Annuity Interventions—Reasons and Gameplans
As mentioned, sometimes annuities are perfectly appropriate, fairly priced, and important components of sound retirement strategies.
All too often (and most of the time in my professional experience) annuities are improperly sold and poor choices for many investors.
They can increase taxes over comparable non-annuity investments, reducing net wealth. Costs often run much higher than other portfolio options, also reducing wealth.
Both tax and internal costs are typically hard to spot, and investors may not know what is happening to them.
Annuity riders increase costs sometimes needlessly
Frequently expensive riders are layered onto policies, greatly increasing costs (and agent commissions in many cases!) to sometimes unbelievable levels.
While riders can provide valuable income features, in many cases they are not great matches for client needs or goals, cutting growth for no good reason.
Avoid the annuity mistakes this doctor made
For instance, I recently met a doctor who had sufficient pension income and did not need income from annuities, but had most of his money in them with expensive income riders. Since his main wealth goal was to pass money on to his son, the riders worked at cross-purposes for him. Worse, income and estate tax treatment differences over alternate investments like stocks or mutual funds will result in a big chunk of potential inheritance needlessly going to taxes instead.
There are a lot of good reasons to own annuities, but at least just as many to not own them, or to own more appropriate or less expensive ones.
Cashing out of annuities – pros and cons
Assuming it makes sense to get out, qualified annuities (those in things like IRAs or 401ks) can be surrendered—the term for cashing in a life insurance product—without fear of tax impact.
Provided the product was a poor choice and the surrender charges are not onerous, you may wish to consider other products like mutual funds or individual stocks or bonds. Even when surrender charges are high, it pays to get a detailed examination of total product costs.
Surrender charges and annuities – sometimes it costs more to keep them
With some products costing in the 5% range each year just for the privilege of owning them, it may not take long to recover even a 10% range surrender charge, and your ultimate wealth may be much higher taking the hit to reap lower ongoing costs and, perhaps, better investment management and performance.
As mentioned earlier in this blog section, actually discovering all the “hidden” costs in multiple documents is sometimes a challenge, and the skeptical may wonder if this is a coincidence. It may be helpful to have a professional review by someone who deeply understands these matters, to help ferret out the many potential costs and put them in context for you. My firm, Camarda Wealth Advisory Group, offers this service for free as part of our Portfolio Stress Test program.
Avoiding tax traps in non-qualified annuities – the silver lining of ordinary losses
For non-qualified annuities (those not in IRAs and qualified plans), tax treatment is a little trickier. For those who actually have losses (far too many in my experience), you have the opportunity to write off an ordinary loss, which is much more valuable in most cases than the more common capital loss and in some cases, nearly twice as valuable, even before you consider the time value of money.
Capital losses by themselves are not meaningfully deductible unless you have offsetting capital gains, but ordinary losses come off your other income, right now, at your highest marginal bracket.
If you have us do the Portfolio Stress Test, we can help you determine your tax opportunities, or exposure.
For those with significant gains in annuities, there are two basic strategies: 1035 exchanges and what I call tax bracket arbitrage.
Annuity tax strategies – 1035 exchanges and tax bracket arbitrage
1035s let you “rollover” an annuity like an IRA, deferring any tax until you actually take money out. As mentioned earlier, a lot of low-cost, high quality, and no-commission products have emerged that make destinations for money from expensive annuities.
1035 exchanges – kicking the annuity tax can deeper into the hole?
1035s are painless, but one must remember that annuities carry perhaps the highest potential tax rate of all investments. So, deferring more gains to ultimately just pay more tax may not be the best plan. Tax arbitrage, which is not unique to annuities, just means pulling as much money out in low brackets as you can.
Remember the US income tax code for ordinary income is progressive, meaning the rates increase as the income goes up. Note that the complexity of the tax code offers much opportunity for tax savings and wealth building to those with advisors who actually understand it well, which, unfortunately, can often be a minority!
Annuity tax arbitrage – working the brackets for greater wealth
It does not take a rocket scientist, however, to note that it is better to pay a lower rate than higher rate. So the essence of this “arbitrage” is simply not taking taxable distributions from annuities (or IRAs or other similar discretionary vehicles) during high bracket years. Admittedly, this takes a bit of sharp, proactive planning (not so easy if you have a typical tax advisor/preparer who works hard to save you tax and does not practice active strategy on the fly), but it’s not really complicated to do.
Believe it or not, your bracket changes more than you may believe year to year, and your decisions can have more power and impact than you may imagine.
Annuity surrender charges – can you get the commission you paid back?
One final word on surrender charges: while many annuity sales are proper and well disclosed, far too many are not.
If you believe the sales agent did not fully disclose risks, charges, surrender charges, or other material items, you should probably consider a complaint to the insurance carrier who issues the annuity and to your state insurance commission if you need to.
There has been enough abuse (particularly in the senior market) that the companies and regulators are very sensitive to this.
There is a good chance that you may get surrender charges back and other concessions if the sale was not pure, but only if you squawk enough.