Q Dear Rick:
I am confused and I hope that you can give me some advice. My husband died a couple of years ago. It was his second marriage and he had children from the first marriage. My husband had a will that left some things to his children but most everything else went to me. Because the kids think that they were not treated fairly, they sued. I basically won the lawsuit and one of the things I inherited was an annuity. My husband who was 25 years older than me had bought the annuity back in the 80s and basically let everything reinvest. According to the annuity company his original investment was $25,000 and today it’s worth nearly $100,000. My first question is if I cash out the annuity, do I have to pay any taxes? My second question is if I have to pay taxes, is there anything else I can do to get out of this low-paying annuity?
A Dear B. P.:
Unfortunately, if you cashed out the annuity you would have to pay taxes. In your situation, this is a non-qualified annuity (non IRA) and you have a basis in the property. Your basis is what you husband originally paid for the annuity and that would be the $25,000. Therefore, if you cashed out the annuity, $75,000 ($100,000 -$25,000 basis = $75,000) would be taxed as ordinary income.
Many people get confused because of the stepped-up basis rule when someone inherits property upon death. For example, if you inherited 100 shares of stock that someone paid $10 a share for, but upon their death is was worth $100 a share, the person who inherited the money would pay no taxes and their basis would be the fair market value as of the date of death and in this situation, $100,000. However, when it comes to things such as annuities or IRAs, the basis is not the fair market value as of the date of death; it is a transfer basis from the decedent. In the situation at hand that would be the $25,000.
There is another option that you can consider. Currently, according to the information you have provided me you have a fixed income annuity. A fixed income annuity is similar to a CD but with an insurance company. Basically, you get a guaranteed rate of return for a fixed period. If you want to invest in more of a growth area you can do what is known as a 1035 exchange. A 1035 exchange is tax free and it allows you to move money from one annuity into another. In your situation, what you would consider doing is moving your money from a fixed annuity into a variable annuity. In a variable annuity it allows you to invest in mutual funds where you’ll have a better opportunity to make money. The key for a 1035 exchange is to make sure the money goes from one Annuity Company into another annuity company.
In shopping for variable annuities, I believe the key is to have good investment options and low cost. In that regard, I would consider looking at annuities through Vanguard or Fidelity. They both offer very low cost, no-load annuities with very good investment options. In addition, in both these variable annuities there are no backend penalties. Most variable annuities are packed with high fees and high surrender charges. In the Vanguard and Fidelity annuities they have very low fees and no surrender charges. Thus, if a year or two from now you decide to do something different with your money, you‘d have complete flexibility. Unfortunately, with most variable annuities, you do not.
In the great majority of cases I would not recommend someone take new money and buy an annuity. However, for people who have money in annuities and who don’t want to recognize the taxes, they can look at being more efficient with their money by considering lower cost variable annuities. After all, if you can save two percent a year in unnecessary administrative fees, that two percent goes to your bottom line and as far as I’m concerned, your bottom line is the most important bottom line.