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Top Annuity Tax Deferral Strategies

Author: Matthew Williams

Annuities continue to stand alone in the financial marketplace as the only type of investment vehicle that can grow tax deferred without having to be placed inside an individual retirement account (IRA) or qualified retirement plan. Although they are not appropriate for everyone, these unique vehicles can provide a wealth of tax and other benefits to both clients and their beneficiaries when they are used correctly. One or more of the following strategies may save you big dollars if your current financial situation matches any of the following scenarios.

Long-Term Care

In 2010, Congress eased the income tax burden for those who are paying for long-term care expenses from annuity distributions. The income that is withdrawn from these contracts may be considered tax-free as long as certain rules are followed. For example, the amount that is exempted from taxation cannot exceed certain daily or monthly dollar thresholds that are indexed for inflation annually by the Internal Revenue Service (IRS). Many contracts also allow those who have annuitized their contracts to withdraw two or three times the normal amount from them in order to pay for these expenses, and even these larger amounts will often still fall within the threshold limits. This break can be substantial for someone who is taking $6,000 a month out of a large contract to pay for nursing home care, as it would exempt $72,000 from taxation for that year. (For more, see: Taking the Surprise Out of Long-Term Care.)

Trust Your Annuity

Annuities are often used to fund charitable remainder trusts and charitable unitrusts because of their tax-deferred status. This is due primarily to the fact that many charitable strategies cannot be done using IRAs or qualified plans. Annuities are also ideal for this strategy because they have no contribution limits imposed on them by the IRS. Therefore, someone who wants to gift several hundred thousand dollars to a qualified charity can place the entire balance in an annuity contract and immediately shield all of the growth of the principal from taxation.

Those with large estates may also want to place their annuity contracts inside a revocable living trust in order to lower their personal tax bills. However, this must be done correctly or they may end up paying even more income tax, because the tax rates for trusts are among the highest in the tax code. Wealthy clients who are seeking to reduce their taxable estates may want to consider placing their annuities inside an irrevocable trust in order to accomplish this. Parents who have children or other dependents with special needs can also use annuities to pay income into a special needs trust. The tax rules for annuities that are owned by trusts can be quite complex in some cases, and both an attorney and a tax or financial advisor should probably be consulted in order to ensure that all applicable rules and limits are met. (For more, see: Establishing a Revocable Living Trust.)

Stretch Even if You're Not Qualified

Current tax law allows beneficiaries of annuity contracts housed inside IRAs or qualified retirement plans to stretch the annuity payments out over their lifetimes as long as the contract has not already been annuitized. But if you own an annuity outside of an IRA or qualified plan, then there are some annuity products offered by certain carriers that will still let your beneficiary stretch the payments from the contract over his or her lifespan as long as he or she isn't your spouse. The beneficiary can thus evade having to pay an enormous tax bill on the lump-sum balance in either a single year or over a 5-year period. The majority of the contract balance will also continue to grow for years to come, thus multiplying the total amount that the beneficiary will receive. However, if your beneficiary will probably need to withdraw the proceeds from the contract within a relatively short time, then you may be wise to add a rider to your annuity that will pay some or all of the tax bill when the contract is liquidated. (For more, see: An Overview of Annuities.)

Shield Your Income

When it comes to tax savings, one of the most straightforward uses of annuities is simply to use them to shelter income that you would otherwise pay taxes on. For example, if you are 45 years old and have $100,000 in certificates of deposit (CDs) and taxable bonds that generate interest on a regular basis that you are saving for retirement, then you will probably profit from moving those assets into a fixed, indexed or variable annuity that will grow tax-deferred until you begin taking distributions after age 59½.

Of course, it should be noted that many financial experts would steer their clients in a different direction here. They would say that it would be more tax efficient to simply move that money into a portfolio of exchange-traded funds (ETFs) that do not pay current income and simply grow in value over time. And when the time comes for you to sell off some or all of your holdings, then you will only pay the lower capital gains rate of tax on your sale, whereas all annuity distributions are taxed as ordinary income regardless of whether they are inside an IRA or qualified plan or not. But the ability to sell your holdings at any time without penalty may also entice you to dip into your retirement savings where you would leave them in an annuity. The right choice here will ultimately depend upon your own objectives and time horizon. (For more, see: Taking the Bite Out of Annuity Losses.)

Another strategy to circumvent the ordinary income issue is to use annuities inside a Roth IRA. Since all Roth distributions are tax-free, all distributions taken from a contract inside a Roth account will also be exempt from taxation. The tax rules for traditional and Roth IRAs supersede the tax rules for standalone annuity contracts.

The Bottom Line

Annuities do have some limitations when it comes to their tax treatment, such as being taxed as ordinary income and levying a 10% penalty on distributions before age 59½. There is also no step-up in cost basis at death for them like there is with real estate or equities. Nevertheless, annuities can provide tremendous tax advantages for retirement savers in certain situations and they should not be discounted from your financial planning. For more information on how annuities are taxed, consult the IRS's Publication 575 or consult your tax or financial advisor. (For more, see: Passing the Buck: The Hidden Costs of Annuities.)

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