Annuities Can Have Unpleasant Tax Side Effects: Here's The Surprising Antidote

Many retirement savers hold a meaningful portion of their wealth in annuities.

Americans hold $2.6 trillion in non-qualified annuities alone. These accounts grow tax-deferred over the years, which means that, without a strategic plan, the increased value can turn into a painful tax bill.

Unless you leave that annuity to charity, you or your heirs will have to pay ordinary income tax on the gains over time.

With Annuity Awareness Month in focus, here are two questions to consider if you have an annuity that has seen significant gains.

How will your annuity be taxed?

An annuity's tax efficiency can depend on whether it's going to be a legacy asset or used as retirement income. How you withdraw money from an annuity also has a tax impact.

If you periodically take money from a non-qualified annuity — to purchase a car, for example — the tax treatment you'll receive is last-in, first-out (LIFO). LIFO treatment means every dollar of gain in the annuity comes out first and is therefore 100% taxable.

What comes out last is your basis — what you put into the annuity — which would be 100% tax-free when you or your heirs eventually get to it.

Not all annuities carry LIFO treatment, however, which is why you have options.

One consideration with older annuities is to turn them into a predictable stream of income by transferring your existing funds from one contract to another, tax-free. Some guaranteed income annuities carry the LIFO treatment, while single premium immediate annuities (SPIAs) work differently, tax-wise. They give you a portion of your basis with each income payment you receive. As a result, you accelerate capture of your tax-free basis by years, possibly decades.

If your existing annuity has an income rider, make sure you price out alternatives before you activate it because a newer annuity contract may offer you a higher amount of guaranteed income, or offer you more favorable tax treatment of that income. You can achieve these outcomes by executing an exchange of your cash value from one annuity company/product to another.

If long-term growth is the objective, periodically review older contracts to ensure fees, riders and investment allocations remain aligned with that goal.

It could be something as simple as adjusting the underlying allocation you have or removing costly riders you don't plan on using.

Or you could look at alternative annuities that allow for more flexibility in what you can buy within the tax-deferred wrapper.

Could long-term care insurance benefit you and your portfolio?

Long-term care (LTC) planning might also be an option for that old annuity, which could mean never having to pay income tax on the embedded gain.

LTC annuities, one of many forms of LTC insurance, typically ask you to forgo most (if not all) future growth in your cash value. In return, they guarantee a multiple of the account value will be available for LTC — tax-free — over time as you need it to pay for help with certain activities of daily living (bathing, eating, toileting, dressing, continence, transferring) or supervision if you have a cognitive condition such as Alzheimer's disease.

Hidden costs to funding long-term care

Most people consider LTC insurance as protection against the cost of care itself. The thinking is that if there are sufficient assets, you can simply self-insure the risk by relying on your portfolio.

While that's true, what is rarely discussed is what LTC insurance does for your portfolio as well as your retirement and estate planning — not as a needed form of coverage but as a tactical allocation within a well-funded retirement plan.

Consider the cost of LTC. The typical home health aide averages $40 an hour or more in higher-cost-of-living areas. A six-hour shift, every day, would run about $7,000 a month and more than $85,000 a year. Nursing costs can be as much as double that, on average, in those same affluent areas.

If you need significant care and don't have a dedicated source of funding, liquidating assets to pay those bills may be the only solution.

However, paying for care from investment assets can create unintended tax consequences, including higher taxable income, increased Medicare premiums and the loss of valuable step-up-in-basis opportunities for heirs.

LTC coverage changes this picture entirely. It insulates the portfolio of assets from quicker liquidation, if not avoiding liquidation altogether, allowing your portfolio to continue to grow tax efficiently.

There's also a compelling financial case for LTC coverage as a complement to your fixed income portfolio, especially if we focus on guaranteed LTC policies where the insurance company cannot raise your premium rates. Those policies contain a death benefit, which guarantees that a family will get their money back if no care is needed.

LTC coverage can provide a level of tax-free income that, depending on how long care is needed, could be difficult to replicate through traditional fixed-income investments.

LTC insurance is by no means a replacement for bonds, nor is it an investment. LTC insurance is an alternative to having more money invested. Its value comes from using a portion of your wealth to create a tax-free pool of funds that insulate the rest of your portfolio from expenses incurred in those less healthy years we all hope never come, but see happening to our older friends and family.

How is this relevant to you?

If you own an annuity with significant embedded gains, are approaching retirement, or have concerns about future long-term care costs, it may be worth reviewing these strategies with your adviser as part of your broader tax and estate plan.

With the right advising team, these are straightforward conversations that can make a meaningful difference in your wealth, long term.

Related Content

• How Are Annuity Withdrawals Taxed?
• Five Things Your Annuity Seller Won’t Tell You
• What You Don't Know About Annuities Can Hurt You
• Long-Term Care Insurance: 10 Things You Should Know
• I'm a Financial Planner: Here Are Some Long-Term Care Insurance Tips for Every Age

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.