Weighing the Benefits and Potential Tax Consequences of Annuities and Life Insurance

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Both annuities and life insurance can be used as investment vehicles with tax-deferred growth. We’ve previously dug deep into the evolution of retirement annuities, but it’s important to understand the pros and cons of each investment vehicle before putting your money into them.

Annuity basics

Before we dive into the differences, let’s break down the basics. An annuity is a contract with an insurer in which you agree to pay the company a certain amount, either in a lump sum or through installments. In turn, it makes a series of payments to you starting now or at some future date. Those payments can be scheduled to last for a specific period of time, like 15 years, or for a lifetime. Lifetime annuities have the obvious attraction of lessening anxiety over outliving your assets.

Annuities at work

The dollar amount of your payments will depend on the value of your underlying account. You can choose between fixed annuities, with a guaranteed rate of return, or variable annuities, whose returns rely on the performance of your selection of stock and bond funds. An indexed annuity is similar to a variable annuity, but its earnings are tied to a specific benchmark, like the S&P 500.

With all types of annuities, high upfront commission fees can cut deeply into your long-term earnings. There are also strict rules for the timing and amount of distributions. If you need any of your money early, you may lose 5%-7% of your withdrawal as a penalty.

Annuities and taxes

In an annuity, your earnings grow on a tax-deferred basis and this can be a benefit. Once you start withdrawing funds, any gains are taxed at regular income tax rates. This is in contrast to stocks and bonds, where your earnings are taxed at the lower capital gains rate.

The types of life insurance that could be used for saving

  • Whole life insurance, in addition to providing death-benefit coverage for life with level premium payments, can also build cash value. This is a savings feature, but you can’t choose how to invest this money, and returns are likely to be as low as 1%-3% annually. With premiums considerably higher than term life (which doesn’t build cash value), whole life can be inefficient both as life insurance and savings.
  • Variable life insurance, a variation of whole life insurance, also offers a fixed premium schedule and death benefit. But its cash value is invested in a securities portfolio that is separate from the general assets of the insurance company. As a policyholder, you choose your own mix of investments from a menu provided, and your returns depend on the performance of your choices. Compared to the conservative growth of a whole life policy, this may increase your growth potential and your risk.

How whole and variable life insurance earnings are taxed

Whole and variable life insurance provide a tax-free death benefit – the money you pay into the policy may be distributed to your beneficiaries upon your death, tax-free.

Also, if managed correctly, whole life policies can provide you with tax-free loans. Loans can be used for a variety of reasons, including supplemental retirement income. Loans come directly out of the death benefit that would go to your beneficiaries and do not need to be paid back. Interest payments, although required, can be taken out of the cash value also. However, if you ever surrender your policy or let it lapse, you’ll have to pay the interest and report the taxable part of the loan (the amount of the loan minus total premiums paid) as income. You will then need to pay taxes on it at a regular income tax rate.

Annuities versus cash-value insurance

Both of these vehicles can come with high fees and complicated tax consequences, lessening their efficiency as savings and investment vehicles. Consider fully funding tax-advantaged vehicles like 401(k)s and IRAs first. It’s best to consult with a financial advisor about how annuities or insurance might fit into your total investment strategy. A United Capital advisor has the expertise and dedication to help you structure your financial picture to provide you with the kind of life you truly want to live

This commentary contained herein is intended for informational purposes only and should not be construed as tax, legal or investment advice. Past performance is not indicative of future results. Clients should obtain their own tax, legal or investment advice based on their circumstances. The material is based on sources deemed reliable but is not guaranteed.

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