Annuities can come with a tax surprise
Dear Liz: I made a one-time purchase of a variable deferred annuity with a $10,000 inheritance I received about 25 years ago, based on a co-worker’s advice. Over the years I have not made any additional payments or withdrawn any funds. It matures in about a year with an option of withdrawing the lump sum, which was nearly $60,000 this year, or receiving monthly payments. Would I be subject to capital gains taxes for the entire $50,000 increase if I take the lump sum? Are there any special tax exemptions or rules I should be aware of?
Answer: The increase in your annuity’s value isn’t subject to capital gains taxes. Instead, the gain will be subject to higher — perhaps much higher — income tax rates, regardless of whether you choose the lump sum or monthly payments.
Variable annuities are insurance products that allow you to invest money tax-deferred for retirement. Like other retirement accounts, you could face penalties for early withdrawal in addition to income taxes if you take money out before you’re 59½.
Taking the lump sum could push you into a higher tax bracket and possibly cause a temporary increase in your Medicare premiums if you’re 65 or older. If you opt for monthly payments instead, you’re likely giving up access to the money in an emergency. (Annuitization means you’re giving up the lump sum you could have accepted in exchange for a stream of monthly payments that typically lasts for life.)
A tax pro can help you weigh the effects of the different withdrawal options on your finances.
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Social Security misunderstandings
Dear Liz: As a former Social Security Administration employee, I can tell you there are countless times people misunderstand the information that is provided to them or only hear what they want to hear. There is no incentive for the employees to misinform or mislead people. Maybe you can begin your responses by saying, “If what you are saying is accurate,” instead of just assuming the worst and blaming the Social Security employees for people’s lack of knowledge.
The letter writer in a recent column not only indicated how helpful the employee was but also that they slept on the information and also discussed that with their trusted advisor. Your response assumed that the representative encouraged them to make a decision you indicated might not be the best.
Most employees do not encourage but inform people of their options. I am very disappointed that you once again chose to bash them with limited information and even when the person said how wonderful and knowledgeable the representative was, and even that they consulted with their trusted advisor.
Answer: The original letter writer mentioned that she learned in a chat with a Social Security spokesperson what her “break-even” point would be for waiting until full retirement age to start her benefit. My response pointed out that break-even calculations aren’t the best way to determine when to start Social Security, since they don’t include important factors such as inflation, tax rates and the impact of early claiming on survivor benefits. Many people also have a poor understanding of life expectancy and assume they will die before their break-even age when they probably won’t.
Social Security is an incredibly complex program, so people may indeed misunderstand what they hear from its representatives. But readers and financial planners alike report countless incidents in which representatives clearly gave inaccurate information. For example, people have been told they couldn’t suspend their benefit at full retirement age to earn delayed retirement credits (they can) or that they wouldn’t receive cost-of-living increases if they hadn’t started their benefits (not true — your benefit starts earning annual COLAs at age 62, whether or not you’ve started).
Bad guidance can be costly. A 2018 report by Social Security’s own inspector general found that faulty counsel from its representatives cost 9,224 widows and widowers approximately $131.8 million in benefits.
My responses aren’t intended to bash hardworking Social Security representatives but to alert readers that they should educate themselves about their options and seek guidance from financial experts before claiming.
Liz Weston, Certified Financial Planner, is a personal finance columnist for NerdWallet. Questions may be sent to her at 3940 Laurel Canyon Blvd., No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.
