Annuities may be a good fit for clients seeking a steady stream of income over their retirement years—and they can also serve as an effective tool for managing taxes on that income. In particular, deferred annuities may be a good fit for investors who seek a way to grow their wealth while avoiding taxes on their accumulating assets.
“One of the primary roles of a financial advisor is to help clients preserve their wealth,” says Eric Fry, director of business development for variable annuities at Nationwide. “Deferring taxes on retirement income can be an effective way to do that.”
Get to know your client
Before considering the tax advantages of annuities, or even whether annuities are a good fit, advisors need to understand their clients’ expectations for retirement income. “Advisors should take a close look at their clients’ portfolios and consider the best options to grow and secure their wealth, in addition to hearing about their clients’ plans for the future,” Fry says.
There are two main types of annuities: those that pay out immediately and those that defer payments to a later date. Both immediate and deferred annuities can be fixed or variable. With a fixed annuity, payments are set at a pre-determined monthly amount. Clients who are particularly risk-averse or otherwise need the assurance of a set income may find fixed annuities particularly appealing.
Other clients may be willing to risk guaranteed income for the opportunity to earn a little more. For such investors, a variable annuity could be a good fit. Like a mutual fund, a variable annuity produces income that is tied to the performance of an underlying bundle of investments. If the portfolio performs well, the annuity’s payout may exceed the guarantee. For some clients, a combination of fixed and variable payments is the right fit.
Save more now, pay fewer taxes later
Regardless of which type of annuity—or what mix of annuities—is best for a client, these products offer a big advantage for investors: All income that a deferred annuity earns during the accumulation phase is tax deferred: The funds grow tax-free until they are withdrawn.
Fry recommends that advisors familiarize themselves with annuities’ tax implications, including the following considerations for deferred variable annuities:
• While there is tax-deferred growth potential in the accumulation phase, earnings are taxed as ordinary income when withdrawn. “One of the added benefits here is that your income tax rate upon withdrawal is based on the income you are earning at that time,” he says. In many cases, investors’ income will have declined by the time they are withdrawing from an annuity, so their tax rate will be relatively low, especially compared to the tax rates they may have paid earlier in their lives.
• Investors may face a 10 percent federal tax penalty on withdrawals before age 59½. Also, the client’s death benefit and the annuity’s cash value will be reduced if early withdrawals are taken.
• Investors can make tax- and penalty-free transfers among their underlying investment options.
A good fit for high-net-worth clients
Advisors should keep clients’ tax obligations in mind, and have a full array of strategies and products at hand to address them, Fry says. “Especially for the investor who has maxed out his or her other tax-deferred options, annuity products can be a great fit,” Fry says.
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