayer expects to withdraw funds from either an index fund or variable annuity.

Contributor

Patrick L. Young, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.