First published on June 29 by Kiplinger

You’ve saved diligently. You have an IRA, a 401(k), and maybe an annuity that has been quietly growing for years. On the surface, everything looks according to plan. But there are decisions embedded in common retirement account structures that many people—and their families—don’t step through until it’s too late to do something about them. Here are two common planning strategies, and questions to consider around them, before you or a loved one reaches that point.

Your annuity has questions for you that determine how it’s taxed

Many retirement savers hold a meaningful portion of their wealth in annuities. Americans hold $2.6 trillion in nonqualified annuities alone. Accounts like these grow tax-deferred over the years. Without a strategic plan, the increased value can quickly turn into a painful tax bill for your family. Unless you leave that annuity to charity, you or your heirs will have to pay ordinary income tax on the gains over time.

The more buckets of money you have, the more options you have, and that includes annuities too. How you view this account—as money you plan on spending in retirement, or something that will most likely pass to your kids—is the first and most important question to consider. If you’re lucky enough to have options, who should pay the income tax on these dollars—mom/dad or heirs? Who is in the higher tax bracket, mom/dad or your heirs? These are questions a financial advisor can walk you through to help maximize your existing annuity.

Additionally, how you withdraw money from an annuity has a tax impact. If you periodically take money from a nonqualified annuity, to purchase a car for example, the tax treatment you’ll receive is last in, first out (LIFO). LIFO treatment means every dollar of gain in the annuity comes out first and is therefore 100% taxable. What comes out last is your basis, i.e., what you put into the annuity, which would be 100% tax-free when you or your heirs eventually get to it. Not all annuities carry LIFO treatment, however, which is why you have options.

One consideration with older annuities is to turn them into a predictable stream of income. Some guaranteed income annuities carry the same LIFO treatment above, while Single Premium Immediate Annuities (SPIAs) work differently tax-wise. They give you a portion of your basis with each income payment you receive. As a result, you accelerate capture of your tax-free basis by years, possibly decades.

If your existing annuity has an income rider, make sure you price out alternatives before you turn on that income rider. You also have the option to take your cash surrender value of the contract and see what insurance companies will offer you on a new contract. With stock market returns over the last few years, I’ve seen scenarios where clients receive 10%, 20%, even 50% more guaranteed income by working with an advisor that knows how to price out a new contract.

If you’re reading this and thinking “I don’t need more income,” then consider what sources of income you might turn off if you were receiving income from your annuity—and the potential value that could create. For instance, nonqualified accounts receive a step-up in basis at death under current tax law, so leaving those dollars to heirs and spending your annuity (instead of the reverse) could improve after-tax outcomes for you and your family. If you’re pulling more than your required minimum distribution out of qualified accounts, consider the broader investment options that are available within an IRA when compared to your annuity and the compounding nature of those returns over time.

If income is not the right answer for you, then make sure you’re working with an advisor who can maximize the tax-deferred growth your annuity is providing you with. Older contracts could have income riders or other features that are charged against your growing cash value each year. If long-term growth is the plan, pick that path and run with it.

Additionally, consider the tolerance for risk you’re taking in that annuity now if you’re not touching it for years, and possibly decades. It could be something as simple as adjusting the underlying allocation you have, removing riders, or looking at alternative contract types that allow for more flexibility in what you can buy within the tax-deferred wrapper that is your annuity.

Long-term care (LTC) might also be an option for that old annuity of yours. Doing so could mean never having to pay income tax on the embedded gain. LTC annuities typically ask you to forgo most (if not all) future growth in your cash value. In return, they guarantee a multiple of the account value will be available for LTC—tax-free—over time as you need it to pay for help with certain activities of daily living (bathing, eating, toileting, dressing, continence, transferring) or supervision if you have a cognitive condition like Alzheimer’s disease.

The hidden costs to funding long-term care

Most people consider LTC insurance as protection against the cost of care itself. The thinking is that if there’s sufficient assets, one can simply self-insure the risk by relying on their portfolio. While that’s true, there are equally important considerations that rarely get discussed: what LTC insurance does for your portfolio as well as your retirement and estate planning—not as a needed form of coverage but as a tactical allocation within a well-funded retirement plan.

Consider the cost of LTC. The typical home health aide averages $40 an hour or more in higher-cost-of-living areas. A six-hour shift, every day, would run about $7,000 per month and over $85,000 per year. Nursing costs can be as much as double that, on average, in those same affluent areas. If you need significant care and don’t have a dedicated funding source, liquidating assets to pay those bills may be the only solution. When you begin selling assets at that pace, the tax consequences can cascade in ways that are easy to underestimate:

  • Higher income-tax rates
  • Loss of the senior bonus deduction, which phases out as income rises
  • Higher long-term capital gains rates triggered by larger realized gains
  • Medicare surcharge increases as the higher income drives up Part B and Part D premiums
  • Medicare contribution tax (the 3.8% net investment income tax), which kicks in above certain adjusted gross income (AGI) thresholds
  • For brokerage assets, liquidating in your final years of life means you pay taxes on dollars that would otherwise receive a step-up in basis to your heirs.

LTC coverage changes this picture entirely. It insulates the portfolio of assets from quicker liquidation, if not avoiding liquidation altogether, allowing your portfolio to continue to grow tax efficiently.

There’s also a compelling financial case for LTC coverage as a complement to your fixed-income portfolio, especially if we focus on guaranteed LTC policies where the insurance company cannot raise your premium rates. Those same policies may provide a death benefit that can return some or all of the premium paid, subject to policy terms and conditions.

Consider the following scenario: A 55-year-old woman purchases an LTC policy with a six-year benefit period and a 3% compound inflation to her coverage. However, she doesn’t start to need care until age 85. If the money were invested in municipal bonds, financial software engines like eMoney suggest a long-term assumption of 3%. Said differently, if you plan on paying for your future LTC expenses first out of bonds, your rate of return expectations are 3%, regardless of how many years you need care.

Compare that to having LTC coverage for that 55-year-old. Thirty years later, you can compute the tax-free rate of return her family receives by how much of her benefit she gets. If care is needed for two years, the return of benefits received would compute to a 4.2% tax-free return. If care is needed for four years, the return on benefits received increases to 6.8%, tax-free. If care is needed for six years, the return on benefits received is just over 8%, tax free.1 If care is never needed, the family will receive their premiums back via the death benefit and their opportunity cost would be the 3% return they would’ve earned, had they had more money invested in bonds all the while.

LTC insurance is by no means a replacement for bonds, nor is it an investment. LTC insurance is an alternative to having more money invested. Its value comes from using a portion of your wealth to create a tax-free pool of funds that insulate the rest of your portfolio from expenses incurred in those less healthy years we all hope never come, but see happening to our older friends and family.

How is this relevant to you?

If any of the following describe your situation, these strategies are worth exploring with your advisor:

  • You hold an annuity with embedded gains that you haven’t actively reviewed or planned for regarding distributions.
  • You haven’t discussed with your advisor how your annuity should be allocated within your financial plan or will be treated at death and what your heirs will owe tax-wise.
  • You are approaching retirement and have not stress-tested your plan against the potential impact of LTC costs.
  • You hold brokerage assets with low-basis positions that you would prefer to pass to heirs with a step-up rather than liquidate.

With the right advising team, these are straightforward conversations that can make a meaningful difference in your wealth long-term. Reach out to your Cerity Partners advisor with any questions, or request an introduction today.

  1. This is example is for illustration only. Under certain assumptions regarding premium, benefit period, inflation rider, age at claim, and tax treatment, LTC policy benefits may compare favorably with some fixed-income alternatives. Actual outcomes will vary based on policy terms, claim duration, inflation adjustments, tax law, and individual circumstances. ↩︎

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