Annuities and Taxes: What Advisors Need to Know

Immediate Annuities

With an immediate annuity, your client purchases the contract and annuity payments commence within a few months. This can be both a solid retirement income and tax planning tool.

From a retirement income planning perspective, the use of an immediate annuity can allow your client to determine when their income will commence based on when they decide to fund the contract. They can tie the timing of the payments to their income needs and also when these payments fit best within their tax situation.

Deferred Annuities

With a deferred annuity, your client pays their premium into the contract, but annuitization is deferred from 10 to 30 years. From a tax planning perspective, the premium dollars grow tax-deferred inside the contract.

The ability to defer annuitization can help with income planning later in retirement and can defer the taxation of the annuity until a period when your client might be in a lower tax bracket.

QLACs

QLACs, or qualified longevity annuity contracts, are a form of deferred annuity available inside of retirement plans like a 401(k) or an IRA. Your client can buy a deferred annuity of up to $200,000, and the commencement of the annuity payments can be deferred as far as age 85.

The $200,000 limit represents an increased amount under the Setting Every Community Up for Retirement Enhancement (Secure) 2.0 Act.

The tax benefit is that the amount of the annuity does not have to be withdrawn as a required minimum distribution until the contract is annuitized. This defers taxes on the RMDs for this amount, potentially until your client is in a lower tax bracket later in retirement.

Other Types of Annuities and Riders

There are many varieties of annuities to consider including variable annuities, indexed annuities and a host of others. They all have different properties that might affect your client’s taxes when they annuitize or take periodic withdrawals in retirement.

Plus, there are a host of riders, essentially contract add-ons, that can tailor the contract in terms of death benefits, living benefits, inflation protection and a number of other factors. Some of these riders can affect the level and timing of taxable income for your client, and this should be taken into account when purchasing the contract and the rider.

Qualified Annuities, Secure 2.0 and RMDs

Annuities can be purchased inside of a workplace retirement plan like a 401(k) or 403(b) in some cases. They can also be purchased inside of an IRA. From a tax planning standpoint, it’s important to understand that the tax rules of the retirement account govern the taxation of the annuity when annuitized or lump sums are taken.

Annuities can also be purchased inside Roth accounts, which can allow for tax-free annuitization or lump-sum payments if certain requirements are met.

The Secure 2.0 Act included several annuity provisions, such as higher limits on qualified longevity annuity contracts. For qualified annuities, the rules as to what does or does not violate the RMD rules for IRAs and qualified plans have been adjusted.

One key provision allows for an annual increase in the contract value of no more than 5% without violating RMD rules regarding benefit increases for annuities.

Also, the Secure 2.0 Act allows account holders to consolidate their RMD calculation between annuities held in the plan and distributions from non-annuity plan assets. Previously, these had to be done as two separate calculations.

If your client brings a qualified annuity to your relationship with them, it’s critical that you get your arms around the tax aspects of distributing the annuity and any RMD considerations. In deciding whether or not to add a qualified annuity, you will need to look at the tax ramifications as well as whether a qualified annuity is the best option for them.

Conclusion

Annuities can play a role in your retirement planning efforts for your clients. Like any other tax-advantaged retirement vehicle, tax planning for annuities as part of your client’s retirement planning strategy is critical.

You will want to balance the various income options available in an annuity with the tax implications. When considering whether an annuity is a good fit for your client’s retirement planning strategy, be sure to contemplate the tax implications of any annuity you are considering in the context of their entire retirement tax situation.

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