Asymmetrical Information has a good article about the political and budget problems faced by pensions everywhere. It touches upon the treatment of annuities, one of the most popular investment vehicles there is. Most defined contribution pensions (e.g. 401k, among others) in the United States are actually funded by variable annuities.
Annuities currently have in interesting tax status, and there are several kinds. They are certainly popular instruments and their tax deferred status gives them appeal to many investors. For this purpose however, I am going to restrict myself to the question of whether or not they have been annuitized, which is the actual process of exchanging a pool of dollars that you control for a stream of income.
Annuities are tax deferred, which means while the money is inside the annuity, it is not subject to taxation. Therefore, it compounds with the entire amount of earnings the investments made (less expenses of course). If your marginal tax rate is 20%, and your investments make 8% per year, you’ll earn about 86 percent over a ten year period taxed, 116% if tax deferred. Even after taxes, you’ll have earned a little under 93% net. Annuities are also a life insurance product – they pass outside your estate to a named beneficiary immediately on death.
If the annuity has not been annuitized, it is taxed on a “Last In First Out” or LIFO basis. What this means is that the dollars that come out are presumed to be from the most recent that went in. In other words, insofar as possible, it is the original principal that is untouched and the earned income you are using. So if you put $100,000 in (assuming the money is “after tax” as many people have annuities with “before tax” money involved), as long as the balance remains over $100,000 you are assumed to be withdrawing earnings and every penny is taxable. Only after you have depleted the annuity account below $100,000 are you presumed to be using your contributed money. Note that every dollar of contributed money you use lowers this threshold, or “basis” in the account. If you take $20,000 of the original money, your basis is now $80,000, and this is the new threshold value. Note that basis can also be increased by subsequent contributions.
If you annuitize the pool of dollars by exchanging it for a stream of income, there are implications brought on by the fact that you no longer own the pool. The first of these is that the exchange is irrevocable. It doesn’t go backwards. You can certainly exchange the stream of income for another pool of dollars now, but expect the pool to be smaller than it was as both exchanges have made the insurance company offering them a profit.
But because the exchange is irrevocable, the IRS will treat it somewhat more favorably. What they will do is take an actuarial treatment of how long you are expected to live, and then make a determination based upon that of how much of each month’s payment is interest and therefore taxable, and how much is a return of principal, and therefore not taxable in most cases. If you outlive your actuarial expectation the whole thing becomes taxable. If you annuitized a before tax account like a traditional IRA or 401k, the whole computation is moot, of course.
The implications are fairly obvious. In general, an annuity is not an account you should “protect” by drawing down other accounts instead. Indeed, annuities should probably be near the head of the list of accounts that you should should draw down and/or use to exchange value for something else that is largely tax free, like cash value life insurance or Roth accounts, lest there be a large tax liability upon your death. It also takes about fifteen years, plus or minus, for a variable annuity’s tax deferred status to pay for itself as opposed to other investments which are not inherently tax deferred, such as mutual funds. There are very strong arguments for placing even tax deferred accounts in variable annuities, but this article is not the place for them, and you should understand both sides before making a decision.
Nonetheless, thanks to Asymmetrical Information for giving me the idea for an article.
Caveat Emptor