Investors can be sold on the idea that annuities are a safe and secure way to receive income in retirement. But, there should be a “buyer beware notice” when considering if an annuity is appropriate for an investment portfolio. There are significant investment expenses as well as varying taxes and estate implications when considering annuities versus a diversified portfolio of mutual funds.
Therefore, it is very important to work with professionals held to a fiduciary standard when deciding whether an annuity or mutual fund is appropriate. To help demystify these options, watch the video overview and/or read the breakdown below:
Understanding Annuities
When considering annuities, the investor should first learn and understand the costs. There are multiple layers to the cost structure of annuities that can include commission, annual expenses, surrender charges, and tax implications.
In addition to financial costs, there are also opportunity costs associated with the impact on beneficiaries after death. Annuities are products that are most often sold by insurance companies and often have high commission charges. These commissions may be as high as 10 percent of the original investment. Additional annual expenses known as M&E fees (mortality and expense) or administrative fees are also included. These annual expenses, which are often combined with riders, can equal between 2–3 percent annually. The additional rider charges are often necessary expenses so that the investor can receive guaranteed payouts, principal protection, and/or increased payouts.
Annuities also have surrender periods and corresponding surrender charges. Typically these surrender periods are between five and seven years, but can be longer. The surrender charge is often reduced the further a surrender period extends. However, most annuities will allow the investor to draw up to 10 percent annually without paying surrender charges. If the owner needs to take a larger distribution during this period, they may be obligated to pay the corresponding surrender charge as well as potential tax liabilities.
Taxes and Penalties
Taxes and early distribution penalties are additional costs associated with annuities. Annuities are tax-deferred but the earnings will be taxed as ordinary income and not at more favorable long-term capital gain tax rates. When an annuity is held within an IRA, distributions from the IRA are fully taxable as ordinary income.
In addition to the higher tax rates on the investment earnings, annuity beneficiaries will miss out on the step-up in cost basis at death. Therefore any gains in the annuity will require the beneficiaries to pay taxes in order to receive the inherited portion of the account. Lastly, for distributions from annuities prior to age 59 1/2, there is a 10 percent early withdrawal penalty, even if the annuities are held within an IRA. Investors will want to be sure to contact their tax specialist when considering distribution strategies with annuities.
In a recent real-life client situation, an elderly married couple used Trust Point’s expertise to save thousands of dollars in taxes. The couple each had a $30,000 tax-deferred annuity that they were not taking distributions on. Given their large medical bills, which offset their taxable income, they were in a low tax bracket. Their daughters, who were listed as the annuity beneficiaries, were in the highest income tax bracket. Trust Point devised a strategy to distribute each annuity to the couple over three years, which allowed them to avoid all federal income taxes on the deferred annuities. Had the couple waited until after death to distribute, the federal income tax liability to their daughters would have been thousands of dollars since there is no step-up in basis at death for an annuity.
Making Sense of Mutual Funds
Mutual funds are cost-effective and important pieces of a properly diversified portfolio. They are appropriate for both tax-deferred accounts, such as an IRA or 401(k) and taxable investment accounts. Fees associated with mutual funds should always be an important consideration. This includes the investment management fees and portfolio expenses—the fees charged by mutual funds to invest with them. Trust Point’s internal expense ratio of a diversified portfolio is approximately 1/3 of the annual expenses of an annuity.
Tax Benefits
Tax-deferred accounts holding mutual funds enjoy the benefits of tax deferral until age 70 1/2 when required minimum distributions must begin. This includes all income and capital gains that are reinvested within the fund. Additionally, all trades and sales within these accounts are given preferential tax treatment by not paying taxes on gains. Taxable investment accounts are held to a different set of tax rules. Income and capital gains must be reported on the account owner’s individual or joint tax return. But capital gains are taxed at significantly lower tax rates than ordinary income. For example, ordinary income can range from 10 percent to 39.6 percent. Taxes on long-term capital gains range from 0 percent to a maximum of 20 percent. These tax rates do not include the 3.8 percent net investment income tax which may apply.
Mutual Exclusive
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- No commissions or surrender charges
- Reduced annual investment expenses
- Lower tax rates on taxable investment accounts
- Step-up in cost basis at owner’s death for taxable accounts
Investors with taxable income less than $94,050 will pay 0 percent on all capital gains. Investors earning between $94,051 and $583,750 will pay 15 percent federal tax on capital gains. An investor with income above $583,750 will pay 20 percent on capital gains. This is based on 2024 tax laws for married filing jointly. Please consult your accountant or IRS.gov for further details, as tax rates and income limits are subject to change annually.
Special Treatment
Mutual funds are not only an important part of a well-diversified portfolio; if held in a taxable account, they are given special treatment by the IRS as part of an overall estate plan. Mutual funds held in a taxable account receive a step-up in basis at the death of the account owner. Let’s say an account owner invested $25,000 in a mutual fund that grows to $150,000 over 20 years. When the owner dies, the heirs would not have to pay a single penny of taxes on the $125,000 in growth. On the date of death, the $25,000 basis is “stepped up” to $150,000, eliminating any taxable gain*. This tax benefit is not available to an annuity.
Ultimately, when the investor decides to consider annuities as part of their overall portfolio, they will want to research and understand the real costs of the product they are buying. Annuities may have a place and time, but often there are better and more economical investments for an investor’s overall portfolio. To learn more about what investment options are best for you, schedule a comprehensive investment and financial review with one of the CFP® professionals at Trust Point.
*Individuals should work with a Certified Financial Planner® or tax professional to better understand state-specific basis step-up rule
