by David M. Cordell, Ph.D., CFA, CFP®, CLU, and Thomas P. Langdon, J.D., LL.M., CFP®, CFA
David M. Cordell, Ph.D., CFA, CFP®, CLU, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., LL.M., CFP®, CFA, is professor of business law at Roger Williams University in Bristol, Rhode Island.
Deferred annuities have held a valued place in retirement portfolios for decades. Unfortunately, the benefits of deferred annuities will decline next year. Changing tax laws resulting from recent legislative enactments, as well as recent failures to enact legislation, are making deferred annuities less beneficial. Financial planners should be extremely diligent in evaluating deferred annuities (annuities), especially for high-income clients. And “high income” may not be what you think it is.
Annuities in the Retirement Portfolio
Annuities have long been a favored product for providing retirement income largely because of the benefits of income-tax deferral. Wealthier clients often use annuity contracts to make retirement savings contributions in excess of the limitations imposed on individual retirement accounts (currently $5,000) and qualified pension plans (currently $17,000 for employee deferral contributions to 401(k) and 403(b) plans). Unlike IRA and qualified plan contributions, which permit a tax deduction for contributions made to those plans, transfers to an annuity contract do not qualify for an income-tax deduction. Annuities do, however, permit the contract owner to defer income tax on the gains in the contract until the owner begins to take withdrawals during retirement, and permit rebalancing of the client’s underlying investment portfolio without triggering any current income-tax consequences.
What is the cost of obtaining these advantages when purchasing an annuity contract, aside from higher fees for guaranteed annuitization? When clients withdraw money from the contract, amounts received in excess of basis are taxed at ordinary income-tax rates regardless of the type of investments purchased inside the annuity contract. Ordinary income is subject to tax at the client’s highest marginal tax rate and does not qualify for favorable capital gains tax treatment. In many cases, however, the benefits of tax deferral from the contract exceed the cost of characterizing the distributions as ordinary income, which yields a net benefit for the client. Provided that the world ends on December 21, 2012, as the Mayan calendar and doomsdayers predict, ordinary income tax treatment is the only tax cost investors will incur when using annuity contracts.
Increasing Tax Rates
In the more likely event the world does not end December 21, wealthy clients will only have 10 days to enjoy the current, favorable tax rules that apply to annuity contracts. After December 31, 2012, two changes will occur that strip away some of the deferral benefits affluent clients receive from annuity contracts: (1) the Bush tax breaks expire, causing ordinary income tax rates to move from the current 10/15/25/28/33/35 percent brackets to 15/28/31/36/39.6 percent brackets, and (2) distributions from annuity contracts made to high-income taxpayers will be subject to an additional 3.8 percent surtax imposed by the Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2010. Clients who are currently in the highest marginal tax rate bracket of 35 percent will see the federal income-tax rate imposed on annuity distributions rise by 8.4 percent to a total of 43.4 percent. Many states, of course, will also impose income taxes on those distributions, causing the total income-tax burden for annuity distributions to approach 50 percent.
The expiration of the Bush tax cuts has long been a subject of public debate. Although the tax cuts were originally scheduled to expire at the end of 2010, Congress decided to extend them for another two years. Whether Congress will address this issue before tax breaks automatically expire January 1, 2013, remains an open question, especially because 2012 is a presidential election year and all of the seats in the House and one-third of the seats of the Senate are up for election.
The 3.8 percent Medicare surtax on investment income and annuity distributions automatically goes into effect January 1, 2013. The Affordable Care Act defines a high-income taxpayer as a single individual with modified adjusted gross income (MAGI) above $200,000, a married couple filing jointly with MAGI above $250,000, or a married person filing separately with MAGI over $125,000. Although it is clear that individuals who currently meet the definition of high-income taxpayer will be affected immediately by these changes, is this a concern for middle-income Americans planning for retirement? The answer is yes, for two reasons. First, the definition of “high-income taxpayer” is not indexed for inflation. Second, the Affordable Care Act imposes a significant marriage penalty.
How Middle-Income Taxpayers Become High-Income Taxpayers
Unfortunately, when the Affordable Care Act was adopted in 2010, Congress chose not to index the income thresholds that define high-income taxpayers. By doing so, consciously or not, the decision imposes the surtax on lower- and lower-income individuals as each year passes. Stated alternatively, the real threshold for “high-income taxpayer” in 2013 (in 2010 dollars) is $183,028 (single individuals) and $228,785 (married couples filing jointly).
Remember the rule of 72? At 3 percent inflation, $100,000 increases to $200,000 in 24 years, which means a client with MAGI of $100,000 in 2010 will be subject to the Medicare surtax on annuity distributions in 24 years if his or her income simply keeps up with inflation. Planners must consider the impact of Congress’s failure to index the definition of “high-income taxpayer.” It means this tax will be paid by rich and middle-income Americans as time goes by. It strikes us as rather ironic that the easiest way for a middle-income taxpayer to become a high-income taxpayer is simply to keep up with inflation until he or she hits the nonindexed dividing line of $200,000. “Congratulations! Even though your purchasing power hasn’t changed, we now declare you to be a high-income person, worthy of paying extra taxes.”
The 3.8 percent Medicare surtax has been touted as a tax on the rich by its supporters, but so were the alternative minimum tax (AMT) and passive activity loss rules when they were enacted in 1986. Like the Medicare surtax, the AMT exemption and the individual investor exception thresholds to the passive activity loss rules were not subject to inflation adjustments. Because these amounts were not adjusted for inflation, more and more middle-income individuals have become subject to the AMT and have lost the ability to recognize passive losses to offset other income over the years. The same fate awaits middle-income Americans with the Medicare surtax, and planners need to consider this eventuality when recommending appropriate products and planning strategies today that will satisfy client needs in the future.
Married Couples: Greater Exposure to the Surtax
A second cause for concern is the marriage penalty imposed by the Affordable Care Act. Single individuals are considered “high income” and subject to the surtax if they have MAGI above $200,000. Two single individuals living together, therefore, could each have up to $200,000 of MAGI, for a total of $400,000 of MAGI, and not be subject to the Medicare surtax. But if those individuals get married, they are considered “high-income” taxpayers above $250,000 of MAGI. In other words, by being married, that couple would lose $150,000 of the exemption, and, all else equal, become subject to paying a greater Medicare surtax than their single counterparts.
When a planner is dealing with two high-income clients who are considering marriage, the clients should be made aware of the tax consequences the marriage will bring. Two young professionals earning more than $125,000 each who marry will pay the surtax, and may want to consider retirement funding options other than annuity contracts to avoid the imposition of the tax.
Like all financial products, annuity contracts are valuable tools for meeting client goals and objectives when used in the right circumstances. The pending tax changes that take effect January 1, 2013, make annuity contracts a bit less attractive for high-income taxpayers and taxpayers who will become high-income taxpayers in the future. In contrast, the Affordable Care Act does not impose the 3.8 percent Medicare surtax on distributions from qualified retirement plans, traditional IRAs, Roth IRAs, or on capital gains received from the sale of a principal residence. It may be wise for planners to maximize use of these vehicles prior to turning to a deferred annuity contract for their high-income clients. If annuity contracts are used as part of the plan, high-income taxpayers may wish to consider purchasing those annuity contracts inside of an IRA to avoid the additional 3.8 percent Medicare surtax.