A recent Wall Street Journal article commented on the mistakes that investors often make in disposing of an unwanted annuity (Maxey, July 9, 2007). A key point was that those looking to cash in an annuity often do so in haste, ignoring the potential tax cost and surrender charges.

In general, annuities come in two flavors. Traditional annuities grow based on the general interest crediting rate of the issuing insurance company, while variable annuities hold underlying stock and bond mutual funds. In this second case, the cash value may increase or decrease depending upon the performance of the underlying investments. A common feature of both forms is the internal insurance charge which tends to be a drag on performance compared to a similar investment in non-annuity form.

But annuities have a significant tax deferral advantage. The growth in the cash surrender value of the underlying investments is not taxable until annuity payments are received or a cash-out is taken by the owner.  

The Wall Street article commented on how some investors who surrender an unwanted annuity are surprised by the large tax cost. That is certainly a valid observation. An annuity that has been untouched for 30 years, for example, typically has appreciated significantly, and can bring a substantial tax bill. The amount received is considered ordinary income, even though the underlying investments may represent capital appreciation in stocks and funds that otherwise would be capital gain.

For those contemplating the cash-in of an unneeded annuity, the article commented on the importance of shopping around, both with the issuing insurer and also with the secondary market. Some annuities are capable of a sale to a third party, giving the investor another option.

But what about taking advantage of a key annuity attribute: A lifetime payout that you cannot outlive? An annuity can generally be “annuitized,” with the issuing insurance company committing to a lifetime monthly payout. This shifts the risk of extended longevity to the insurance company. Using an annuity as a core monthly retirement income source is probably an underutilized feature.  

And there are other choices as well. Perhaps the annuity should simply be left to your heirs. Or how about leaving it to charity where all of that accrued income might avoid taxes?

Unfortunately, designating your heirs as beneficiaries does nothing to cleanse the significant deferred income tax cost. Unlike many other investments, annuities do not receive a fresh tax cost when they pass through an estate. Accordingly, all of that income will still be taxable to your children or other heirs when they cash in the annuity after you are gone.

Charitable transfers, of course, fare better. If an annuity is transferred to a charity during lifetime, the owner must recognize the deferred income at the point of transfer. But an offsetting charitable deduction is allowed for the full proceeds of the annuity that move to the charity. Generally, this should produce a charitable deduction that is larger than the income by the sum of the owner’s investment in the annuity contract.

Another option is to pass the annuity to charity after death by naming a charity as the beneficiary. For those who desire to leave some amount to charity as a bequest, using an annuity is a tax-efficient choice. The charity is not subject to any income taxes when it receives the proceeds. Other assets with no deferred tax liabilities can then be left to your heirs.

Leon Dutkiewicz, CPA, CRSP, is a member of Margolis & Company’s Tax Advisory Services Group and is the firm’s expert on retirement planning. Fore more information, please call Leon at (610) 667-6250, ext. #136 or contact him at ldutkiewicz@marg.com.