Question: I am 50 years old and my financial advisor has suggested a deferred annuity. What is a deferred annuity? What are the tax aspects? What are the Medicaid implications?
Answer: Purchasing a tax-deferred annuity can be an excellent idea in certain situations. If needed, an annuity can provide you with a steady stream of income during retirement. For an instance, if you are still working and in a high income tax bracket, you can purchase an annuity with after tax dollars and defer paying income tax on the earnings until you withdraw monies from the annuity. If you wait until you are retired to take distributions, you will presumably be in a lower income tax bracket. In addition, it will grow tax deferred as long as it is in the annuity. In addition, you get the benefit of tax deferred growth.
A non-qualified deferred annuity is a type of insurance contract which you purchase with a lump sum using after tax dollars. According to IRS regulations, when that investment grows, it grows tax-deferred, provided the person is a “natural person”. No tax is paid until there is a withdrawal. A portion of the withdrawal is a return of principal and a certain portion is interest income which is taxable.
Payments from an annuity can be received regularly (i.e., monthly, quarterly) or in lump sums. You should be cautious however, because most annuity contracts do not allow withdrawals in excess of 10% per year without penalty, during the contract period. The amount of that penalty will be set forth in the contract and is usually reduced by 1% per year until the end of the penalty period. Typically, penalty periods end between 5 and 10 years. If you need access to the money you plan to invest, then an annuity may not be the best investment for you.
There are basically three types of annuities. Fixed Annuities are contracts that earn you a fixed interest rate during the term of the annuity. Sometimes the annuity begins at a high rate that is only guaranteed for a short period of time. Check the contract for the initial rate and for how long it is guaranteed before you make the purchase. Variable Deferred Annuities are contracts where the owner chooses the investment options. And lastly, Equity Indexed Annuities invest funds for growth similar to stocks but there is added protection against potential losses wherein a minimum contract rate is guaranteed at death.
There are some basic terms you should be familiar with in considering an annuity. The “annuitant” is the individual whose life is used to determine when payments begin and how much they are. The “owner” controls the contract and has the ability to transfer ownership or change the beneficiary. The owner does not have to be an individual; a trust can own an annuity. And the “beneficiary” is the party entitled to funds upon the death of the annuitant or the owner.
While annuities grow tax-deferred, there will come a time when the income tax is due. Unlike some other assets, there is no step-up in basis when the annuitant dies. The beneficiary will still have to pay the income tax at ordinary income tax rates (not at the more favorable capital gain rate). On the positive side, the annuity will pass to the named beneficiary and not be subject to probate, providing you designate a beneficiary. It is advisable to keep a copy of the beneficiary designation in a safe place with your other estate planning documents.
Don’t confuse non-qualified deferred annuities with IRA annuities. If the annuity is an IRA, then it is purchased with before tax dollars, it grows tax deferred as does any IRA investment, but distributions are fully taxable since these monies were never taxed. Also, the treatment of IRA annuities and non-qualified annuities is completely different when applying for Medicaid. We will discuss the Medicaid aspects next week.