Defer Taxes on a Lump Sum Payment in Retirement by Funding an Annuity

When most of our clients come in asking about retirement income strategies and for financial planning advice, they usually show up with a retirement portfolio with funds held in a 401(k) or IRA. For the most part, when it’s suitable for the client, the transition to annuities is an easy one because qualified annuities (ones purchased with pre-tax funds) follow many of the same rules as retirement accounts when it comes to paying income taxes. But every now and then, we have a new client who’s come into a lump sum and wants to protect that sum for the future.

People who get lump sums of money for whatever reason don’t usually think of annuities as an option unless one is offered. Generally, it’s never recommended that you put all your eggs in one basket (or annuity), but if you’re dealing with a sudden lump sum, often an annuity can be a tax-efficient way to help protect your money.

Life Events That Might Trigger Lump Sums

Once you hit your retirement years, you’re hopefully enjoying the most rewarding years of your life —  you’ve established your career, business, and family. Often, the profits from the sale of a home or business can be used to fund a portion of your later years. In addition, you may also run into those sudden, unexpected after-tax windfalls, like lottery wins or inheritances, and you might want to find a way to protect those funds.

The problem is these sudden, bulk amounts can cause issues on your taxes, shifting you into a higher tax bracket, and potentially giving you a big tax bill at the end of the year. Using options like annuities can help defer taxes on the growth of these funds until you begin taking distributions, while turning that lump sum into a future stream of income. Keep in mind, any annuity distributions are subject to ordinary income tax, and if taken prior to age 59 ½, may incur an additional federal penalty.

Types of Annuities to Consider for Lump Sums

There are two basic categories of non-qualified annuities that those who receive windfalls may want to consider: fixed and fixed-indexed annuities. Fixed annuities are insurance contracts that promise a fixed amount of income based on the initial premium payment. Fixed annuities earn an interest rate that is guaranteed by the insurance company. Fixed-indexed annuities have the fixed component to them, which means you will not lose money due to market risk, but also allow you to accumulate interest that is calculated based on positive movements in an external market index.

Fixed-indexed annuities generally offer the potential for higher interest than standard fixed ones, but they also have their limitations. Fixed-indexed annuities have caps that limit their interest growth potential. In addition, getting out of both types of annuities before the end of their surrender charge schedule can be an issue. While surrender charge percentages and time periods vary widely by insurance company and product, a fixed annuity may have a seven to nine-year surrender period, whereas a fixed-indexed annuity may have a 10 to 12-year timeframe. All annuity guarantees are backed by the financial strength and claims-paying ability of the issuing company.

What to Do With A Windfall

When looking at which annuity would suit your situation, you want to look at the initial tax bill on your windfall. Some windfalls can actually be pretty tax advantageous, while others can catapult you into a higher tax bracket.

Probably among the more expensive of these windfalls are lottery winnings. Lottery winnings are added to your income for the year and can push your federal tax up to 39.6%, taking a huge chunk out of your earnings.1 If the amount you win is over $5,000, 28% will automatically be withheld by the payer.

Probably the opposite of the lottery tax is the tax you have to pay on an inheritance. Often times, that amount is zero, although tax laws are complicated and may depend on the overall value of the estate. Federal estate taxes are paid by the estate of the decedent and not the beneficiaries and there is no federal level inheritance tax for beneficiaries. Currently, only six states have inheritance tax for beneficiaries — Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

At the same time, as the inheritance may be unexpected, you’re likely not dependent on it. If that is the case, it may mean that you don’t necessarily need the funds for income right away and can afford to wait to take withdrawals from the annuity, allowing it more time to accumulate and potentially increasing your future income payment.

There are some cases you might want to start receiving payments right away. There are annuities that can work during this time as well, by creating an immediate stream of income.

When an Immediate Annuity Is a Choice to Consider

An immediate annuity starts payments to the annuitant right away, generally within the first year, rather than having a traditional accumulation period like a deferred annuity. If you’ve just sold your home or your business, funding an immediate annuity with some of the proceeds can give you an immediate regular income stream.

Both the sale of a business and the sale of a home are considered capital gains, not regular income, and are taxed at a rate that can go up to 33%. For the sale of your home, however, you’re generally exempt from paying taxes on the first $250,000 of proceeds, subject to restrictions and limitations.2

Based on a $250,000 premium payment with an annual rate of return of 2% over 25 years. This example does not represent any specific insurance company or annuity, and the interest rate credited is not guaranteed. Please note that this is a hypothetical example and does not reflect product fees or expenses which would reduce the figures shown.

Based on a $250,000 premium payment with an annual rate of return of 2% over 25 years. This example does not represent any specific insurance company or annuity, and the interest rate credited is not guaranteed. Please note that this is a hypothetical example and does not reflect product fees or expenses which would reduce the figures shown.

That monthly benefit would be made up of two things: A portion would be the return of your premium, while the rest would be interest accumulated. Because in this example, the annuity was purchased with after-tax dollars, the only portion that’s taxable is the interest.

The sale of a business or business interest isn’t as tax-friendly, but when used to purchase an annuity, will allow you to continue to take advantage of growth potential while deferring taxes on any accumulated interest. In some cases, that business interest can even be paid out through an annuity, though this is a more complex arrangement that will likely require the assistance of a qualified tax professional to manage.

If you think you might be faced with one of the lump sum events above, you might want to look into using a portion of that windfall to purchase an annuity. One of the financial professionals in Retirement HQ’s network can go over all the options available to you based on your individual situation.

By contacting RetirementHQ, you may be offered information regarding the purchase of insurance products. All of our financial professionals are licensed insurance agents. Additionally, some individuals may also be registered with a broker/dealer or as an investment adviser. Our financial professionals do not offer estate planning, tax or legal advice. Always consult with a qualified advisor concerning your own situation.

Show 2 footnotes

  1. “Tax Topics – Topic 419 Gambling Income and Losses,”, Internal Revenue Service,  accessed May 20, 2016.
  2. “Tax Topics – Topic 701 – Sale of Your Home,”, Internal Revenue Service, accessed May 20, 2016.