Are the tax attributes of capital assets really more attractive than those of annuities?Article added by Ken Davis, CPA, CFP, CLU, ChFC on May 8, 2012
Ken Davis

Ken Davis, CPA, CFP, CLU, ChFC

Fountain Hills, AZ

Joined: November 23, 2009

Annuities are generally held longer and when they are liquidated, the money is frequently moved tax free to another one and the deferral is continued. And we all know the value of tax deferral.

The popular press says to stay away from annuities because they produce ordinary income at distribution. They say it is better to invest in capital gain type assets that are only taxed at 15 percent tax rates instead.

The fact is that capital gains sometimes are taxed at a much higher effective rate than 15 percent. And, the assumption that there will be capital gains at all is not guaranteed and losses are quite possible. If there are capital gains, they may not be long-term capital gains. Let’s explore these points in a little more depth below. We owe it to our clients to help them overcome this media “wisdom.”

Let’s start with this example. A 65-year-old widow has $30,000 in pension income and no itemized deductions. She also has $24,000 in Social Security income. Her income tax is $4,128, using 2011 income tax tables.

She adds to that $10,000 in long-term capital gain income. In theory, the increase in tax is supposed to be 15 percent of the $10,000 long-term capital gain, or $1,500. The actual tax in this example is $7,338 or an increase of $3,210 instead of $1,500.

This is an effective rate of 32 percent, not 15 percent! (CPAs call this kind of computation a within and without calculation). How did this happen?

As a side note, before we go on, you may have seen a similar example in my article, “How can line 20(b) help you sell more annuities?”

The difference in this example is that we are talking about long-term capital gains here and not interest income. With interest income, the effective rate was 42 percent because of the difference in tax rates between ordinary income and cap gains for part of the taxable gain. In my other article, I discuss how a combination annuity strategy can help overcome this tax issue.

The simple answer to why the widow paid a 32 percent rate is that while most long-term capital gains may be taxed at 15 percent, the total amount of capital gain (not just 15 percent) is included in income. The income flows through the return to adjusted gross income on the bottom line of the front page of the return.

When a taxpayer has AGI above certain limits, it may trigger the inclusion of Social Security income on line 20(b) of the return. In this example, that added 85 cents of taxable Social Security Income for every dollar of long-term capital gain realized.

The 85 cents of taxable Social Security income is taxed at ordinary income tax rates and the long-term capital gain is taxed at 15 percent. The two are added together to get the 32 percent blended effective rate.
In addition, AGI is used to phase out many income tax deductions, exemptions and credits on top of taxing Social Security Income. So, the reduction in AGI could have even more impact on tax reduction given different facts.

Another situation where capital gain assets do not impart the full benefit of the 15 percent long-term capital gain treatment is with mutual funds. Mutual funds distribute their capital gains from the trading of securities annually. Realized capital gains from internal fund trading must be distributed as capital gain dividends annually to comply with tax laws.

Unfortunately, actively managed mutual funds frequently trade their investments so rapidly that much of the gain is short-term capital gain instead of long-term capital gain. Short-term capital gains are taxed at ordinary income tax rates, not the 15 percent rate.

If you look at most IRS Forms 1099 from mutual funds, you will see less long-term capital gain and more short-term capital gain treatment than you might expect coming out of mutual funds. Therefore, the low 15 percent tax rate is largely elusive for mutual funds.

In comparing the tax attributes of capital assets and annuities, consider that section 1035 of the Internal Revenue Code allows annuity owners to do a like-kind tax-free exchange of money in one annuity to another. Unlike annuities, mutual funds or even individual stock holdings cannot be transferred tax free into another mutual fund or stock through a like-kind tax-free exchange.

Capital assets can defer income like annuities, but investors sell their assets more frequently to lock in gains and therefore trigger income taxes more frequently. Annuities are generally held longer and when they are liquidated, the money is frequently moved tax free to another one and the deferral is continued. And we all know the value of tax deferral.

Finally, annuity holders have one more tax trick up their sleeves. If the annuity holder annuitizes their annuity, then any tax basis is amortized over the expected life of the payments until the tax basis is used up. That amortization of basis reduces the amount of the payment that is taxable each year.

In my article “How can line 20(b) help you sell more annuities?” I demonstrate how to combine various types of annuities to obtain a very favorable tax result and to lower the taxation of Social Security income.

I know much of this is complex and hard to learn and then explain to your clients. There is some nice software that can show a before and after picture based on the client’s real data. It takes effort and an investment in this kind of presentation but it may be worth it to make the sale.

The summary and detailed analysis is also impressive to any CPA who may be looking over your shoulder. If they do challenge you, then ask what assumptions they think are reasonable. If they are too far out on their perceptions, show them actual historical data to support more reasonable assumptions they can then agree with and run those.

Welcome their input and don’t fight them. You may make the sale and get some referrals with the right analysis and attitude. And once you find a friendly CPA who likes this stuff, then refer tax projection work to them. Work as a team and everyone benefits.

So, learn how the tax laws work and use them to help your clients save taxes and increase your income at the same time.

IRS Circular 230 Disclaimer: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.
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