As part of your retirement planning, you may have invested in a deferred annuity. And, hopefully, over the years you’ve enjoyed tax deferred growth in the contract. The annuity may be a fixed annuity, where the insurer credits interest based on its own investment experience, or a variable annuity, where you choose the subaccounts (i.e., mutual funds) used to measure growth. Either way, now that you’ve retired, the question is whether to hold on to the annuity, surrender it, or give it away.
On your way to retirement
You may have good reasons to consider a gift of your annuity to someone else, or even surrender the policy for cash. Perhaps now that you’re in a lower tax bracket, tax deferral isn’t as important. Or maybe you feel you can get a better rate of return investing the proceeds in a mutual fund or ETF. And possibly your tax deferred annuity might be a good gift for a child in a high tax bracket. Alternatively, the beneficiary could be a charity, generating a tax deduction for you. Even better, why not surrender the policy and gift the proceeds?
On paper, all these reasons for disposing of your annuity may make sense. In practice, however, it is usually better planning to retain the annuity for your own retirement planning.
Tax Traps
There are a number of tax traps lurking around annuities if they are improperly handled. Consider these four tax concerns before dumping the annuity you so proudly purchased years ago.
1. Surrendering your annuity will result in an immediate ordinary income tax gain, not capital gain. The gain is the difference between what you paid for the annuity and what you receive for its surrender. This taxable income could cause a spike in your overall taxes, subjecting you to other taxes such as the Social Security tax torpedo, the dreaded IRMAA Medicare premium, or the net investment income surtax.
2. If you gift the annuity to your children, you’ll have to pay ordinary income tax on the gain in the contract. It will be treated as a disposition of the policy, and you’ll be on the hook for the gain, even if the annuity company is willing to allow the policy to remain intact when you assign it to someone else. In some cases, a deferred annuity may be a variable annuity that is in loss territory. Unfortunately, you won’t enjoy a tax advantage from this loss if you use the standard deduction. And since retirees are often in lower tax brackets, and receive a higher standard deduction (for seniors age 65 and older), a deductible tax loss may be more theory than fact.
3. Gifting the annuity to a charity faces a similar challenge. The deduction you expect to get for your donation may be moot because you don’t itemize your deductions.
4. Unless you’re gifting your annuity to your spouse or to a qualifying charity, the transfer will be a taxable gift for federal gift tax purposes. Granted, it takes a lot of gifting before the prospect of incurring a gift tax is real, but for affluent and wealthy individuals, the 40 percent gift tax rate is a definite threat.
Annuity Contract Considerations
Your deferred annuity may have contractual features which argue against gifting or surrendering your policy. You may be giving up valuable benefits and incurring unnecessary costs. Before acting, consider these four potential issues.
1. The annuity contract may not permit a transfer of the annuity to another individual. Be sure to check with the insurance company as to what is or is not permitted with your particular annuity.
2. If a gift by transfer is not possible, cashing in your annuity with the issuing company may result in a surrender charge. You would be gifting cash to your beneficiary with a value that is less than the worth of your annuity if it was still in force.
3. In the last decade, a popular provision with deferred annuities has been the so-called guaranteed lifetime withdrawal benefit (GLWB). This rider is a useful means of locking in a lifetime income in the future. However, these riders typically come at a cost, and if you gift or surrender your annuity, the value of the GLWB rider may be lost – with no refund of your costs.
4. Your annuity may have guaranteed annuitization rates that are better than what you can otherwise purchase in the open market. Your old annuity may have an annuity rate (the rate used to calculate your lifetime income) based on less favorable mortality. This means the contractual table assumes a shorter life expectancy, resulting in a higher guaranteed annual payout than what would otherwise be currently available for purchase.
You Have Options
Properly handled, an existing deferred annuity can be a valuable retirement planning tool. In fact, a review of your policy may remind you why you bought the contract in the first place. Further, you typically have several options as to what you can do with your annuity now that you’ve retired. Below are three of the most common alternatives retirees consider for the disposition of their deferred annuities.
1. Annuitize your contract. Particularly if the only other guaranteed source of income in retirement is your Social Security benefit, your annuity can be a tax-efficient way to lock in even more lifetime income. Your annuity company can quote you how much guaranteed monthly income it will provide you for life. The tax efficiency comes from the fact that the built-up taxable gain in your annuity will be prorated over your life expectancy. Rather than recognizing ordinary income immediately, the tax is spread over each monthly payment – stretching your taxes over your projected lifetime.
2. Exercise your GLWB. The guaranteed lifetime withdrawal benefit common to many deferred annuities is often underutilized, simply because it is complicated and insurers are sometimes hesitant to advertise its availability. Check with your insurance company to determine if you have such a feature, and how much income it would guarantee for life. In past years, a number of insurers issued liberal GLWB guarantees that they now regret, so be sure to insist on getting the information you need to make a decision. Understand, though, that your payments will likely generate ordinary income taxes. Be sure to compare annuitization of your contract to the use of your GLWB on an after-tax basis.
3. Exchange your annuity to another annuity carrier. A particularly attractive annuity tax provision is IRC Sec. 1035. This allows you to make a like-kind exchange from one annuity to another without incurring current taxation. This offers you a chance to move from a variable to a fixed annuity – or visa versa – and it gives you a way to obtain more modern annuity contract features, such as a long-term care rider. It also gives you an out if you’re worried about the financial integrity of your current annuity carrier. Bottom line, if you’re not happy with your current annuity, rather than giving it away or surrendering it, consider retaining ownership but exchanging it to a different carrier.
Your retirement is an excellent time to review your deferred annuity. Your tax status is changing, your income needs have shifted, and you may have an increased desire for guarantees in your financial plan. You may find that your annuity offers you ways to save taxes and lock in a supplemental retirement income you can’t outlive.
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