Annuities are the new tax target

Stan Haithcock for MarketWatch writes: Annuities are growing in popularity every year with an estimated $200 billion to be sold in 2013. As with every investment, you have to consider the tax ramifications and should always receive all of your tax advice concerning annuities from a qualified tax professional.

The best overall resource I have found is a recent book by renown annuity tax guru John Olsen, called "Taxation and Suitability of Annuities." As John puts it so simply in his book, with annuities you have to prepare for taxes during life and after you pass away. Things get a little complicated when using annuities with Trusts and in estate planning, so this is further reason to always use a tax pro.

Below are some basic points to be aware of when it comes to commercial annuities. This list is by no means "all inclusive" and just scratches the surface on all the rules and exceptions, but is a good foundation if you currently own an annuity or are considering the purchase of one.

Tax deferral

Over 80% of all annuities are deferred annuities. With non-IRA money, you can place your money within a deferred annuity structure and not be required to pay taxes until money is taken out. All gains grown and compound tax free during the deferral years. When you eventually take money out, it is typically taxed at ordinary income levels and using LIFO (last in, first out) accounting.

Annuity payments

Annuities were developed to pay an income stream for life, regardless of how long you live. The two ways you can receive a lifetime income stream from an annuity is by annuitization or drawdown.

• Annuitization — This is the original way to create a lifetime income stream. With non-IRA funds, annuitization provides an income stream of which a portion is excluded from taxes. This is called the “exclusion ratio.” Annuitization is a combination of return of principal and interest, and all deferred annuities can be annuitized for income needs.
• Drawdown — The newest way to create a lifetime income stream with deferred annuities. This strategy is primarily used with the now popular “income riders” which are attached benefits to a policy that can be used for lifetime income. Using non-IRA funds, the income stream is taxed at ordinary income levels and using LIFO (last in, first out). LIFO taxation applies if your annuity was purchased after Aug. 13, 1982 and no additions were made after that date.

1035 transfer rule

The IRS approved 1035 transfer rule allows you to transfer a non-IRA annuity to another non-IRA annuity without triggering any taxes. Whatever your cost basis is with your initial annuity will transfer to the receiving annuity company. You will eventually have to pay taxes when you take money out of the annuity.

Taking money out

The majority of deferred annuity contracts allow you to take money out on an annual basis if needed.

• 10% free withdrawal — Deferred annuities allow you to take out money from your annuity on an annual bases without incurring surrender charge penalties. Most policies allow 10% of the accumulation value to be withdrawn, and the taxation is LIFO if there are gains in the policy.
• 59 ½ Rule — Just like with your IRA, if you take money out of a non-IRA annuity, you will be penalized under the IRS early withdrawal rules. However, there is a way around this penalty utilizing Rule 72(t), if you really do need to access the funds earlier than planned. There are a few exceptions, like being disabled, that will not trigger the penalty.

Individual retirement accounts

Some practitioners don't believe in placing annuities within IRA's, and that is an argument for a different day. Right or wrong, hundreds of millions of annuity dollars are currently in traditional IRA's. Roth IRA's can house annuities as well, but the points below are for traditional IRA's.

• IRA Transfer Rule — If you have a deferred annuity within an IRA, you can transfer that annuity directly to another IRA as a non taxable event.
• RMDs — Annuities within an IRA that pay a lifetime income stream (like Immediate Annuities), can help cover your annual Required Minimum Distributions. The income stream from the annuity has no tax advantages within the IRA, and the income is taxed at ordinary income levels just like any money that you take out of your IRA.

Annuity death benefit

Annuities are life insurance products issued by life insurance carriers. However, unlike life insurance, annuities are taxable at death. Within an IRA, an annuity is taxed like other IRA assets. Outside of an IRA, the gains are taxed.

• Stretch IRA — One strategy that will limit taxes at death is stretching your IRA using an annuity strategy. You can stretch your IRA without using an annuity, but fixed annuities provide a principal protected way to maximize this strategy. Stretching means that the spouse and subsequent beneficiaries can take the deceased IRA owner’s RMD’s over their life expectancy instead of paying taxes on the lump sum. This would permit them to only pay taxes on the RMD amount, and is a great legacy strategy as well.

With Washington in need over continually increasing revenue, expect annuities to be targeted as a new tax resource.

California, Nevada, and a few other states have already instituted a "premium tax" on annuity income and expect this trend to flow from the West Coast very quickly. I also predict similar new progressive taxes on annuities in the coming years.

Don't try to "do it yourself" when it comes to taxes on annuities. Always consult with a qualified tax professional.