Ep #20: I Have This Annuity Thing. Now What?

Benjamin Haas |

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Benjamin Haas  00:03

Hi everyone and welcome to A/B Conversations where we will help you CFP your way out of it. A podcast where you get into the minds of a couple of Certified Financial Planners on how we think and feel about everyday financial planning questions and what should really matter most to you. A healthier financial life starts...now! How are you doing Adam? Having a good day today?


Adam Werner  00:29

Yeah, actually I am.


Benjamin Haas  00:33

It's Friday. Gotta love it. Weekends, you know, kind of feel like weekdays anyway at this point but we're getting there. Post COVID world coming fast let's hope.


Adam Werner  00:46

Yeah, not fast enough.


Benjamin Haas  00:48

Okay. So today’s topic. It's another one of those questions that I would say we get quite frequently when we meet someone for the first time, you're starting to comb through data, and they're sharing their financial history or what they have. It's not uncommon for somebody to say I have this annuity thing and sometimes it's in that language. This thing I don't fully understand and now what is there something I should be doing with this? Is there something different about it? So let's focus a little bit on that annuity product and ultimately, let's get to where it fits into financial planning, or how we deal with it, I guess is the point.


Adam Werner  01:28

Yeah. So I joked about this earlier, just when we were briefly prepping and I and I said, annuities, it's like Forrest Gump. They're like a box of chocolates, you never know what you're gonna get. They come in many shapes and sizes, there are so many different kinds and they are all somewhat complex in the way that they work. But ultimately, it's our job to help sift through that and figure out if somebody already owns it, what role can it play in their financial life or if there's something that they should be doing differently with it, then we will help guide them through their options.


Benjamin Haas  01:29

So let's just start at the beginning. An annuity is some sort of investment product but it's a product put out by a specific company. I think that's why we say, you know, the box of chocolate joke, you know, that can come in many shapes and sizes and at the same time, like you don't really know what you own because every company may have had a little bit of a different spin on it, or what is in that contract? And I guess that's important to say, too, these are contractual obligations.


Adam Werner  02:37

When you say specific company, it's their insurance products.  It is from an insurance company that is giving this investment option but to your point, it is contractual to some way, shape or form.


Benjamin Haas  02:50

Yeah, so let's just cut right to it. If you have an annuity, you were sold an annuity by somebody that can offer an insurance product. It was their solution to potentially an issue or a concern or an objective at that time. So let's just leave that there. What do we as CFPs then look for, if somebody already has this and they're asking, Can I do something different? What process would we go through to kind of get ourselves to the point where we can answer with something other than it depends?


Adam Werner  03:20

Our favorite and most hated answer I think, right off the top, is it in a retirement account or is it not in a retirement account? Yes. Number one, the first thing that we want to look at is how is it titled from a tax perspective because then that does impact a lot of different variables or a lot of different options.


Benjamin Haas  03:44

Like what? Break that down for me.


Adam Werner  03:50

If it's in a retirement account, then the annuities are treated very much like a retirement account already because they get some preferential tax treatment to be within this annuity umbrella. So if you're putting an IRA inside of annuity, you're really not getting any additional tax benefits for that. But I guess you have the positive side is there's really no difference in the way that it is taxed moving forward, unlike any other retirement accounts.


Benjamin Haas  04:18

Well, it's the other side of this that gets absolutely sticky, hairy and confusing and we don't want people to glaze over but this is important to know, right?


Adam Werner  04:28

Yeah. It's those accounts that are considered non-qualified or non retirement dollars that have now been put in this annuity shell or underneath the annuity umbrella that now are treated differently than all of your other non-retirement dollars from a tax perspective. They are taxed very differently and that is usually I think the part that people we talked to are the most confused about or just they weren't educated on the outcome of owning this, like some of the intricacies of how this is going to work in the future, after more often than not, you're not going to see or hear from that salesperson again.


Benjamin Haas  05:12

So you're 40 years old, you've got this lump sum of money that came to you. Maybe it was an inheritance. Maybe you just had the savings and you're asked, hey, do you want to pay taxes on this money every year or do you don't wait until you're 59 and a half? I'll wait. Why would I want to pay taxes? Boom, annuity but now here we are. Somebody comes to us and says, Well, I want to do something different with this. Maybe they're 50 or 55. I put 100 grand into this thing. It's worth $200,000. Now, we got to be careful about this, right?


Adam Werner  05:45

Let's just again, run that comparison between an annuity, a non-retirement annuity and just a non-retirement investment account. So let's start with the investment account, if you put $100,000 in an investment account and it has grown to $200,000 over whatever that period of time was, you will pay on your dividends and interest as you go. I think this was a recent podcast of ours or will be an upcoming one around tax time. You're paying as you go for anything that it kicks off in terms of dividends and income but you're not taxed on that larger gain. So if it grew to $200,000, you're not taxed on that $100,000 in gain until you sell it. But then I guess the nice thing is, the IRS will say that that is a capital gain and it is treated differently from a tax perspective. It's usually at a slightly lower tax rate, right, or 15, or 20%. Not at your ordinary income rate is the point. It's at a reduced rate of either 15 or 20%.


Benjamin Haas  06:45

We don't have a live audience to ask people to raise their hands up like we just went too deep but here's the key with the annuity side of it. While you defer taxation and maybe that was part of the strategy, hey, we'll defer it, that gain is now not gains. I know that's confusing to say. It's ordinary income. So you actually delayed the taxes, but you may have put yourself in a more difficult tax position from a like rate, income tax rate standpoint.


Adam Werner  07:15

So let me just add one more wrinkle or just one more specific part to that. Saying they deferred that income. Using that same example, they put $100,000 in, let's say it, it kicked off 2% of dividends and interest, whether you were owning stocks or bonds, $2,000 a year of taxes, or a $2,000 a year of income, that would be taxable to you. If you put that $100,000 in the annuity, that $2,000 a year that may be generated by the investments, you're not going to pay that tax. In any given year, you're only going to pay that tax when you take it out in the future. Much like a retirement account. However, to your point, even if it's a non-retirement annuity, you are going to pay taxes as if it is earned income.


Benjamin Haas  08:04



Adam Werner  08:05

So you no longer get that capital gains treatment.


Benjamin Haas  08:08

So here's my takeaway, depending on how that account is titled and whether it was in a retirement account or not makes a huge difference right off the bat on whether we think you can do something different with this or not because if it is a non-qualified a non-retirement annuity, there are tax considerations that we really got to be careful about.


Adam Werner  08:33

The word the key word there is careful.


Benjamin Haas  08:35

Careful. So yeah, because you don't want that messed up. Riders, annuities are sometimes sold with frills and benefits. The most common in my mind is Oh, you may be worried you're more conservative investor. Let's put some sort of income protection on this. What the heck is that and what should people know?


Adam Werner  09:05

So usually those income riders or those income benefits are tied to a variable annuity. So rabbit hole number one, what the heck is a variable annuity? What does that even mean? And the variable side of it is just the investments within the annuity, the investment options you have and can fluctuate with the market, hence the term variable.


Benjamin Haas  09:30

It feels like any other stock investment mutual fund, my 401k, whatever.


Adam Werner  09:36

Yep. So those income benefits were sold as a way to essentially replicate a pension but you're doing it with your own dollars with an insurance company. They're going to give you a quote unquote, guaranteed income stream over time, that there's again even here like my wheels are turning because each company has their own rules. There are so many different insurance companies and each income rider is very different than the next company's. Even within companies, they can have multiple versions of an income rider and essentially what they're doing is they're promising to pay you back a percentage of that value at some point in the future in retirement, theoretically and then for the rest of your life.


Benjamin Haas  10:23

Over your lifetime. So here's the point, my takeaway, if somebody has that income protection and the idea is maybe you don't want this anymore or it doesn't serve a purpose, it behooves us to kind of understand is the value that they will give you right now, much lower than the value of the income over your lifetime, like, we need to do that analysis with you. It's not so simple or shouldn't be so simple as to say, I don't feel like I want this thing anymore. It's truly what is best for you. In the same way. Another type of rider is a death benefit, where maybe if the value of the contract went down, but the death benefit was the original amount you put in it, depending on where you are in life, it may make sense to just continue to have that contract because somebody is going to get more out of it at your death then you will get out of it right now. If that matters to you.


Adam Werner  11:12

By the way, those additional features, they don't come for free. They have their own inherent costs. So when you're thinking about it from in the world of a variable annuity, where you're hoping for that contract to grow because it's an investment, meanwhile, you're not only paying for the investment side of things, you're paying for the insurance wrapper on top of it but now you're paying for some additional insurance in the term of either guaranteed income streams in the future or a guaranteed death benefit, those fees start to add up very quickly, which makes it even harder for that contract to really grow over time because you're just having to jump over a bigger hurdle each year.


Benjamin Haas  11:48

Yeah, so there should be one more thing that we mentioned there and like, what do we as CFPs look at and one of the first things we may look at is, what is the length of this contract? Are you still in some sort of period where you're penalized to do something different? Because to get some of those benefits, or even to engage with that company's product, they may say, you've got to be in this for three years, seven years, 10 years, whatever it is. For you to even think about doing something different would be to your detriment because you're going to give up, you're going to pay a penalty. Right, to get access to that money. So that's an important caveat to know here, too.


Adam Werner  12:26

Yeah, absolutely.


Benjamin Haas  12:28

One more thing, I think that we would want to look at and you brought it up. Are these variable contracts there, there is the other side of this: fixed contracts, which I guess we can just, I would like to breeze over that it is essentially like a CD, right? We're going to give you a set interest rate over a period of time. So if somebody was able to have a renewable three, four or 5% interest rate, or we're certainly not in that interest rate environment anymore, maybe it makes sense to keep.


Adam Werner  12:59

It's to your point, we certainly see that in our world, for people that have stronger relationship with a bank, if they have a larger savings account, it's very easy for the bank to reach out and say, Hey, here's something that's going to earn more than a CD, by the way, it's a little less liquid because you do have to tie it up for three or five or seven years are somewhere in that timeframe. But you're getting a little bit more return on your savings for that. But again, you lose some additional flexibility through that process.


Benjamin Haas  13:29

Flexibility. Yep, liquidity and let's not even go to indexed annuities, I think, for the sake of today, even you know, not wanting to go down rabbit holes, as you said.


Adam Werner  13:40

If you have an index annuity, you have a question, we will absolutely address that for you.


Benjamin Haas  13:48

Yeah, and this should be a rule of thumb for anybody. If you don't understand what you own or you don't understand what's being recommended to you, you probably shouldn't buy it. Okay, so moving on, how we handle it. I know we make the joke, it depends. What if somebody can't do something different, either based on the contract or based on the tax situation? I know that we would go through the process then of maybe trying to see where it fits into the plan that they have. Mental accounting, repurposing things. If we can't do something different. I'm thinking the example, you're in a contract certainly doesn't behoove you to get out of it. Maybe it's got that income protection. Maybe that can act more like a bond in your portfolio, your overall allocation because you now have what feels to us like a not risky asset and we should count for that with everything else.


Adam Werner  14:44

Yeah and yes, so that's absolutely one way that we can kind of look at that as if they have something that you really can't get out of, and if the income benefits just far exceed the actual value in the contract, you know, it has more value over time for just that income stream, then yeah, maybe it is just that mental bucketing in your head that you know this portion of all of my assets, I'm going to look at that just for its income stream. It's going to act like a bond, it's going to allow me to maybe adjust my overall allocation accordingly. That's certainly one way to look at it. I guess, one thing that we should have said earlier, for non-retirement annuities for you to really get access to those, it now looks like a retirement account. If you've bought before you were age 59 and a half, you have to wait to get access to it until you're after age 59 and a half.


Benjamin Haas  15:39

So my mind was going to if you're in that situation, there now are other options with annuities that would allow you to exchange one for the other if you don't have a surrender period, that may give you to a broader basket of investments at this point. Maybe it's more cost efficient but you need to keep it in that kind of shell. Not only for tax purposes but if you're a little bit younger.


Adam Werner  16:06

You can move annuity to annuity and again, like anything else, there's rules. There's things that you need to make sure you have your T's crossed and your I's dotted. But yes, you can move from annuity to annuity and still keep that a tax free event moving from one to the other. But yeah, if it's trying to get into something that is a little bit more streamlined, way more cost effective, gives you better investment options. It's kind of the making the best of a not so great situation, if you're already kind of in that in that annuity shell.


Benjamin Haas  16:38

I guess here's maybe my summary of what people should be taking away from this. There are a lot of complexities, there are a lot of intricacies. Again, we hope your eyes aren't glazed over at this point. But if you do have an annuity, it is good to try to understand. Okay, what really is it and what role is it going to play for you moving forward? Or going back to the original question, if you can do something different and it behooves you to do something different than you know, having an independent financial adviser, a Certified Financial Planner, assess that and give you a recommendation.


Adam Werner  17:12



Benjamin Haas  17:15

So how to handle it? It depends. But let's do the education first.


Adam Werner  17:22

You got to know what you own.


Benjamin Haas  17:24

Box of chocolates. I like it. Now you got me hungry for a box chocolates. Not really. I don't like chocolate. Hey everyone, Adam and I really appreciate you tuning in. Please note that the opinions we voiced in this show are for general information only and are not intended to provide specific recommendations for any individual. To determine which strategies or investments may be most appropriate for you. Consult with your attorney, your accountant and financial advisor or tax advisor prior to making any decisions or investing. Thanks for listening!

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