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Wealth Management 2021 Midyear Outlook

David Lau
August 16, 2021

An Overlooked Benefit of Annuities—Tax Planning

Rumblings from Washington about potential changes to the tax code have prompted renewed investor focus on tax efficiency. While a growing number of advisors are talking to clients about the benefits of annuities—especially newer commission-free products—as a wealth accumulation and retirement income tool, many still write them off (tax pun intended!) in the context of tax planning because of their “last-in, first-out” treatment. However, annuities can be beneficial in tax planning, particularly as they provide virtually unlimited tax deferral.

Tax-efficient product solutions include low-cost variable and fixed index annuities, particularly those offering exclusion ratio provisions on withdrawals to meet retirement income needs, and variable annuities with non-qualified stretch provisions for legacy planning.

Tax-efficient Income—The Golden Ratio

On the front end, variable and fixed index annuities are a CPA’s best friend. They can provide tax-deferred growth with low product and investment costs. Due to the compounding benefits of tax-deferral, assets grow at a greater rate since the tax-drag on performance is eliminated during accumulation.

To best utilize these products for tax deferred accumulation, invest in tax-inefficient asset classes, such as fixed income, and funds with high turnover rates, such as small cap equities.

Investors can also consider additional tax mitigation steps when taking income. Compare the various mechanisms:

  • Annuitization creates a lifetime guaranteed income stream while providing an exclusion ratio on income distributions until the account value is exhausted; after that, payments are treated as ordinary income. PROS: Guaranteed lifetime income, tax-efficient; CONS: Very limited flexibility in income amounts
  • Systematic withdrawals without annuitization keep accumulated cash value intact while allowing for control over distributions. Assets remain invested, allowing for growth potential during withdrawals. Withdrawals are taxable until cost basis is reached. PROS: Control of assets, can remain invested while taking withdrawals; CONS: Can be tax-inefficient depending on how assets were invested.
  • Certain products offer optional living benefits that, when used for income-generation, provide an exclusion ratio on withdrawals. This allows income to be distributed as part-gain, part-cost basis, requiring less money to be withdrawn to meet income needs on an after-tax basis. PROS: Maximizes income per dollar, client retains access to cash value in the event of an emergency, and continues generating lifetime income once the cash value is depleted; CONS: Income needs to be withdrawn over a pre-set period.


Stretching Can Mitigate Legacy Tax

Taxes on non-qualified assets can erode a legacy. Fortunately, variable annuities provide a provision to help mitigate taxes on inherited assets—the non-qualified stretch.

Inheriting annuity assets can mean a large tax burden because, unlike other taxable assets, annuities receive no step-up in basis. However, the non-qualified stretch allows beneficiaries to spread the tax liability of unrealized gains over their lifetime, versus realizing them the year the annuity was inherited. Many variable annuities offer a non-qualified stretch provision to help maximize client legacies, and some also offer a non-qualified restricted stretch that enables clients to require the stretch and specific conditions of taking the stretch for the beneficiary.


Tax Duty

Increasingly advisors are coming to realize their fiduciary duty to learn about annuities and their role in retirement planning. That includes understanding how to optimize tax treatment both during accumulation and when taking income.

David Lau is founder & CEO and Rob Saag is Director of Product Marketing at DPL Financial Partners.

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