Q Dear Rick:
I have a couple questions regarding annuities that I hope you can help me with. About 10 years ago my husband passed. At the time he had an annuity that was worth about $100,000. Today the annuity is worth about $140,000. I received notice from the annuity company that the annuity had matured. I am getting conflicting information as to what my options are. My first question is what happens if I cash out the annuity? My agent told me that I would have to pay tax on the entire amount of the annuity, less what my husband originally paid for it. When he first bought the annuity he paid approximately $50,000 for it. A good friend of mine said I do not have to pay tax on the money because it was an inheritance. My second question is that if I do what my agent recommended and roll it over into a new annuity, he said I don’t have to pay any tax. The downside is that the annuity will have an 11 year penalty period; do I have any options?
Becky

A Dear Becky:
With regard to the tax consequences, your agent is correct. Unfortunately, annuities do not receive the favorable treatment upon death as other investments do. When someone inherits an annuity and cashes it out they pay tax on the accumulated income within that annuity. For example, in the case at hand, if the annuity was worth $140,000 and your husband originally paid $50,000 ($140,000 – $50,000=$90,000) that $90,000 is the interest earned on the annuity and thus, that is the amount that is subject to income tax. Therefore, if you cash the annuity out in one year, you would have to pay tax on the $90,000. The amount taxed is taxed at your ordinary income tax bracket not the favorable capital gain rate.

Your agent was also correct in the fact that you can avoid the taxes by having the money transferred into a new annuity. That money can continue to grow on a tax deferred basis; thus, you would only pay taxes once the money is withdrawn. That being said, your agent was incorrect in telling you that the only option is to roll it into another annuity with an 11-year penalty provision. You can directly transfer that money into any annuity; it doesn’t have to be an annuity from the same company or even through the same agent. Therefore, you can choose to transfer the money into an annuity that has no penalty provisions. There are many companies that offer annuities without penalties. Companies such as Fidelity, Charles Schwab and Vanguard all offer penalty-free annuities.

You may ask why someone would buy an annuity with a penalty versus one without a penalty. To me, the answer is quite simple and that is most people don’t know that you can buy penalty-free annuities. The reason the salespeople don’t mention them is because they cannot earn commissions. When you use a penalty-free annuity there are no commissions and thus the salespeople, who unfortunately are mostly interested in their commissions, won’t tell you that there are other options. That is why it is always important to get independent advice; advice that’s not tainted by commissions.

I recognize that the best commission salespeople never worry about commissions; they worry about taking care of their clients. That being said, commissions create a great conflict of interest and it’s always important to keep that in mind when dealing with commission salespeople. Don’t ever be afraid to check your options independently.

Good luck!
Rick is a fee-only financial advisor. His website is www.bloomassetmanagement.com. If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com