Surrendering an Annuity: Beware of Taxes and Surrender Fees

There are many reasons why individuals decide to surrender their annuities. Unfortunately, one of the most common reasons that we see is that individuals realize they were sold the annuity by a broker that was either not in their best interest, or they discover that there are other investment solutions that will better meet their investment objectives. This situation can often lead to individuals making the tough decision to cut their losses and surrender the annuity.  But before surrendering their annuity, it’s important for investors to understand the questions to ask the annuity company about the surrender fees and potential tax liability before making the final decision to end their annuity contract.

Surrender Fee Schedule

Most annuities have what are called “surrender fees,” which are fees that are charged against the account balance in the annuity if the contract is terminated within a specific number of years. The surrender fee schedule varies greatly from annuity to annuity.  Some have a 5-year surrender schedule, others have a 7-year surrender schedule, and some have 8+ year surrender fees.  Typically, the amount of the surrender fees decreases over time, but the fees can be very high within the first few years of obtaining the annuity contract.

For example, an annuity may have a 7-year surrender fee schedule that is as follows:

Year 1:  8%

Year 2:  7%

Year 3:  6%

Year 4:  5%

Year 5:  4%

Year 6:  3%

Year 7:  3%

Year 8+: 0%

If you purchased an annuity with this surrender fee schedule and two years after purchasing the annuity you realize it was not the optimal investment solution for you, you would incur a 7% surrender fee. If your annuity had a $100,000 value, the annuity company would assess a $7,000 surrender fee when you cancel your contract and move your account.

When It Makes Sense To Pay The Surrender Fee

In some cases, it may make financial sense to pay the surrender fee to get rid of the annuity and just move your money into a more optimal investment solution.  If a client has had an annuity for 6 years and they would only incur a 3% surrender fee to cancel the annuity, it may make sense to pay the 3% surrender fee as opposed to waiting 2 more years to surrender the annuity contract without a surrender fee.  For example, if the annuity contract is only expected to produce a 4% rate of return over the next year, but they have another investment solution that is expected to produce an 8%+ rate of return over that same one-year period, it may make sense to just surrender the annuity and pay the 3% surrender fee, so they can start earning those higher rates of return sooner, which essentially more than covers the surrender fee that they paid to the annuity company.

Potential Tax Liability Associated with Annuity Surrender

An investor may or may not incur a tax liability when they surrender their annuity contract.  Assuming the annuity is a non-qualified annuity, if the cash surrender value is not more than an investor's original investment, then there would not be a tax liability associated with the surrender process because the annuity contract did not create any “gain” in value for the investor.  However, if the cash surrender value is greater than the initial investment in the contract, then the investors would trigger a realized gain when they surrender the contract, which is taxed at an ordinary income tax rate.  Annuity investments do not receive long-term capital gain preferential tax treatment for contacts held for more than 12 months like stocks and other investments held in brokerage accounts. The gains are always taxed as ordinary income rates because it’s technically an insurance contract.

Not all annuity companies list your total “cost basis” on your statement.  Often, we advise clients to call the annuity company to obtain their cost basis in the policy and have the annuity company tell them whether or not there would be a tax liability if they surrendered the annuity contract.  You can call the annuity company directly; you do not need to call the broker that sold you the annuity.

If there is no tax liability associated with surrendering the contract, surrendering the contract can be an easy decision for an investor. However, if there is a large tax liability associated with surrendering an annuity, some tax planning may be required.  There are tax strategies associated with surrendering annuities that have unrealized gains, such as if you are close to retirement, you could wait to surrender the annuity until the year that you are fully retired, making the taxable gain potentially subject to a lower tax rate.  We have had clients that have surrendered an annuity, incurred a $15,000 taxable gain, and then turned around and contributed $15,000 more, pre-tax, to their 401(k) account at work, which offset the additional taxable income from the annuity surrender in that tax year.

Is Paying The Surrender Fee and Taxes Worth It?

For investors who face either a surrender fee, taxes, or both when surrendering an annuity contract, the decision of whether or not to surrender the annuity contract comes down to whether or not paying those taxes and/or penalties is worth it, just to get out of that annuity that was not the right fit in the first place. Or maybe it was the right investment when you first purchased it, but now your investment needs have changed, or there is a better investment opportunity elsewhere.  If there are no surrender fees and minimal tax liability, the decision can be very easy, but when large surrender fees and/or tax liability exists, additional analysis is often required to determine if delaying the surrender of the annuity contract makes sense.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Beware of Annuities

I’ll come right out and say “I’m not a fan of annuities”.  They tend to carry:

1)      Higher internal fees

2)      Surrender charges that prevent investors from getting out of them

3)      “Guarantees” that are inferior to alternative investment solutions

Unfortunately, annuities pay Financial Professionals a lot of money, which is why it is not uncommon for Investment Advisors to present them as a primary solution.  For example, some annuities pay Investment Professionals 5% - 8% of the amount invested, so if you invest $200,000 in the annuity, the advisor gets paid $10,000 to $16,000 as soon as you deposit the money to the annuity.  Compared to an Investment Advisor that may be charging you 1% per year to manage your portfolio, it will take them 5 to 8 years to earn that same amount.

To be fair, there are a few situations where I think annuities make sense, and I will share those with you in this article.  In general, however, I think investors should be very cautious when they are presented with an annuity as a primary investment solution, and I will explain why.

Fixed Annuities & Variable Annuities

There are two different types of annuities. Fixed annuities and variable annuities. Within those categories, there are a lot of different flavors, such as indexed annuities, guaranteed income benefits, non-qualified, qualified, etc.  Annuities are often issued by banks, investment firms, insurance companies, employer sponsored plan providers, or directly to the consumer.   It is important to understand that not all annuities are the same and they can vary greatly from provider to provider.  The points that I will be making in this article are my personal option based on my 20 years of experience in the investment industry.

Annuities Have High Fees

My biggest issue with annuities in general is the higher internal costs associated with them.  When you read the fine print, annuities can carry:

·         Commissions

·         Contract fees

·         Mortality expenses

·         Surrender fees

·         Rider fees

·         Mutual fund expense ratios

·         Penalties for surrender prior to age 59½

When you total all of those annual fees, it can sometimes be between 2% - 4% PER YEAR.  The obvious questions is, “How is your money supposed to grow if the insurance company is assessing fees of 2% - 4% per year?” 

Sub-Par Guarantees

The counter argument to this is that the insurance company is offering you “guarantees” in exchange for these higher fees.   During the annuity presentation, the broker might say “if you invest in this annuity, you are guaranteed not to lose any money. It can only make money”.  Who wouldn’t want that?  But the gains in these annuities are often either capped each year, or get chipped away by the large internal fees associated with the annuity contract.  So, even though you may not “lose money”, you may not be making as much as you could in a different investment solution.

Be The Insurance Company

At a high level, this is how insurance companies work. They sell you an annuity, then the insurance company turns around and invests your money, and hands you back a lower rate of return, often in the form of “guarantees”.  That is how they stay in business.   So, my question is “Why wouldn’t you just keep your money, invest it like the insurance would have, and you keep all of the gains”? 

The answer: Fear.  Most investments involve some level of risk, meaning you could lose money.  Annuity presentations prey on this fear.  They will usually show financial illustrations from recessions, such as when the market went down 30%, but the annuity lost no value.  For retirees, this can be very appealing, because the working years are over and now they just have their life savings to last them for the rest of their lives.

But like other successful investors, insurance companies rely on the historical returns of the stock market, which suggest that over longer periods of time (10+ year) the stock market tends to appreciate in value. See the charge of the S&P 500 Index below. Even with the pull backs and recessions, the value of the stock market has historically moved higher.

Annuity Surrender Fees Lock You In

The insurance company knows they are going to have your money for a long period of time because most annuities carry “surrender fees”.  Most surrender schedules last 5 – 10 YEARS!!  This means if you change your mind and want out of the annuity before the surrender period is up, the annuity company hits you with big fees.   So, before you write the check to fund the annuity, make sure it’s 100% the right decision.

Do Not Invest an IRA In An Annuity

This situation always baffles me.  We will come across investors that have an IRA invested in an annuity.  Annuities by themselves have the advantage of being “tax deferred vehicles” meaning you do not pay taxes on the gains accumulated in the annuity until you make a withdrawal.  You pay money to the insurance company to have that benefit since annuities are insurance products. 

An IRA by itself is also a tax deferred account.  You can choose to invest your IRA in whatever you want – cash, stocks, bonds, mutual funds, or an annuity.  So, here is my question: since an IRA is already tax deferred vehicle, why would you pay extra fees to an annuity company to invest it in a tax deferred annuity?  It makes no sense to me.

The answer, again, is usually fear.  An individual retires, they meet with an investment advisor that recommends that they rollover their 401(k) into an IRA, and uses the fear of losing money in the market to convince them to move their full 401(k) into an annuity product.  I completely understand the fear of losing money in retirement, and for some individuals it may make sense to put a portion of their retirement assets into something like an annuity that offers some guarantees. But in my experience, it rarely makes sense to invest the majority of your retirement assets in an annuity.

Guaranteed Minimum Income Benefits

Another sparkling gem associated with annuities that is often appealing to retirees are annuities that carry a GMIB, or “Guaranteed Minimum Income Benefit”.  These annuities are usually designed to go up by a “guaranteed” 5% - 8% per year, and then at a set age will pay you a set monthly amount for the rest of your life.  Now that sounds wonderful, but here is the catch that I want you to be aware of.  For most annuity companies, the value of your annuity associated with the “guaranteed increases” only matters if you annuitize the contract with that insurance company. After 10 years, if instead you decided to surrender the annuity, you typically do not receive those big, guaranteed increases, but instead get the actual value of the underlying investments less the big fees.  This is why there is often more than one “balance” illustrated on your annuity statement.

Here is the catch of the GMIB – when you go to turn it on, the annuity company decides what that fictitious GMIB balance will equal in the form of a monthly benefit for the rest of your life.  Also, with some annuities, they cap the guaranteed increase after a set number of years.  In general, what I have found is annuities that were issued with GMIB prior to 2008 tend to be fairly generous, because that was before the 2008/2009 recession. After 2008, the guarantees associated with these GMIB’s became less advantageous.

When Do Annuities Make Sense

I have given you the long list of reason why I am not a fan of annuities but there are a few situations where I think annuities can make sense:

1)      Overspending protection

2)      CD’s vs Fixed Annuity

Overspending Protection

When people retire, for the first time in their lives, they often have access to their 401(K), 403(b), or other retirement account.   Having a large dollar amount sitting in accounts that you have full access to can sometimes be a temptation to overspend, make renovation to your house, go on big vacations, etc. But when you retire, when the money is gone, it is gone.  For individuals that do not trust themselves to not spend through the money, turning that lump sum of money into a guaranteed money payment for the rest of their lives may be beneficial.  In these cases, it may make sense for an individual to purchase an annuity with their retirement dollars, because it lowers the risk of them running out of money in retirement.

CD’s vs Fixed Annuities

For individuals that have a large cash reserve, and do not want to take any risk, sometimes annuity companies will offer attractive fixed annuity rates.  For example, your bank may offer a 2 year CD at a 2%, but there may be an insurance company that will offer you a fixed annuity at a rate of 3.5% per year for 7 years.   The obvious benefit is a higher interest rate each year.  The downside is usually that the annuity carries surrender fees if you break the annuity before the maturity date.  But if you don’t see any need to access the cash before the end of the surrender period, it may be worth collecting the higher interest rate.

Final Advice

Selecting the right investment vehicle is a very important decision.  Before selecting an investment solution, it often makes sense to meet with a few different firms to listen to the approach of each advisor to determine which is the most appropriate for your financial situation. If you go into one of these meetings and an annuity is the only solution that is present, I would be very cautious about moving forward with that solution before you have vetted other options. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Do I Have To Pay Taxes On My Inheritance?

Whenever people come into large sums of money, such as inheritance, the first question is “how much will I be taxed on this money”?  Believe it or not, money you receive from an inheritance is likely not taxable income to you.

Of course there are some caveats to this.  If the inherited money is from an estate, there is a chance the money received was already taxed at the estate level.  The current federal estate exclusion is $5,430,000 (estate taxes and the exclusion amount varies for states). Therefore, if the estate was large enough, a portion of the inheritance may have been subject to estate tax which is 40% in most cases.  That being said, whether the money was or was not taxed at the estate level, you as an individual do not have to pay income taxes on the money.

Although the inheritance itself is not taxable, you may end up paying taxes if there is appreciation after the money is inherited.  The type of account and distribution will dictate how the income will be taxed.

Basis Of Inherited Property

Typically, the basis of inherited property is the fair market value of the property on the date of the decedent’s death or the fair market value of the property on the alternate valuation date if the estate uses the alternate valuation date for valuing assets.  An estate will choose to value assets on an alternate date subsequent to the date of death if certain assets, such as stocks, have depreciated since the date of death and the estate would pay less tax using the alternate date.

What the fair market value basis means is that if you inherit stock that was originally purchased for $500 and at the date of death has appreciated to $10,000, you will have a “step-up” basis of $10,000.  If you turn around and sell the stock for $11,000, you will have a $1,000 gain and if you sell the stock for $9,000, you will have a $1,000 loss.

Inheriting a personal residence also provides for a step-up in basis but the gain or loss may be treated differently.  If no one lives in the inherited home after the date of death, it will be treated similar to the stock example above.  If you move into the home after death, any subsequent sale at a loss will not be deductible as it will be treated as your personal asset but a gain would have to be recognized and possibly taxed.  If you rent the property subsequent to inheritance, it could be treated as a trade or business which would be treated differently for tax purposes.

Inheriting An IRA or Retirement Plan Account

Please read our article “Inherited IRA’s: How Do They Work” for a more detailed explanation of the three different types of distribution options.

When you inherit a retirement account, and you are not the spouse of the decedent, in most cases you will only have one option, fully distribute the account balance 10 years following the year of the decedents death.   The SECURE Act that was passed in December 2019 dramatically change the distribution options available to non-spouse beneficiaries. See the article below: 

If you are the spouse of the of the decedent, you are able to treat the retirement account as if it was yours and not be forced to take one of the options above.  You will have to pay taxes on distributions but you do not have to start withdrawing funds immediately unless there are required minimum distributions needed.

Note: If the inherited account was an after tax account (i.e. Roth), the inheritor must choose one of the options presented above but no tax will be paid on distributions. 

Non-Qualified Annuities

Non-qualified annuities are an exception to the step-up in basis rule.  The non-spousal inheritor of a non-qualified annuity will have to take either a lump sum or receive payments over a specified time period.  If the inheritor chooses a lump sum, the portion that represents the gain (lump sum balance minus decedent’s contributions) will be taxed as ordinary income.  If the inheritor chooses a series of payments, distributions will be treated as last in, first out.  Last in, first out means that the appreciation will be distributed first and fully taxable until there is only basis left.

If the spouse inherits the annuity, they most likely have the option to treat the annuity contract as if they were the original owner.

This article concentrated on inheritance at a federal level.  There is no inheritance tax at a federal level but some states do have an inheritance tax and therefore meeting with a professional is recommended.  New York currently does not have an inheritance tax. 

About Rob……...

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.