Picture this: You're on the cusp of retirement, and you've just learned about a financial tool that promises to shield your hard-earned savings from taxes until you need them.
This tool is the non-qualified annuity, an insurance contract funded with after-tax money that defers taxes on your income and growth until withdrawn.
Sounds like an easy decision, right?
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Hold that thought ...
In a world devoid of pensions, 401(k)s and similar employer-sponsored plans have become many Americans' go-to retirement saving option. These plans offer upfront tax breaks and deferred taxation on earnings, a seemingly ideal combination.
But there's a catch.
Every dollar withdrawn from a tax-deferred account is taxed as ordinary income — the least-favorable type of income tax there is.
An unfortunate surprise for many
Now, let's circle back to non-qualified annuities. By opting for one, you're essentially converting all potential long-term capital gains (which enjoy favorable tax treatment) into ordinary income, thus increasing your tax burden when those gains are withdrawn. It's an unfortunate twist many don't see coming and are unaware of when buying a non-qualified annuity.
Consider this scenario: You're a modern-day retiree with a diverse portfolio of investments — most of which have been saved in tax-deferred accounts, some in tax-preferential accounts and a small amount in tax-free accounts. Adding a non-qualified annuity might seem prudent, especially if you are a tax-sensitive investor. But if your retirement nest egg is already concentrated in tax-deferred accounts, that type of annuity will only make your future tax exposure less diverse.
As you can see in the chart below, ordinary income tax rates (blue) are generally higher than tax rates on long-term capital gains and qualified dividends issued by stocks (orange), which is why it is advantageous for today's retirees to preserve their non-tax-deferred assets rather than convert them:
Before jumping into a non-qualified annuity, ask yourself:
How diversified is my tax exposure in retirement? Don't just diversify your investments; diversify your future tax liabilities. On the day you retire, aim to have your savings split into equal thirds among tax-deferred, tax-preferential and tax-free accounts. This lets you choose which accounts to withdraw from each year to achieve the lowest tax rate.
What does my retirement withdrawal plan look like? If you anticipate needing all your savings for retirement expenses, it’s likely advantageous to keep your taxable investment accounts due to their favorable tax treatment rather than shifting that money into another tax-deferred option like a non-qualified annuity.
Will my retirement lifestyle push me into the highest tax brackets? If yes, it would be wise to reconsider piling more money into tax-deferred savings. If not, then the tax-deferred benefits of a non-qualified annuity may fit your situation well.
Do you care about maximizing your financial legacy? Taxable brokerage accounts left to your heirs receive a step-up in basis upon your death. This is a major tax benefit for heirs that adjusts the principal in your account (cost basis) to the fair market value of your investments on the date of your death. In some cases, this can lead to thousands of dollars in capital gains taxes being forgiven. Alternatively, even though it is funded with after-tax dollars, a non-qualified annuity does not receive a “step-up in basis” upon your death. This is a major downfall of the non-qualified annuity, in my opinion.
Based on my experience …
From my experience as a financial adviser, I've found that the retirees who need to withdraw most of their savings to afford their lifestyle in retirement are better off nurturing their after-tax investments in taxable brokerage or tax-free accounts rather than piling more into the tax-deferred bucket. Next to health care costs, income taxes are a retiree's most significant expense. The goal is to minimize your income taxes as much as possible.
Although a non-qualified annuity offers immediate tax relief, it can lead to a higher tax burden in the long run. A wiser approach may be to focus on preserving your non-tax-deferred savings. This doesn't make non-qualified annuities bad financial instruments. It just means the decision to use one in your financial situation requires careful consideration from a variety of perspectives.
Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment advisor and affiliate of Wealth Enhancement Group®.
Related Content
-
Stock Market Today: Trump Retreats, Markets RejoiceStocks rally, yields soften, the dollar rises, and even beaten-down names enjoy the wages of potential trade peace.
-
In Trump’s Economy Should 401(k) Savers 'Set It and Forget It?'It’s hard to bury your head in the sand when the markets are volatile. Here’s when it makes sense and when it doesn’t.
-
Bouncing Back: New Tunes for Millennials Trying to Make ItAdele's mournful melodies kick off this generation's financial playlist, but with the right plan, Millennials can finish strong.
-
Early-Stage Startup Deals: How Do Convertible Notes Work?Some angel investors support early startups by providing a loan in exchange for a convertible note, which includes annual interest and a maturity date.
-
SRI Redefined: Going Beyond Socially Responsible InvestingNow that climate change has progressed to a changed climate, sustainable investing needs to evolve to address new demands of resilience and innovation.
-
Here's When a Lack of Credit Card Debt Can Cause You ProblemsUsually, getting a new credit card can be difficult if you have too much card debt, but this bank customer ran into an issue because he had no debt at all.
-
Going to College? How to Navigate the Financial PlanningCollege decisions this year seem even more complex than usual, including determining whether a school is a 'financial fit.' Here's how to find your way.
-
Financial Steps After a Loved One's Alzheimer's DiagnosisIt's important to move fast on legal safeguards, estate planning and more while your loved one still has the capacity to make decisions.
-
How Soon Can You Walk Away After Selling Your Business?You may earn more money from the sale of your business if you stay to help with the transition to new management. The question is, do you need to?
-
Two Don'ts and Four Dos During Trump's Trade WarThe financial rules have changed now that tariffs have disrupted the markets and created economic uncertainty. What can you do? (And what shouldn't you do?)
