Annuities - The Tax Time Bomb You Want To Avoid

In this video, we discuss the hidden tax pitfalls of annuities, which we describe as a “ticking tax time bomb.” While annuities are often marketed for their tax-deferred growth, they can become costly later because withdrawals are taxed as ordinary income rather than at lower capital gains rates. For example, a client who invested $50,000 decades ago saw it grow to $1 million. Now, nearly all of that gain is subject to income tax—potentially at rates of 22% or higher—whereas a brokerage account might have been taxed at just 15%.

Annuity holders have limited options when withdrawing funds. They can take lump sums and pay taxes on the gains or annuitize, trading access to the full balance for monthly payments. Many retirees find annuitizing restrictive, especially if they want flexibility for emergencies, travel, or estate planning. The issues compound when annuities are inherited: heirs must withdraw the money within five years and pay taxes at their own (often high) income tax rates, with no option for tax-efficient distributions or charitable gifts.

We also warn about annuities held inside IRAs or 401(k)s. These offer no additional tax benefit but still come with high fees and complexity. Unlike IRAs, annuities don't allow for Qualified Charitable Distributions (QCDs), Roth conversions, or gifting to charity with a tax deduction—limiting their usefulness in financial and legacy planning. We recommend understanding these implications fully and consulting with a fee-only, tax-focused advisor to avoid being caught off guard by the tax consequences later in retirement or when passing assets to heirs.

#ACPMemberWisdom #annuities #taxes #taxplanning #retirementplanning

Resources:

- Alliance of Comprehensive Planners: https://www.acplanners.org

- John's firm website: https://www.trinfin.com

-Find us on Facebook: www.facebook.com/friendstalkfinancialplanning

TRANSCRIPT:

Bridget: John considers annuities a ticking tax time bomb, and he used to sell these things. Hi, I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.

John: I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. Before we dig into why annuities are a ticking tax time bomb, I want to remind everybody to hit that subscribe button. Click on that thumbs up. Let everybody else find this information here on YouTube. And with that, let's get into talking about why they are. I don't think they are. They are a ticking tax time bomb, Bridget.

Bridget: I think that they're often sold for tax benefits because you do get a tax deferral. You put the money in, and whatever it earns you don't have to pay taxes until the money comes out. But there's a lot of details in that equation that are not revealed or that people don't really understand. So the first one is how you get the money out, or what your options really are. Go ahead.

John: Let's just talk about that a little bit more. We're talking about money that's not inside of an IRA. This is more like saying, “I've got extra money to invest. Where do I invest it?” And the sales pitches is, listen, if you buy an annuity, you can buy mutual funds and stocks and bonds and things inside of this annuity. And it grows, and there's no taxes until you take the money out, so it’s completely tax deferred growth, kind of like the 401(k)s, 403(b)s. I put the money in, it grows, and I don't pay any taxes. If I rebalance or sell this and buy that, no taxes on it. So that's the sales pitch, and it's factually true. You don't pay any taxes.

You and I were talking before we hit record here, that in a brokerage account, there are some taxes, but you can manage those. It's not quite as bad as most people think. But annuity is totally tax free. But what none of the sales folks talk about is what happens on the other end? When I take this money out, how does it look? So the tax deferral is absolutely accurate. On the other end, though, things can be difficult, like when I'm in my 60s, because you have to be over 59 and a half to take money out of these, kind of like an IRA; it’s very similar to IRA rules.

So when I'm in my 60s, 70s, and 80s, when I take that money out, all the money that comes out of those annuities above my investment (so the gain portion) comes out, and it's taxed as regular income. And that's significant in that it's different than capital gain taxes. And just in real broad strokes, capital gain taxes today are at 15% for most people, and income taxes for most people end up in the 22% or 24% brackets compared to 15%. There're more details, but we're not going to do a detailed tax dive right now. That's sort of the thing is capital gains at a lower rate, income at a higher rate in general. And that's really the rub on this at the end of the day.

Bridget: So you're saying that if people had just put it in a brokerage account, they would probably be paying 15% on the gains, but because they have it in an annuity, they're paying 22%.

John: Right. I'll give an example. So we've got a client who bought an annuity 30 years ago, a long time ago. And let's just say they put in $50,000, something like this back in the 80s, and it’s just kind of grown and grown and grown. And now when they're well into their retirement years, that annuity is now worth $1 million. There have been tremendous returns over the last 35 or 40 years. It's been great. When they go to take that money out now, all of that gain, which is substantial, 95% of the total is taxed at regular income tax rates, and they're already in the 22% tax bracket.

So additional income coming out from their annuity would be taxed at 22%, maybe 24%, maybe up into the 30% range. And it's all income to them. As you just described, if they had put that same money into a brokerage account, would they have paid some taxes along the way? Sure, absolutely. There would be some taxes along the way. But right now, with that big lump sum, if they would take that money out and sell it, they'd be paying 15% in taxes. So a 10% difference on every dollar that comes out. So that's exactly right.

Bridget: Okay, great. Now let's talk about the options when you do have an annuity. So one is what your clients did for many years. They just let it ride. The issue also with letting it ride is that sometimes then your heirs end up with this annuity. Let's talk about what the tax time bomb is for the heirs.

John: That really is the big one. On IRAs and 401(k)s, when I take money out, it's taxable as regular income. But I've got a tax deduction going in on the front side of things. And there was no other option to get that tax deduction. Now we're talking about, I could have put it into a brokerage, a taxable account versus the annuities. There're basically two ways you can take it out. You can take it out in lump sums. I just take out a chunk. My client could take out $100,000 to buy a new car or whatever thing they need to do. They just pay taxes on the gain portion there. Or you can annuitize, which means taking an income stream, sort of like Social Security.

If you think about Social Security, there is no lump sum. You just get a payout. Or if you have a pension, you get a payout every month, that sort of mentality. And that's what an annuity really is, it’s this payout phase sort of thing. Those are sort of the two choices you have. Take out lump sums, the whole thing partially, and pay taxes on those lumps, or spread it out. There is, however, a problem in general with spreading it out. My client could give up their rights to their million-dollar balance, and in exchange they're going to get a payout. $8,000 a month or $6,000 or some math that goes into it.

All right, I'll exchange that lump sum for $5,000 a month in income for the rest of my life. But I don't have that lump sum anymore. What happens when I want to take a trip around the world? What happens if I find out I got some kind of crazy cancer? What happens when I want to leave it behind to the kids? So it's not wrong to annuitize. But most people, at least the people that we're working with, go, “Yeah, that's not as appealing of a choice. I've already got Social Security coming in. I don't need that guaranteed income.” So usually, we're looking at this Bridget from the standpoint of I want to take out chunks of money, where is the place to take it?

And mentioned inheritance as well on that. We've got a lot of folks, like this client, who don't need that money to live off of. It's a great safety valve. If they ever need long-term care, that's where we're going to take the money from, because the tax cost of the annuity is offset by long term care costs. But for people that are going to inherit or leave that money behind, when the kids inherit that money, now the kids have the same rules, all the money comes out taxable.

And unlike IRA type things where the kids inherits, and they can wait to take distributions for maybe 10 years or take minimums for 10 years, on an annuity, it's a five-year withdrawal basically, so they can annuitize over their lifetime again with some of those drawbacks, or they've got to take all that money out within five years. I was talking to a friend of mine recently whose dad passed away. He had like 10 or 12 annuities that he inherited from different companies. He's in his peak earning years. And he has to take all this money out within five years and pay it at his tax rate. So that's where this time bomb idea comes in. It's all income, and there're really restrictive rules as to how you can get that money out. Cool.

Bridget: There’s one other thing I want to talk about, and this is one of my pet peeves. We were talking about the difference between having an IRA or 401(k) and just having an annuity. And now there's a new option which is what I consider the worst of both worlds, which is having an annuity in a 401(k) or in an IRA. So do you want to talk about that? And another thing we haven't talked about again is just the cost of these is not efficient. It costs a lot less to not have an annuity than it does to have an annuity. Although they're not going to really tell you how much it's going to cost. It might take a lot of head scratching for them to figure this out for some reason.

John: Right. There's a lot of complications with it. And in general, I think it's Occam's razor. When faced with two choices, usually the simplest one is the best, that sort of thought process. So that clearly makes sense. You alluded to having an annuity inside of an IRA, and there are some reasons for it, but those reasons are really in the minority. For 98% of people, it doesn't make any sense to have those things in there. There's no reason to have the extra costs of an annuity inside of an IRA.

I think one of the things that maybe comes to mind as you think about this, especially from a tax standpoint, is you go, listen, annuities don't have awesome distribution taxes, right? Most people don't think about it until it's too late. But it’s the same thing with 401(k)s or IRAs. Why do you care about this? Are you saying we shouldn't invest in a 401(k)? Here's one of the key differences. With things like IRAs, as you get older, if you're over 70 and a half, you can do qualified charitable distributions. We've got whole episodes on that.

So if I go, listen, I want to give this money to charity, I've got a choice as far as how I can do this with an IRA on a very tax efficient basis. Some of that IRA money might never be taxed. I can take some of that IRA money when I've got lower tax years in the early years of retirement. I can convert it into Roth. We just had somebody who was retired, and they were in a pretty high tax bracket. In the early years of retirement, they're in 10 or 12%. I got a friend of mine who just got laid off from their job, which isn't awesome, but now they're in a low tax bracket, geez, let's convert some of that IRA money over to Roth.

We saved 30 cents on the dollar going in, and we're paying 10 cents on the dollar going out. We avoided 20% taxes forever on that. With annuities, there are none of those options. There is no QCD to give distributions to charity. There is no conversion on some tax effective basis. And moreover, my buddy that just inherited annuities said, “Geez, I don't need these. I want to give these to charity.” You can't even give these things to charity and take a tax deduction for it. If he just says, “Listen, I don't want the money. Let's support United Way or my church or whatever.” That’s not an option.

He's got to take it out and pay taxes on that and raise his adjusted gross income. And yes, he can give the net money to charity, but it causes all kinds of other problems. So even for somebody who says, “Oh geez, I don't really need this; let's have this be part of our do-good budget,” you can't do it like you could with an inherited IRA. If my buddy had inherited IRAs from his dad, he could do the QCD thing once he's over 70.

There're limitations, but he's got an option. With annuities, there really is no option. And I've worked very hard for a couple of clients with some of these annuities. What do we do with this? Can we do some charitable giving and get income back? For basically all the options, the answer is: you have to pay taxes on all that gain. So that's really where that time bomb thing comes in no matter how you slice it.

Bridget: All right, so with that, it's a great time to wrap it up. Hi, I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.

John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. If you have annuities and would you like some advice on how to avoid this ticking tax time, both Bridget and I are taking on new clients. We'd love to talk to you, but we're also both members of the Alliance of Comprehensive Planners, a group of fee-only, tax-focused advisors across the country. And if you want to find an advisor in your area, you can check out acplanners.org.

Bridget: And don't forget to subscribe.

At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.