Given the Proposed Changes in President Joe Biden’s Tax Plan, Could A Non-Qualified Annuity Make Sense?

What is an annuity and what are the associated costs?
What are the pros and cons of annuities?
How do the proposed tax law changes affect annuities?

I almost always tell family, friends, clients, and prospective clients to run the other way if they are speaking to a Financial Advisor, and they mention the word ‘Annuity’. Typically, when the word ‘annuity’ comes up during a sales pitch, it often ends with a signed contract, a very happy financial advisor, potentially 8 years of high fees for the client, and little to no understanding of the benefits received. 

Generally, my opinion on annuities has not changed much, but in President Biden’s current tax proposal plan, there is a potential tax law change that might make non-qualified annuities worth further analysis. This tax plan proposes the elimination of favorable long-term capital gains tax treatment for wealthy Americans in favor of ordinary income tax treatment (i.e. higher tax rates). Before diving deep into the proposal, let’s review the key features of an annuity. 

An annuity is a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning immediately or at some point in the future¹. 

You can purchase an annuity two different ways: within an IRA, referred to as a qualified annuity, or with after-tax money, known as a non-qualified annuity. Some annuities have guaranteed payout rates, and some have other unique features. Annuities in general, and each additional annuity add-on, can come at a hefty price. 

Listed below are typical fees that annuities charge:

• Mortality Expenses (M&E): Provides death benefits to your heirs. Investment fees can cost up to 1.5% of the account value annually².
• Administrative Fees: A service fee for your retirement account. You can expect to pay up to .30% of the account value annually².
• Investment Expense Ratio: An investment advisory fee for choosing various investment choices (equity and fixed income) called sub-accounts. Annuity owners can expect to pay up to 2% of the total value annually².
• Guaranteed Lifetime Withdrawal Benefit: An income rider (Guaranteed Lifetime Withdrawal Benefit) fee similar to an index annuity’s income rider. Annuity owners can expect to pay up to 1% of the account value annually².
• Enhanced Death Benefit Riders: An optional estate planning rider to protect the annuity owner’s beneficiaries’ investment. The cost can be up to .50% of the account value annually².

After learning of all the fees associated with annuities above, you are probably asking yourself why would a Financial Advisor suggest an annuity in the first place? Annuities often come with high commissions, ranging from 1% - 8% of the contribution depending on the type of annuity3. You can see why some advisors would want to sell annuities; it can be a very lucrative business. 

To this point, I have painted the picture of why annuities can be expensive investments, but they can have some benefits. Non-qualified annuities work very similarly to an IRA from a tax perspective, meaning that once you make a contribution to the annuity, the earnings grow tax-deferred; however, you do not receive a tax deduction for the contribution like you would for an IRA (if you meet the income tests).

While the tax deferral inside a non-qualified annuity is a nice benefit, when you withdraw funds from the non-qualified annuity in the future, a portion of that money will be subject to ordinary income tax (versus capital gain tax treatment inside a brokerage investment account). 

For individuals at the highest tax brackets, long-term capital gains tax is much lower than ordinary income tax. In addition, under the current law, you would also be giving up a step-up in basis upon your death for your beneficiaries. 

Let’s review the pros and cons of annuities.

• Pros of annuities: guaranteed rates of return for risk-averse investors; tax-deferred growth for non-qualified annuities; and no required minimum distribution for non-qualified annuities.
• Cons of annuities: many of them have high fees; limited investment options; investment gains are taxed at ordinary income tax rates; do not receive step-up in basis upon death; and qualified annuities do not give you additional tax-deferral benefits.

Now that you understand the basics of annuities, we will discuss why non-qualified annuities might be a good fit in your financial plan, if President Biden’s tax proposal is passed.

Under his current tax proposal, President Biden would increase the long-term and short-term capital gains tax rate to 43.4% (39.6% long-term capital gain plus 3.8% Obamacare tax) for anyone with over $1 million of income per year. In addition, he is proposing the elimination of the step-up in basis tax treatment upon death for beneficiaries. 

For those with income over $1 million, this would eliminate the long-term capital gains tax benefits of holding assets in a brokerage account for over a year by almost doubling the tax rate. If this plan comes to fruition, a more compelling argument for holding assets in a non-qualified annuity may be made. 

As I mentioned earlier, assets held inside a non-qualified annuity grow tax-deferred. If you are going to pay close to the same tax rate on distributions from the annuity (ordinary income rates) and gains from a brokerage account (43.4%), the tax-deferred growth in a non-qualified annuity may be a good option.

There are still plenty of uncertainties in President Biden’s tax proposal and what Congress might actually pass into law. However, the potential change in long-term capital gains rates for those making over $1M a year could make non-qualified annuities worth additional consideration. 

Interested in learning more? We would be happy to discuss financial planning in more detail with you. Please contact Schneider Downs Wealth Management to set up a conversation.

¹https://www.investopedia.com/ask/answers/12/what-is-an-annuity.asp
²https://www.annuityexpertadvice.com/annuity-101/annuity-fees/
³https://www.annuity.org/annuities/fees-and-commissions/#:~:text=Typical%20Commissions%20on%20Varying%20Annuity%20Types%3A&text=The%20commission%20on%20a%2010,of%202%20to%204%20percent.

Schneider Downs Wealth Management Advisors, LP (SDWMA) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). SDWMA provides fee-based investment management services and financial planning services, along with fee-based retirement advisory and consulting services. Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice. Registration with the SEC does not imply any level of skill or training.