By Keith Singer
Many deferred annuity owners have seen their accounts appreciate over the years without having to pay any taxes. However, at some point someone is going to have to pay taxes. The question is, how does one mitigate the impact of taxes?
When a deferred annuity owner takes withdrawals from his or her account, the gains will come out first and be taxed as ordinary income and subject to federal and possibly state income tax. For out-of-state residents, it may make sense to become a Florida resident prior to taking annuity withdrawals to avoid state income tax.
Also, there are some new annuities that have received a private letter ruling from the IRS, which allows withdrawals to be treated as part-income and part-basis. This will allow annuity owners to pay less taxes on their annuity income. Owners of standard annuity contracts, which tax all gains first, are permitted to do a taxfree exchange of their older annuity contract for one with more favorable tax treatment if they so desire.
For those who have gains but don’t need additional income, continued lifetime deferral is a common strategy. However, if the contract is left to one’s children, the kids will have to pay tax on the gains based on their tax bracket. In other words, continued deferral will likely cause the eventual tax liability to grow each year.
Given today’s historically low tax rates, we have been devising strategies to convert tax-deferred annuities to modified endowment contracts. Like deferred annuities, modified endowment contracts also grow tax-deferred. However, unlike deferred annuities, modified endowment contracts have an income-tax-free death benefit.
As far as appropriate asset allocation, Ibbotson said that he still believes in 60/40 portfolio designs but that “the 40 percent isn’t necessarily bonds because bonds could have poor performance going forward.” He concluded that index annuities allow for low risk equity participation with principal protection. Therefore, investors should consider using uncapped index annuities instead of bonds as the conservative portion of their portfolio.