Is Your Annuity Safe? by David Disraeli

“Annuities – Tax Deferred or Tax Time-Bomb?”

Tax Deferred Annuities have become a very popular investment vehicle over the last ten years. With interest rates at twenty-year lows annuities are highly competitive. Owners received safety, tax deferral (for the interest which is not withdrawn) and an asset which passes outside of the probate system in all fifty states. Newer products have exciting features like nursing home waivers (ability to avoid surrender charges) and interest rates linked to the stock market’s performance. You and literally defer thousands of dollars in income taxes using deferred annuities, so what’s not to like?
Plenty perhaps, or maybe nothing. Like anything else, it depends on the individual situation. However, the enormous annuity marketing engine stops short of forcing you to analyze complex tax questions before selling you an annuity. The concept behind tax deferral is based on the concept that you will probably be in a lower tax bracket when you need the money than you are during the accumulation phase. For many people this is true, for others, the annuity itself actually forces them into a higher bracket.

The reason I use the term time bomb is twofold:
1. You don’t have control over when it goes off
2. There is a loud bang

Annuities in review

It probably makes sense backup and talk about annuities in
general. There are many new types of annuities with new
features including annuities which convert into Long Term
Care Policies if the owner becomes disabled. The two
broad categories of annuities are fixed and variable. Fixed
simply means that the insurance company backs the annuity
with their general assets, where variable means that the
funds are invested in “side accounts” which are identical to
mutual funds and carry market risk. The purpose of this
book is not to differentiate between types of annuities, but
to call into question their use. In some situations, annuities
are not the right investment. The ratings of annuity providers
is also beyond the scope of this booklet because the
topic of insurance company ratings is quite involved. If
you are interested in this subject please call our office to
speak with a financial advisor. Moving on, I want to touch
on appropriateness of annuities and alternatives to annuities.

The Picture Begins to Blur

It is a known fact that 70% of all annuity owners will
NEVER touch the interest that is building up. This
means the owner may never pay taxes on the accumulated
interest –an outstanding feature. If you manage to
consume the interest during your lifetime, then you will
avoid the time bomb. Odds are you won’t however.
Therefore, your beneficiaries (other than your spouse
who can continue the annuity) will have to figure out

how to best pay the taxes. If they choose a payout to
spread out the taxes, their investment return will go down
to around 2% For example, if you die and leave $100,000
annuity to your heirs (not your spouse) they have one of
two choices at your death. 1. They can pay taxes all at
once, or 2. they can take a payout over a period of time to
defer the taxes due over the longest possible period. This
process is called “annuitization”. Insurance companies
love this because the interest rate they are paying is
around 2 to 2 1/2 %.
The IRS is not benevolent. They don’t allow people to defer
billions in taxes because they are nice. They allow it because
they know that they will eventually get their money,
maybe more than if they didn’t allow it. Let’s discuss IRA’s
and 401(k)’s as an example. It’s easier to illustrate this concept
because both the principal and earnings have never
been taxed and therefore anything withdrawn is taxed. If
you have, for example, $100,000 in an IRA, you should
know that only $70,000 of that belongs to you, the other
$30,000 belongs to the IRS. The account may be in your
name, you may be able to move it around, but you will
never be able to get at the other $30,000! Whether you take
the money out slowly, all at once or die, no one will ever see
the $30,000 of the IRS’s money. They will let you manage
it and watch it, but they won’t let you have it. Its not yours
and never was yours. It would be simpler if banks and brokerage
firms would show on your statement your portion
and the IRS’s, but they don’t. Annuities Can Actually Increase Taxes
Consider that it is entirely possible that your kids or heirs
will be in a higher bracket than you and pay more taxes than
you would have. This could happen either because they are
working and have to report IRA distributions on top of their

other income or Congress may raise the top tax bracket by
the time your heirs inherit the money. In other words, if
you have money in annuities and you are in the 20%
bracket and your heirs may be in the 39% bracket. Other
problems are that heirs may lose current tax deductions because
the income from annuities is considered “ordinary
income” which is added to their adjusted gross income.
Since certain deductions are based on your adjusted gross
income, it is possible that an inheritance of an annuity
could cause a deduction to be disallowed. Medical expenses,
moving expenses, professional fees, and many
other types of deductions are only deductible to the extent
they exceed 2% of adjusted gross income. Therefore, the
higher AGI, the lower the amount of deduction. So the
bottom line is that your heirs may not only pay 39% of
your annuity income in taxed, but the cost may go much
higher due to the reasons mentioned above.
Annuities and Trusts Don’t Go Together
One of the benefits of annuities is that they are not probate-
able, meaning the balance is paid directly to beneficiaries.
However, this means you can’t protect the assets
in a trust. Well you can name a trust as the beneficiary
but you will almost certainly force immediate taxation of
the deferred interest. The fact that something is not probated
is not necessarily a good thing. Leaving assets in
trust could provide a lot more benefit than the tax deferral
aspect of annuities. In summary, a lump sum may be
used to fund a trust but will create an immediate tax bill,
or the trust could receive annuity payments to spread out
the taxes, but then the beneficiary doesn’t have access to
the principal. The estate planning aspects of annuities
are quite complex and require delicate care. Unfortunately
most insurance agents don’t possess the technical expertise to navigate the tax and legal options.
Why Would you Want to Leave Funds in Trust?
There are dozens of reasons why it is advisable to
leave money in trust instead of outright. For now, I
will mention a few of the most important and most frequently
observed reasons:
1. A minor or disabled person cannot inherit money
2. Beneficiaries get divorced, sued and have other financial
problems. For example, a child who is a doctor
or in another high-risk profession, they should not inherit
money directly because it would be available to
3. Beneficiaries may need help managing money and
should not receive it directly.
4. Beneficiaries may lose all sorts of government and
other benefits if they receive money directly. If money
is left in trust, they may not be disqualified.
The decision to own annuities involves a number of
important issues. For example, your income needs, tax
situation, your heirs needs, your health, and your entire
estate must be considered together before deciding if
annuities make sense –even if you already own them.
What Are the Alternatives?
We’ve seen that annuities have many benefits and several
disadvantages, mainly that if you don’t manage to
spend the money, you are saving a tax bill for your heirs. We also discusses that your heirs may pay much
more taxes that you would have and the inheritance
could cause all sorts of other side effects. Fortunately
there are a number of good alternatives to annuities depending
on the likelihood that you may need the money.
If you truly believe you will consume the interest or
could care less about the tax consequences on your heir,
stick with annuities. I will add that in 18years almost
everyone thinks they will need to get to their money, but
almost no one does. The other important issue is
whether you already own a long-term care policy or
have done other planning. If you haven’t done any planning
and you do wind up in a long-term care situation,
there may not be any assets left to worry about. This
booklet will focus on two alternatives to annuities:
1. Single Premium Whole Life – Life Insurance is
and has always been tax-free to the beneficiaries. This
is one of the true remaining freebies offered by the government.
Regardless of when you die or how much you
leave, the entire amount is income tax-free to your heirs
(but it is part of your taxable estate). You do have to
reasonably healthy to qualify for this type of product,
however, there are certain companies that have abbreviated
underwriting and liberal standards. These products
do accumulate interest and you can still get to your cash.
They don’t pay as much as annuities, but your heirs will
thank you. Most of these products have a new feature
called “accelerated death benefit”. This means that if
you are diagnosed with a terminal illness to last less
than 12 months, you may get at the death benefit, not
just the cash value – tax-free. In certain cases a loan
against the cash value is not taxable – another option not available through an annuity. The death benefit can be
made payable to a trust without any adverse tax consequences.
2. Modified Endowment Contract – This is part annuity
and part life insurance. Any withdrawals (certain
exceptions apply)taken during your lifetime are taxed
like an annuity, but the entire value passes tax-free at
your death. Most of these polices also have an option
to access the death benefit in the event of a long term
care need – defined as being unable to do 2 out of 6 activities
of daily living (eating, dressing, bathing etc.).
These payments may also be tax-free. This is a great
parking place for cash in case you do have a long term
care need or other need but whatever you don’t spend
passes tax-free and may be made payable to a trust.
The key to making the right decision is taking a complete
look at your situation and weighing the tax and
practical consequences of different options. Being licensed
to sell insurance and being competent in estate
planning are two different competencies.

For more information contact David Disraei at 512-464-1110 or

Copyright@2017 David Disraeli/ The Personal CFO, Inc.