Sometimes cashing out of an annuity can make more sense than doing a tax-free transfer into a new product — even if it presents the client with a tax bill.
“If a new client comes in with an annuity that’s inappropriate for him — a young person whose tax rates will be higher in 30 years than they are now, for example — I’d probably encourage him to get out of it this year, when tax rates are at a historic low,” said Loretta Nolan, a financial planner and head of an eponymous firm in Old Greenwich, Conn.
Many non-partisan political and tax analysts expect taxes to rise in 2009 or 2010, regardless of who wins the White House. They point out that the rising cost of entitlement programs, defense spending and interest on the national debt — to say nothing of potential shorter-term expenses like bailing out of financial institutions — will put enormous upward pressure on taxes.
“With the federal deficit growing, and tax revenues falling because of the weak economy, the government will need to raise money,” said Bob D. Scharin, senior tax analyst from the tax and accounting business of Thomson Reuters in New York.
“It’s more important than ever to weigh the likelihood of an increase in tax rates against the benefits of tax-deferral,” Ms. Nolan said.
Indeed, you may find it makes more sense for your client to take money out of his annuity this year than put it in — even if the annuity is an appropriate long-term investment, she said. “If a client will owe alternative minimum tax, for example, or has a lot of big deductions this year and not a lot of income, he might want to surrender his current product this year and start over with a new annuity.”
And for some clients, she added, an annuity simply isn’t the best investment vehicle.
As an example, Ms. Nolan cited a young couple who already owned an annuity when they became her clients. When the time comes for them to withdraw their money, they’ll be in a higher tax bracket than they are now, she said. “It’s better for them to take whatever withdrawals the annuity allows without a surrender charge, and pay taxes and a 10% early withdrawal penalty on that money, than for them to pay income taxes on all their annuity earnings 30 years from now at a higher rate,” Ms. Nolan said.
Obviously, you’ll want to determine the total cost of cashing out an annuity before making a recommendation.
“It’s a decision that depends partly on the surrender charges and on the tax bill,” said Robert Carlson, president of Carlson Wealth Advisors LLC, a Fairfax, Va., financial adviser with $20 million under management.
“There’s virtually no cost to cashing out an annuity that has yet to have much appreciation, and on which the surrender period has expired.”
Another reason to consider cashing out of an annuity is if it doesn’t fit the client’s estate plan. “People used to look at an annuity as a way to leave something to the next generation,” Mr. Carlson said. “But an annuity isn’t really a good
estate planning device.” As part of the client’s estate, it is subject to estate taxes and the client’s heirs will also owe ordinary income taxes on the annuity’s earnings as they’re withdrawn.
“I have heard some financial planners and insurance agents say that if you have a taxable estate, your heirs will wind up with more money if you liquidate an annuity, pay the taxes and put the money into a life insurance policy instead,” Mr. Carlson said.
That strategy can only work if the life insurance policy is owned by an irrevocable life insurance
trust, or by a person other than the client. When he doesn’t own the policy, its value isn’t included in his estate, and therefore isn’t subject to estate taxes. And the heirs don’t pay income taxes on the life insurance policy proceeds; a policy death benefit isn’t taxable income to beneficiaries.
The downside: Once the client no longer owns the policy, he can’t borrow against it, cash it in or change its beneficiary.
