If you’ve maxed out your retirement savings vehicles, such as 401ks and IRAs, and still have discretionary income to save, you may be considering tax-deferred annuities. While annuities have their advantages, for those with strong legacy goals, they’re usually not the best option, especially if charitable giving factors heavily into those legacy goals.
To understand why this is, let’s start with a quick refresher on annuities.
What is an annuity and how does it work?
An annuity is essentially a contract between you and your insurance company, in which your insurance company makes payments to you. You may purchase an annuity with either a single premium or smaller regular premiums spread out over time. The payout from your insurance company may also come as a single payment or a series of fixed payments.
Annuities come in three forms – fixed, variable, and indexed. A fixed annuity is when the insurance company is required to pay you a fixed amount on a periodic basis. With a variable annuity, the insurance company is still required to make payments to you, but the amount is variable based on the amount you put in, the rate of return, and expenses. Finally, there are indexed annuities, where the amount of your payment from the insurance company is based on the return of a stock market index (such as the S&P 500).
A noteworthy difference between the three types of annuities is that state insurance commissioners regulate fixed annuities, while the Securities and Exchange Commission (SEC) regulates variable and indexed annuities. This difference in regulation exists because variable and indexed annuities are considered securities, while fixed and indexed securities are considered insurance products. That’s because according to the U.S. Supreme Court, “absent some guarantee of fixed income, the variable annuity places all the investment risks on the annuitant and none on the company.” What this tells us is that variable annuities come with more risk than fixed annuities (though variable annuities do also come with the potential of a higher ROI).
Why do people purchase annuities?
Since they offer periodic payments, annuities – especially fixed annuities – are often purchased as a way to help individuals manage their income in retirement. Individuals may also choose to purchase an annuity because of the option to designate beneficiaries to receive annuity payouts after the annuity owner dies. Finally, and perhaps most advantageously, annuities provide tax-deferred growth, meaning neither the income nor the investment gains are taxed until payouts are made. This provides one-half of the double tax advantage of an IRA (which offers both tax-deferred growth and tax-deductible contributions).
What are the tax effects of transferring an annuity?
The goal of an annuity is to help manage income in retirement, but especially for those of us with legacy-based financial goals, it’s important to consider how annuities are transferred and how this affects taxation. The tax implications of transferring an annuity depends on the timing of the transfer and on whether the transfer is to another person, a trust, or a charity.
Let’s talk about transfer timing first. As previously mentioned, the individual named as the beneficiary on an annuity will receive the money if you die before receiving any payments, but you also have the option of transferring the annuity to another person during your lifetime. If you sign your annuity over to someone else while you’re still alive, that individual has the immediate ability to start payments, withdraw money, or change the beneficiary. Transferring the annuity means it will no longer be part of your taxable estate unless you die within three years of transfer. However, if you give the annuity as a gift you must pay taxes on any gains at the time of transfer, and depending on the value of the annuity gift taxes may apply.
The second transfer option is to a trust, which may allow you to decrease the value of your taxable estate and/or avoid potential mismanagement of the funds by the beneficiary. If you choose to transfer an annuity to a trust, you also must pay gift taxes based on the value of the annuity.
Finally, you may transfer an annuity to a charity. While there may be other reasons to donate an annuity to a charity, from a tax perspective gifting annuities to charity during your lifetime is not the best charitable giving option, since any untaxed gains must be reported as income in the year you donate the annuity.
Given the available transfer or donation options and their various tax implications, you can begin to see the potential concerns that may arise for those of us with financial legacy goals, whether those goals are for loved ones or charitable causes. If you do decide to purchase an annuity (or have already purchased one) the best way to include it in your legacy minded giving plans is usually to consider it as an option for testamentary giving (giving done after your death), as opposed to giving during your lifetime.
Should you gift an annuity to charity?
For someone for whom charitable giving factors largely into financial legacy goals, annuities simply aren’t the best vehicle for charitable giving during your lifetime. Consider an annuity in contrast to other savings vehicles, such as Qualified Charitable Distributions from an IRA. All of the annuity’s gains that received tax-deferral over the years have to be reported as income in the year the gift is made. Now, the deduction for the charitable donation would offset this income spike, but it still leaves you with little tax benefit, and every dollar you pay in taxes is one less dollar you could give to charitable causes or future generations.
Even with the charitable giving deduction, donating an annuity may still be a net tax harm because the higher gross income could hurt your eligibility for other tax credits and deductions or drive your Medicare premiums higher.
If you have strong financial legacy goals, you’ll want to consider every financial planning decision through the lens of how it impacts these goals. Savings vehicles, such as an annuity, may not provide the highest ROI for those who prioritize their financial legacy, especially if that financial legacy contains a charitable gifting component. If you’re interested in learning more and discussing how these different decisions may impact your financial legacy goals, please schedule a free initial consultation using the button in the navigation menu.