The Tax Implications of a Rolling Annuity

by Jack Ori

People approaching retirement age have the option of rolling their IRA or 401(k) funds over into an annuity, another type of tax-deferred account that collects interest and doesn't require you to pay taxes until you withdraw the funds. While annuities allow you to hold onto retirement funds and delay paying taxes on them, they can have serious tax consequences for your heirs after your death.

Ordinary Income

When your heirs inherit an annuity, the distributions are taxed as ordinary income, not capital gains. This means that your heirs may pay far higher taxes on their inheritance than you planned. They must report distributions as income, which can push them into a higher tax bracket. In addition, capital gains are usually taxed at only 15 to 20 percent, while ordinary income can be taxed at a rate of up to 35 percent.

Estate Tax

Although annuities don't have to go through probate before your heirs can access them, they are considered part of your taxable estate. Thus, the executor of your estate may have to pay estate taxes on annuity funds before your heirs get them, which can significantly cut into the amount of funds to which your heirs will be entitled.

Alternative

You can sell your annuity in favor of a life insurance policy. Life insurance policies don't have any of the tax problems associated with annuities, and at your death your beneficiary will receive the full sum your policy entitles him to. Your life insurance benefit is not part of the taxable estate; thus, your heir will receive the money tax-free and not have to worry about estate taxes.

Short-Term Implications

In the short term, rolling funds over from a 401(k) or IRA into an annuity has positive tax consequences. Annuities are tax-deferred accounts, so you won't pay any taxes on the funds you roll over, as you would if you withdrew the funds. In addition, if you are under the age of 59 1/2, you won't have to pay a 10 percent penalty tax if you roll funds over instead of withdrawing them.

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