HELP: After-Tax Variable Annuity TAXES

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Slow_and_Steady
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HELP: After-Tax Variable Annuity TAXES

Post by Slow_and_Steady »

Hello Bogleheads,

My father is retiring soon, and I am trying to help him manage his taxes. He has been enrolled in a retirement plan throughout his career called the NJ SACT which is an after-tax variable annuity. He contributed after-tax dollars every paycheck to the fund and those dollars grew tax-deferred.

Now he is getting ready to retire and we realized that it appears the capital gains he has made are going to be taxed as ordinary income. He knew that taxes on the gains would have to be paid but didn't realize that because of the account type the rate would be the ordinary tax rate.

What are the options here? Is there a way to roll this into something else and get the more favorable capital gains tax treatment?

Doesn't seem fair that he saved his whole life in what he thought to be a "favorably treated tax-sheltered account" when he probably would have just been better off in a normal brokerage account paying taxes on dividends as they came due and deferring the LTCG.

Note: He's looking to take the lump sum option (Total Capital Gain is about $275k). I thought about trying to spread the payments out for lower tax brackets through the years, but he will be receiving a decent pension so I don't think that's a good option either.

Thanks for any input/guidance.
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Stinky
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Re: HELP: After-Tax Variable Annuity TAXES

Post by Stinky »

Slow_and_Steady wrote: Sun Feb 02, 2025 6:00 pm Is there a way to roll this into something else and get the more favorable capital gains tax treatment?

Doesn't seem fair that he saved his whole life in what he thought to be a "favorably treated tax-sheltered account" when he probably would have just been better off in a normal brokerage account paying taxes on dividends as they came due and deferring the LTCG.
I’m sorry, but I’m afraid that your dad is on the hook for paying taxes on the entire gain at ordinary income tax rates. That’s just the way that it is.

“Tax sheltered” is really a misnomer. “Tax deferred” is more accurate.

There might be a couple of options to soften the tax bite a little bit -

—- Can he take money out of the NJ annuity over a period of years? That would allow him to spread the taxable income out. Distributions from the annuity will be taxed as gains first, then return of basis.

—- Can he do a 1035 exchange into another annuity product? If so, he could consider exchanging into a low cost variable annuity like the Fidelity Personal Retirement product or a multi year guaranteed annuity (MYGA). This would allow him to further delay recognition of taxable income.

Just one more annuity “gotcha” - if he does defer recognizing all or part of the income, realize that annuities do not get a step up at death. So if he doesn’t fully recognize the taxable income during his lifetime, his heirs will.

Sorry that I don’t have better news.
Retired life insurance company financial executive who sincerely believes that ”It’s a GREAT day to be alive!”
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grabiner
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Re: HELP: After-Tax Variable Annuity TAXES

Post by grabiner »

The way to get the more favorable tax treatment was something he could have done years ago: holding bonds in the variable annuity and stocks in his taxable account. Bonds do benefit from being in a variable annuity, as the tax on gains is deferred until withdrawal. (I still don't usually recommend variable annuities to hold bonds, because the extra cost of the annuity is usually more than the tax savings. However, if you already have a variable annuity, holding bonds in it will improve your future tax situation.)
Slow_and_Steady wrote: Sun Feb 02, 2025 6:00 pm Note: He's looking to take the lump sum option (Total Capital Gain is about $275k). I thought about trying to spread the payments out for lower tax brackets through the years, but he will be receiving a decent pension so I don't think that's a good option either.
Spreading it out over a few years is likely better, because is spreads out the tax brackets. For example, if he is single now and his taxable income is $100,000 (adjusted gross income of $115,000 if he takes the standard deduction), he is near the top of the 22% bracket, and could withdraw $97,300 and stay in the 24% bracket. This would be enough to deplete the annuity in three years. If he withdraws it all this year, most of the withdrawal will be taxed at 32% and 35%.

Another alternative, if he is charitably inclined, is to withdraw the whole thing and make a large contribution to a donor-advised fund. In the example above, if he withdraws the whole thing, he will have an adjusted gross income of $390,000. This would allow him to contribute $234,000 of cash to a donor-advised fund and take it all as a charitable deduction, wiping out the amounts taxed at 32% and 35%. With this large donor-advised fund, he could then make five-figure charitable donations every year for a long time without spending any more money.
Wiki David Grabiner
Harmanic
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Re: HELP: After-Tax Variable Annuity TAXES

Post by Harmanic »

Have you looked at annuitization? There could be fixed and variable annuitization options and there could be income riders. In some cases, they can be valuable.

Either way, he will be on the hook for taxes.
The question isn't at what age I want to retire, it's at what income. | - George Foreman
snic
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Re: HELP: After-Tax Variable Annuity TAXES

Post by snic »

If he annuitizes, are the payments adjusted for inflation? Most annuities don't do this, but maybe one that's offered by a state to its employees (which I assume this is?) is different. If so, it could be quite valuable because there are very few inflation-adjusted income streams in retirement (social security and TIPS ladders being the only ones I know about). That protects against longevity risk in ways that other investments don't.
"Financial ignorance is expensive."
Harmanic
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Re: HELP: After-Tax Variable Annuity TAXES

Post by Harmanic »

snic wrote: Mon Feb 03, 2025 2:25 pm If he annuitizes, are the payments adjusted for inflation? Most annuities don't do this, but maybe one that's offered by a state to its employees (which I assume this is?) is different. If so, it could be quite valuable because there are very few inflation-adjusted income streams in retirement (social security and TIPS ladders being the only ones I know about). That protects against longevity risk in ways that other investments don't.
If you choose variable annuitization, you might be able to choose a TIPS fund as the underlying investment. It will track inflation closely. However, because of the AIR, the payments will likely stay flat unless there is a period of very high inflation.
The question isn't at what age I want to retire, it's at what income. | - George Foreman
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