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A Popular Investment Vehicle with Surprising Tax Consequences

Jun 23, 2016 2:47:33 PM
Author: Hanson McClain



This caller was sold a popular investment vehicle, but there are tax consequences that will be a huge burden down the road.

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Read Full Audio Transcript:

Scott: Robert, you're with Hanson McClain.

Robert: Hi. Good afternoon, gentlemen.

Scott: Hi, Robert.

Robert: I wanted to find out what I should I do with a variable annuity that I have. I started this about 20 years ago and I've seen the ups-and-downs. I've been through 2007 and '08, it went down over half what it was worth. And mainly it's as high now. So anyway I've been thinking about what to do with it. I don't really need income from it. I was thinking of eventually just forwarding it to my kids.

Pat: How old are you?

Robert: I'm 66 now, so that's why...I'm getting close to retirement, maybe about four years. And it's worth like $270,000. But my monthly ... if I annuitize it, it'd be only like $1,400 a month.

Pat: Is it inside an IRA or outside an IRA?

Robert: It's outside an IRA. I have it in a variable annuity, so it's in a pretty aggressive portfolio.

Pat: And what was your cost basis in it? How much money have you put in, either at one time or over the years?

Robert: I'd started with a bulk amount. The amount that I've put in was $106,000, so it's worth $272,000. And that's over a 25-year period.

Pat: Got it.

Scott: So here's the thing. Here are your options. One option is you can just leave it where it is and let it continue to grow and you're going to retire in four years and let's presume it's going to have some additional growth and it could provide some additional income. Two, you can start taking some with just a withdrawal without annuitizing it.

Pat: But you don't need income right now, is that correct?

Robert: No, I don't. I think I have enough from my pension and my Social Security and IRAs. I have quite a bit of IRA that I will have to start taking at age 70 and a half. So that's why I'm planning to retire at 70, because it's going to be mandatory...

Scott: So the thing about these annuities, back in the day, you thought, "Oh, this'll be good because they have good tax-deferred growth. I don't have to pay any tax on the growth, which is great." The challenge you're at now, now you're 66 and you're thinking, "Hmm, I got a bunch of money in IRAs I'm gonna be forced to take withdrawals on. That's gonna be taxable income. I don't really need the income off this," so you're probably not gonna take an income. You're thinking at age 70, you don't really need it. You're probably not gonna take the income. The challenge with these, if you take out a withdrawal yourself, the way it's taxed is all your first withdrawals is interest out first, principal second. You start taking money out...it's all taxable to you.

Pat: ...and you have other...

Scott: And if you die, there's no step-up in basis like there is in other assets. This gain is gonna be taxable to either you or your heirs as ordinary income.

Pat: And you have other choices. You can annuitize it over a 10-year period or a 15-year period. Do you think your children are in a lower income tax bracket than you, the same, or much higher? How many beneficiaries are there on the annuity?

Robert: I have my two kids. They'll probably be...one is lower, actually. The other one'll probably be higher, so it's hard to say exactly. So I'm not quite sure.

Scott: If this were me, I wouldn't do anything with it. If I did anything, I'd be maybe looking for a lower cost annuity. I don't how this is structured, but a really low-cost one.

Robert: I did that, too. I did a 1035 exchange. I actually was at Hartford and went to Vanguard. Much lower fees than the...

Pat: Yeah, so I agree with Scott. I would actually just let this thing ride.

Robert: Okay.

Pat: I would let it ride. And for the rest of the listeners, it sounded good when it was pitched to Robert that you get this tax-deferred growth. But the reality is, if you had a low-cost, tax-efficient portfolio...

Scott: If this was just an index fund...

Pat: You would have gotten to the same place and we wouldn't have to worry about the taxation. You would have paid a little bit of taxes along the way, but it would have come out as capital gains or...

Scott: And if you die with it, it's...

Pat: It's a full step-up in basis under current law. So in your situation because you don't need the money, because you don't need the money and because it's probably a wash for your children...

Scott: I'd just hold on.

Pat: ...one being a lower, one being a higher, I would just hold on to it and would look at it as something that...

Scott: Ten years out, twenty years out...

Pat: Thirty years out. Just something that the kids will inherit.

Robert: Okay.

Scott: And another option to think about, you can always annuitize this. And rather than annuitize this for a fixed dollar amount, you can annuitize it for a fixed unit amount. So the way this works, Robert, is instead of getting a fixed amount of money per month, you get a fixed amount of units of an underlying asset, mainly the sub-accounts within the variable annuity. What this could provide is...you'd probably have a little lower income today, but it would grow. As the underlying investments grew, it would have some growth along there with it. So that's just another option to think about.


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