Key Takeaways
- A few states have laws that protect annuities against actions from creditors.
- Financial aid programs and Medicaid do not include certain annuities when calculating your assets.
- Annuities receive a step-up in tax basis when gifted, which can be beneficial to the new owner.
- With variable annuities, you can avoid the embedded gains and FIFO concerns that come with investing directly in mutual funds.
Investors looking to grow their retirement savings with little to no market exposure might consider annuities for a variety of reasons.
The most common reasons to purchase an annuity include tax-deferred growth, principal protection and highly customizable contracts. But annuities provide many other benefits that you might not know about.
Advantage #1: Protection From Creditors and Litigation
In a few states, including Florida, New York and Texas, annuity owners have almost complete protection from creditors. These protections are similar to the ones that certain states afford qualified retirement plans.
“Annuities provide substantial asset protection from creditors in specific states,” Linda Chavez, founder and CEO of Seniors Life Insurance Finder, told Annuity.org. “In the case of bankruptcy or litigation, an annuity’s cash value and income stream are generally safeguarded from creditors, rendering it a valuable financial instrument for individuals concerned about potential legal matters.”
Asset protection is essential to a holistic financial plan, whether you have a high net worth or modest means. Litigation and creditor safeguards make annuities a key element of that asset protection.
Advantage #2: Eligibility for Financial Aid”
Applications for financial aid programs such as the Free Application for Federal Student Aid (FAFSA) for public universities or the College Scholarship Service (CSS) Profile for private schools use a family’s assets to determine the student’s eligibility for financial aid.
The FAFSA does not consider the assets you hold in an annuity or a retirement account for financial aid calculations. It does consider other comparable investments, such as mutual funds or individual securities. This gives annuities an advantage for people hoping to qualify for financial aid.
The CSS Profile has a similar rule. However, the CSS only excludes qualified annuities — annuities you purchased with funds from a qualified retirement account — when calculating financial aid eligibility.
Advantage #3: Qualifying for Medicaid
Many Americans depend on Medicaid to cover long-term care expenses. But to receive Medicaid benefits, a person must spend almost all of their money.
This can cause complications for married couples when only one spouse requires Medicaid benefits. Fortunately, certain types of annuities are Medicaid-compliant and offer a loophole that allows the couple to qualify for Medicaid while preserving their financial assets.
Annuities that have started income payments do not disqualify Medicaid applicants. A couple hoping to qualify for Medicaid could place their assets into an immediate annuity that starts distributions right away. Doing so might lower their available assets enough that the spouse who needs Medicaid benefits can qualify for them, while the healthy spouse receives income payments from the immediate annuity.
Medicaid-compliant annuities have many rules and requirements, but they can be a useful strategy to ensure that a couple can maintain a comfortable lifestyle in retirement.
Advantage #4: Stepped-Up Basis When Gifted
Certain assets receive a step-up in basis when they are gifted or inherited. The value of that asset adjusts to its current fair market value, as opposed to the value it had when it was originally purchased. The cost basis of an asset is used to calculate how much tax will be owed when the asset is transferred.
Most assets, such as real estate, stocks or mutual funds, do not receive a stepped-up basis when the owner transfers the asset as a gift prior to their death. The IRS requires that the person receiving the gift takes on a tax basis of either the initial purchase price of the asset or the value of the asset on the day they received it, whichever is lower.
From a tax perspective, a lower cost basis is disadvantageous to the asset’s new owner because any gains on the asset will appear greater than they would with a higher basis.
For example, an asset purchased for $100,000 might have increased in value to $180,000 when the owner gifts it to someone else. When the new owner goes to sell the asset, perhaps for $190,000, they’ll owe taxes on a gain of $90,000, even though the asset only appreciated by $10,000 while they owned it.
Annuities are an exception to this rule. These products receive a stepped-up basis when gifted. Therefore, the recipient of an annuity takes on the cost basis of the annuity’s value at the time they receive it, even if the annuity had accumulated growth with the previous owner.
This benefits the annuity’s new owner but comes at a cost for the original owner. In the year they gift the annuity, the donor must report the annuity’s gains on their income tax return. If the value of the annuity is greater than the annual gifting limit, $18,000 in 2024, then the amount exceeding that will need to be reported on a gift tax return and would be subtracted from the lifetime gift limit, which is $13.61 million in 2024.
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Advantage #5: No FIFO Concerns
The first-in-first-out rule, or FIFO, refers to the tax consequences of selling mutual fund shares. When you sell shares of a mutual fund, the IRS assumes you are selling the first shares you purchased unless you specify which shares you are selling at the time of sale. This can result in less tax efficiency when selling fund shares.
For example, say you bought shares of a certain fund at $8 per share in January and then bought more at $12 per share in June. When you go to sell in October, the price per share has increased to $15. To minimize the tax you’ll owe, you want to sell the $12 shares you bought in June, resulting in only $3 per share of profit to report on your taxes.
However, unless you specify that you are selling those $12 shares, the IRS will assume that you sold the $8 shares, meaning you’ll be taxed for $7 per share of gains.
FIFO concerns are one reason you might prefer to invest in a variable annuity over a mutual fund. Because annuities are not taxed while they’re in the accumulation phase, you can allocate your premium dollars and rebalance your portfolio without triggering taxation. Therefore, you don’t have to worry about the FIFO rule.
Annuities provide investors with more control over their investment income during the accumulation phase of their life due to the beneficial tax deferral. At the time of withdrawal or annuitization, it is important to understand the difference in how distributions are taxed. An annuitized contract will produce payments that are a proportional mixture of the growth and cost basis. If the account is 50% principal and 50% growth, each payment will be too, and therefore 50% taxable as income. For an unannuitized contract, withdrawals are taxed as Last In, First Out (LIFO). This means, all the growth will be withdrawn first, and therefore 100% taxed as income, before the cost basis is touched.
Stephen Kates, CFP®, Licensed Life Insurance ProducerPrincipal Financial Analyst for Annuity.orgStephen Kates, CFP® is a personal finance expert specializing in financial planning and education. He serves as the Principal Financial Analyst for Annuity.org, where he delves into industry trends to support consumers and financial advisors on wealth management, annuities, retirement planning, and investing.
Advantage #6: Avoiding Embedded Gains
Another key advantage of variable annuities over mutual funds is the ability to avoid embedded gains. An embedded gain is a tax liability that happens when a fund is forced to sell its stocks to meet redemption obligations. Often, this occurs when the price of the fund’s shares drops significantly, causing nervous investors to sell off their shares.
If a majority of the stocks sold had a large profit per share, the fund’s remaining shareholders will receive a distribution representing a cut of those profits per share. Those shareholders have actually lost some of their net worth due to the price of the funds’ shares dropping; however, they now owe capital gains tax on the distribution they received from the embedded gains.
For mutual fund shareholders, embedded gains can represent a ticking time bomb. You never know when the fund’s managers might decide to sell off their stocks and pass the profits, and the tax liability, on to you.
But this concern does not exist for variable annuities. With a variable annuity, the annuity owner is in complete control of when taxable events occur. There is no chance of unexpected taxable income or losses.
Editor Bianca Dagostino contributed to this article.
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