Annuities and taxes: a complementary pairing

By Ryan Parker

Bankers Annuity Brokerage


Taxes. To most Americans, it's an ugly word with an even uglier meaning, but nevertheless, taxes are likely to be at the forefront of many of your clients' list of concerns this time of year. As your calendar fills with client reviews and meetings — situations in which you know the subject of taxation is bound to arise — why not take this opportunity to discuss the many tax advantages, among other benefits, that annuities can provide? Think of it as a killing-two-birds-with-one-stone type of opportunity. With these simple tips, you can open the annuity discussion that could ultimately protect their income for life — all without hefty taxation.

Different annuities offer different benefits and have different rules. So, as an advisor, it can be helpful for you to perform a quick assessment of each client's current situation and then explore the annuity options you feel would be most appropriate for them. This will not only be appreciated when you present your homework at your client meeting, but it will ensure you can better articulate the details of each policy and its tax provisions as they will impact your client individually.

Tax deferral plus interest cubed

One of the most appealing qualities of all annuities is their tax deferment — any money earned by the annuity does not become taxable until your client withdraws funds. Another aspect of the annuity’s charm is its ability to compound interest on three different levels, a fact few of your clients will likely be aware of. So enlighten them. In addition to tax deferral on their annuity's assets, annuity owners also earn interest on their principal, interest on their interest and even interest on money they don't withdraw.

Tax-favored income

When your client does begin withdrawing income from their annuity in the payout phase, those payments are actually comprised of both the return of premium and return of any gains. This is called the exclusion ratio. Here is an easy-to-understand example developed by Lloyd Loughton:

Make the following assumptions: A) the $100,000 your client paid grew to $150,000 in value, and B), based on your client's settlement option, they receive a $1,500 monthly payment. In this example, $1,000 of the monthly payment represents the return of premium, which is not taxable, and the $500 represents their gains, which are taxable. This means only a third of your client's monthly income would be subjected to income taxation.

Delaying taxation

If your clients have other assets to draw from, particularly during the first years of retirement, they can elect to leave their annuity funds untouched for as long as possible. This will delay any taxation on annuity assets until later in their retirement, when their taxable income should be less.
Mitigating Social Security taxes

A little-known fact: Annuities' ability to mitigate or eliminate taxes on Social Security income holds plenty of appeal for clients. This is a strategy that only works for clients who have enough income to live off of currently. This is because any income they earn over a certain period could mean that their Social Security income will be taxed, and the hit can be as high as 85 percent. However, your client could fund an annuity with enough money to reduce their annual income below this threshold to ensure their benefits won't be subject to taxes.

Deferred annuities and tax benefits

If your client would do well in a deferred annuity, they'll enjoy a degree of liquidity most other annuity owners do not. This is because these types of annuity products typically come with a withdrawal provision which, after the first year of the annuity's life, lets your client withdraw up to 10 percent of their principal without suffering tax consequences.

What's more, with tax-deferred annuities, interest on tax dollars is simply allowed to accumulate. This essentially provides income in the future on the money your client otherwise would have had to pay in taxes. In fact, it's possible for this annuity owner to live off of interest for the rest of their lives, without necessarily having to pay taxes on the money that originally developed this interest.

Sure, tax time may be here, but with just a little extra work and a lot of client education, you can find solid ways to address their tax concerns while also considering their retirement needs. It's a natural segue into the annuity discussion. After all, if your clients are worried about taxes now, think of the peace they'll take from the knowledge that their annuity — selected and crafted by their attentive advisor — is not only earning them money, but protecting them from additional taxation as they move into their retirement.

Source: How Annuities Can Benefit Your Clients, by Lloyd Lofton