Q Dear Rick:
Here’s my situation that I hope you can help me with. About 20 some odd years ago my husband purchased an annuity. When he passed a little over nine years ago the annuity was transferred into my name. It just sat there and I really never have done anything with it. I don’t need the money and I’d like to cash out the annuity and give the money to my two children. The agent told me that if I did that I would have to pay taxes on the entire annuity which is about $100,000 and I would also have to pay gift taxes to give the money to my children. My question to you: is that right and do you have any suggestions how to avoid the taxes? I should mention that this money is not in an IRA.

Thank you.
M.P.

A Dear M.P.:
You agent was correct that when you cash out the annuity there will be an income tax consequence; however, he was wrong regarding the amount of the taxes. Since this annuity was not in an IRA or another type of qualified account, you have a basis in the investment. The basis is what your husband originally paid for the annuity. The tax consequence is the amount you received less the original purchase price. For example, if your husband originally paid $60,000 for the annuity and today it’s worth $100,000, the amount that would be subject to tax would be the $100,000 less the cost basis of $60,000; thus, $40,000 would be subject to income tax. Unfortunately, there is no way to avoid the income tax when the annuity is cashed. However, there may be a way to reduce the amount of taxes you have to pay.

As opposed to cashing the annuity out in one year, I recommend that you consider spreading it out over two years or possibly even three years. For example, if I used the example above that there was $40,000 in tax liability, if you cash out the annuity in one year, $40,000 would be added to your income and that could cause you to be put into a higher tax bracket and potentially, if you are receiving Medicare, your Medicare premiums could rise. On the other hand, if you spread the distribution out over two or three years you will lessen that effect. In addition, spreading the distribution out over two or three years will also help you from the gift tax standpoint.

Gift taxes are something that most Americans are unfamiliar with. What makes gift taxes unique is that it’s not the person who receives the gift who pays the taxes; rather, it is the person who is making the gift. Under our tax laws you can currently give $14,000 a year to anyone you choose tax free. Therefore, if you spread the distribution out over two years you would be able to exempt $56,000 from gift taxes. If you did it over three years, $84,000 would be exempt from gift taxes.

Whether you spread the distribution out over two or three years, there will be a gift tax consequence. However, once again there is a way you could avoid paying those taxes. Every American has a little over $5 million of exemptions from estate or gift taxes. Typically, most people will use this exemption at death. However, you can choose to use part of it during your lifetime. For most people this would not cause any issues because upon death their estates are not worth $5 million. To use your exemption during your lifetime does require you to file a gift tax return.

I think it’s wonderful when someone has the resources and they use those to help a loved one. After all, when you gift money during your lifetime as opposed to waiting until death, you can see the enjoyment someone gets from your generosity. However, one thing I always want to caution people on is that gifts are irrevocable and if for some reason you need the money in the future, it won’t be available to you. Therefore, I always tell people who plan on gifting during their lifetime to proceed with caution and make sure they have the resources to protect themselves no matter what the future brings; particularly, when gifting substantial money,

Good luck!
Word Count=729

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