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This Web site contains a compilation of more than a thousand consumer finance  columns written by Tony Novak from the 1980s through 2006, updated and reformatted for maximum usefulness today.  New material was added after 2010.

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Saving taxes on annuity

originally posted: 11/22/2006  reposted: 2/18/2011 This post has not been recently reviewed or revised by the author and may be out of date. If in doubt, please send a new question or ask for an update.

Q: I have several tax-deferred annuity accounts and I just learned that they will be taxable about ordinary income rates when I cash them in? Can I convert it to a life insurance policy? If not, how can I get the lower capital gains rates?

A: Yes, this is one of the big disadvantages of annuities that is seldom discussed by the insurance representatives who sell them. Even worse, you do not get out of the problem when you die because your beneficiaries still wind up paying the higher tax rates! It makes sense to deal with the problem now because the tax issue will only continue to get worse as the contract accumulates taxable value over time. Most annuity owners are not even aware of the tax problem and, as a result, millions of dollars in avoidable taxes will be paid by baby-boomers in the same situation. While life insurance policies can be transferred to annuity policies, it is not possible (from a tax perspective) to convert annuity to a life insurance policy and enjoy the tax-free benefit. Usually the best thing is to consider selling your annuity especially if you can get an offer significantly more than the contract's face value. Financial firms now specialize in buying and selling these "after-market" annuity contracts. Insurance companies only offer "face value" if you cash in your annuity contract. If your health is good, the annuity can be worth more than its face value. This is because an annuity contract has a built-in "income for life" feature that is based on average mortality tables. If your life expectancy is longer than "average" then the annuity contract may be worth more than you realize. The proceeds can then be reinvested in a tax-efficient investment vehicle. In your case, placing the cash value into a life insurance policy might give your family or trust account twice the current value on an after-tax basis at your death if the money is not likely to be needed during your lifetime. Otherwise, many other investments would offer long term capital gains tax rates. (There is now a legislative proposal to completely eliminate taxes on long term capital gains). An annuity sales transaction is best handled by a non-commissioned investment adviser since because the annuity firms do not deal directly with the public and it might be wise to avoid creating a conflict of interest by using a commission-based representative. Discuss the specifics of your annuity contract with OnlineAdviser to see if this strategy will work.


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