Problem Number 1: Taxing Capital Gains as Ordinary Income
When you own a variable retirement annuity, you are required to not pay taxes on the accumulated interest or capital gains until you begin to withdraw the funds. However, when you start withdrawing money from the variable retirement annuity, you are required to treat the first withdrawals as gains (rather than capital). For example, if you invested $50,000 in a variable retirement annuity, and the investment is now worth $90,000, you will pay taxes on the first $40,000 you withdraw. The remaining $50,000 can be withdrawn without paying taxes.
The problem here is that these gains, like those due to IRAs and other tax-deferred investments, are taxed as ordinary income rather than capital gains when withdrawn, and the tax rates on income are higher than the tax rates on capital gains. This means that despite the tax deferral, you may end up paying more taxes on the funds held within the annuity contract rather than investing in a lower-cost alternative, such as a variable index fund, which is not held within the annuity contract.
Problem Number 2: Lack of Step-Up in Cost Basis for Heirs
Upon your death, your heirs receive something called a step-up in cost basis when they inherit assets like real estate, stocks, and mutual funds. Let’s say you invested $100,000 in a stock mutual fund 12 years before your death. Over the 12 years, the $100,000 doubled to $200,000.
Upon your death, your heirs inherit the $200,000. Tax rules state that their cost basis in the investment will be the value of the investment at the date of your death: $200,000. They can now sell their shares in the fund and not pay taxes on the $100,000 of profit.
However, this step-up in cost basis does not apply to money placed in variable retirement annuity contracts. Let’s say you invested the same $100,000 in a mutual fund that is held within a variable retirement annuity, and it also increased in value to $200,000 by the time of your death. Your heirs will have to pay taxes at their ordinary income tax rate on the $100,000 of profit. This means there could be a tax bill of up to $37,000, depending on their tax rate.
Investment Assistance
If all this sounds complicated – and taxes on retirement investments often are – you may want to consider seeking help from a qualified financial planner. They can assist you in developing a retirement strategy that aims to preserve as much of your money and your heirs’ money as possible.
Sources:
- Internal Revenue Service. “Publication 575: Pension and Annuity Income,” Page 5.
- Internal Revenue Service. “Publication 575: Pension and Annuity Income,” Pages 10-14.
- Internal Revenue Service. “Is Money Received From the Sale of Inherited Property Considered Taxable Income?”
- Internal Revenue Service. “Publication 575: Pension and Annuity Income,” Pages 5, 39.
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2021.”
Source: https://www.thebalancemoney.com/tax-deferral-of-variable-annuities-2389024
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