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Substantial gains in your non-qualified annuities? You’ve got options

by Susan Wright | Contributor
Feb 18th, 2022


When you invest for retirement, it is likely that your goal is to grow the value of your portfolio as much as possible. But, while this is certainly a good strategy to follow, the withdrawals that you take from certain types of accounts could be taxable – and this, in turn, can reduce the amount of money that you have left over for paying your essential living expenses, such as housing and food as well as the “non-essentials” that include vacations and entertainment.

Non-qualified annuities, for instance, can provide you with growth that is tax-deferred. But this doesn’t mean that you’ll never pay taxes on the gains. Rather, you are simply postponing the tax until a time in the future when the taxable portion of the annuity may be significant.

So, before taking funds out of a non-qualified annuity, it is recommended that you have a good solid plan in place for how you will handle these taxable non-qualified annuity withdrawals and/or income payments.

Is your non-qualified annuity a ticking tax time bomb?

Photo of a cash bomb

If you own an annuity outside of a retirement account – meaning that it is not within a traditional IRA or an employer-sponsored plan such, and that your contributions are made with after-tax dollars (and thus are not deductible from your gross income) – it is considered to be a non-qualified annuity.

These types of annuities can provide you with a number of nice benefits, such as tax-deferred growth and an income stream in the future that could last for a set period of time such as 10 or 20 years, or even for the remainder of your lifetime, regardless of how long that may be.

Non-qualified annuities differ from qualified annuities in that the contributions that go into a qualified annuity are typically deposited on a pre-tax basis. Therefore, the amount of the contribution to a qualified annuity is not taxed as income to the investor in the years that the contribution was made.

With a qualified annuity, the growth in the account is tax-deferred. So, just like a non-qualified annuity, there is an opportunity to grow the account significantly over time. However, because none of the money that is inside of a qualified annuity has been subject to taxes yet, 100% of the withdrawals and/or income payouts will be fully taxable at your then-current income tax rate. Based on this, your net spendable income could be much less than the gross amount of money that you access from the annuity.

But non-qualified annuities can also be a “ticking tax time bomb,” because money that is withdrawn from these financial vehicles is taxed as last-in-first-out, or “LIFO.” This means that all of the gains come out first – and these gains are taxable.

In fact, non-qualified annuities could have a considerable amount of taxable gain in them, as the growth that takes place in the account is tax-deferred. Therefore, gains can essentially be generated from your contributions as well as from any of the prior gains, and from funds that would have otherwise been paid out in taxes over time.

With that in mind, the more the account value grows, the more money you will have in the annuity that will be taxable upon withdrawal. These funds are taxed as ordinary income in the year that they are accessed – so depending on when you make your withdrawals from a non-qualified annuity, as well as the way in which you file your income tax return, you may only net out 50% (or less, when state taxes are factored in) as actual net spendable income.

Chart of Federal Income Tax Brackets and Rates in 2021

For 2021, the highest federal income tax rate is 37%. Although that might seem high, the reality is that it is quite low in comparison to the rate over the past 108 years – where it has been at 70% or more 49 times (and is anticipated to go up again in the near future).

Given that, having a good solid plan in place for what you will do with your taxable non-qualified annuity gains can make a tremendous difference in the amount of money that you have available in retirement to spend on your needs and wants.

Chart of top federal income tax rates 1913-2021

How to cushion the tax hit on non-qualified annuity gains

Based on your specific objectives, time frame, and retirement income needs, there could be several potential options available for you to help “cushion” the tax-related hit that your non-qualified annuity withdrawals may receive.

These could include one or more of the following strategies:

  • Transfer the non-qualified annuity via a 1035 exchange to an annuity that also offers long-term care benefits
  • Use the withdrawals to purchase and pay the premiums on a life insurance policy
  • Coordinate investment losses to offset some or all of the taxable gains on the annuity withdrawals
  • Wait to file for Social Security until at least your full retirement age (FRA) so that the benefits are less likely to be taxable

1035 exchange to an annuity with a long-term care rider

One viable option for reducing the tax blow on substantial non-qualified annuity gains is to conduct a tax-free 1035 exchange of your current annuity for one that also offers long-term care benefits. This is oftentimes accomplished by adding a long-term care rider to the new annuity.

Provided that you qualify for the long-term care payout (which is typically based on your physical and/or cognitive health condition), most of these plans will generate a multiple of your regular monthly income stream from the annuity to go toward your care – and depending on the annuity that you choose, a long-term care rider may even double or triple the monthly payout over a certain period of time (such as five years).

For instance, an annuity that has an account value of $100,000 may pay out a cumulative total of $200,000 – or even $300,000 – worth of long-term care benefits for up to a maximum time period.

As an added bonus, the benefits that are paid out under an annuity with a long-term care rider would be income tax free if these funds are used for covering expenses related to long-term care. Also, if you never end up needing the long-term care benefits, a death benefit from the annuity could be paid out to one or more named beneficiaries.

The Pension Protection Act made several changes and reforms to pensions governance, and Section 844 of the act deals specifically with annuities, long-term care and “new” tax advantages.

The PPA states that withdrawals from specific annuity contracts to pay for qualifying long-term care expenses or to pay qualified long-term care insurance premiums are no longer taxable income but considered as a reduction of cost basis.

Purchase a life insurance policy

Purchasing a life insurance policy could also help with cushioning the tax burden of income and/or withdrawals from a non-qualified annuity. Although most people do not like to discuss the concept of life insurance (due to its correlation with their own mortality), the reality is that this financial vehicle can be one of the most beneficial and flexible options that is available in the marketplace today – and in many cases, certain benefits may be used while the insured is still alive.

In the case of purchasing a life insurance policy, you would still be taxed on the income or withdrawals (from gains) that you generate from the non-qualified annuity, but you would be putting these funds toward the eventual payout of an income tax free death benefit for the policy’s beneficiaries.

If you purchase a permanent (i.e., cash value) life insurance policy, it may be possible to grow the funds in the cash component on a tax-deferred basis, as well as to access them via a tax-free loan. The money may then be used for supplementing retirement income, paying off high-interest debt or any other want or need that you have.

While the balance that is due on the loan would typically be charged an interest rate, you won’t necessarily have to repay the outstanding amount during your lifetime. Rather, the remaining amount due could instead be repaid upon the insured’s death using the policy’s death benefit proceeds (and the remainder of these funds, if any, would then be paid to the beneficiary or beneficiaries who are named in the policy).

Coordinate investment losses with the taxable annuity income or withdrawals

Another way to help with offsetting taxable gains from non-qualified annuities is to coordinate the annuity withdrawals with investment losses. For instance, if you sell a capital asset like shares of stock, mutual funds or bonds at a profit, you will have either a short-term or a long-term capital gain.

This depends on how long you held the asset. In this case, short-term capital gains are generated from profitable investments that were held for one year or less. These are then taxed at your maximum income tax rate.

If the investment was held for longer than one year, and then sold at a profit, you would have a long-term capital gain. These gains are taxed at a different, long-term capital gains tax rate. Based on your income and your tax-filing status, long-term capital gains tax rates are (in 2021) 0%, 15% or 20%.

Chart of long-term capital gains tax rates in 2021

If you sell an investment at a price that is below what you purchased it for, you will incur a capital loss. These, too, may be short-term or long-term. It may be possible to deduct these losses in order to offset capital gains, as well as income from various sources – at least up to a set annual limit of $3,000 (in 2021).

So, for instance, if you generated $1,000 of short-term capital gain in a given year, and you have $2,000 of short-term loss, then the $1,000 loss could be deducted against the gain. If you end up with any excess net capital losses, these may be carried over to subsequent years.

Delay filing for Social Security until full retirement age (FRA) or later

Many people are not aware that a portion of their Social Security retirement income benefits – either up to 50% or 85% -- could be subject to income tax. This is the case if you earn “too much” income during the year. This is the case if you start collecting Social Security benefits before your full retirement age – which is between age 65 and 67, based on the year you were born.

Chart of social security full retirement age year by year

It is important to note, though, that if you are still working and earning an income, a portion of your benefits could be subject to taxation, if the total amount that you earn exceeds the Internal Revenue Service’s income limits.

In addition to non-qualified annuity gains, there are several other potential sources of retirement income that are considered taxable by the IRS. These can include:

  • Defined benefit (employer-sponsored) pension income
  • Other tax-deferred financial vehicles, such as traditional IRAs (individual retirement accounts), 401(k)s, 403(b)s, etc.
  • Gains from personal savings and investments

In some cases, a portion of your Social Security income could also be taxable, based on when you file for these benefits and how much other taxable income that you generate. For instance, if you file your federal income tax return as an individual, and your combined income is (in 2021):

  • Between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits
  • More than $34,000, then up to 85% of your Social Security benefits may be subject to federal income tax

If you instead file a joint income tax return, and you and your spouse have combined income that is:

  • Between $32,000 and $44,000, you may incur federal income tax on up to 50% of your Social Security retirement benefits
  • More than $44,000, then up to 85% of your benefits could be taxable

(Note that combined income is determined by adding the amount of your adjusted gross income, non-taxable interest and one-half of your Social Security retirement benefits.)

Are you ready to reduce, eliminate or compensate for tax on your non-qualified annuity?

Taxes have the ability to take a sizeable chunk of money from your net spendable income in retirement. Yet, with the near disappearance of employer-sponsored defined benefit pension plans, more people are turning to annuities to generate income in retirement. But the income payments and/or withdrawals that come from these financial vehicles could be taxable.

The good news is that there are some possible solutions that may be used for reducing – or possibly even eliminating – the tax that is owed on non-qualified annuity funds. Because everyone’s situation is different, though, there is not one single plan that will be right for everyone. That’s why it is recommended that you first discuss your specific short- and long-term objectives with financial professional from Alliance America.

Alliance America can help

Alliance America is an insurance and financial services company dedicated to the art of personal financial planning. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.


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