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How to get a step up in basis on an annuity

Julianne Leybag
04 April 2018 4 minute readShare
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Thoroughly understanding step ups, taxation, and all other considerations relevant to an annuitant’s annuity, especially the inherited ones, will certainly help in maximising  annuity’s benefits. Here’s how.

To better maximise the advantages and/or benefits of an annuity, especially the inherited ones, annuitants need to consider the following:

Understanding step ups

A step up enables annuitants to maximise on the advantages of rising markets—a very real economic phenomenon—in increasing annuity benefits, especially inheritance annuities and death benefits, for heir(s) and/or beneficiary(ies). This is done by making a new guaranteed annuity benefit from locking up the higher amount from the rising value of the investment.

Possible step up fees

Take note however some insurance and annuity contract companies require and charge fees for features, especially the guarantees, that are included in certain annuities. This is important to bear in mind since annuitants might end up losing more money than actually getting more financial benefits from their (inherited) annuity contract.

Variable annuities may especially pose financial risks when not carefully managed and attended to. While this kind of annuity offers great tax savings by having deferrals on investment gains, annuitants might lose more money when they take withdrawals.

How does this happen? Of course, after depositing the post-tax money, without needing to pay taxes on the interest of  investment gains, capital gains, and dividends, annuitants usually take some time before finally taking some withdrawals. Everything’s fine; these are annuitants manoeuvering and deciding on the best option: exchanging between investment alternatives inside their (inherited) annuity without activating the need for taxation.

But here’s the catch. There may be two complications with this particular process.  First, the issue of taxing investment gains as regular income and, second, the possibility of heirs/beneficiaries not receiving any step up in cost basis.

Taxation on investment gains as regular income

In this premise, we take the annuity contract as a container. The nature of the container overrules, and actually dictates, the rules of the investment in question.

If annuitants have an annuity that pays interest income, they will need to attend to interest payment requirements annually. On the other hand, if they have a variable annuity, they usually won’t need to pay taxes on any investment gains until the time they decide to take a withdrawal.

Note that when annuitants take a withdrawal from an annuity, it is always considered that the first to be withdrawn are the gains. Unless of course they have already foreseen and prepared for this and have annuitised the contract. Also, bear in mind that the withdrawn gains—all of them—are subjected to taxation based on the ordinary or regular tax rate.

So why are these situations disadvantages for beneficiaries? Investment or capital gains tax rates are much lower than ordinary tax rates. Beneficiaries might be required to pay as much as 20 per cent (top tax bracket) on their ordinary income than on their investment gains. This results in loss of money despite the already given tax deferrals.

But if the annuitant’s plan is to set up and have a variable annuity for over 25 years before finally deciding on taking withdrawals from said annuity contract, then the annuity’s earning interest on tax deferrals may have enough time to work and “undo” the very real threat of financial loss.

To make sure that annuitants don’t fall prey to this situation, they should always consult with their trusted accountant or financial adviser.

Heirs/beneficiaries not receiving any step up in cost basis

The named heirs or beneficiaries receive a step up in cost basis upon the passing of the annuitant. This covers all inherited assets—annuity, mutual funds, real estate, and shares/stocks.

Taxation will then be based on the cost basis of the investment, making it the capital’s value upon the annuitant’s passing. They may now sell it if they wish to. And no taxation will be involved.

However, this premise doesn’t really apply to annuities. When the heirs or beneficiaries decide to sell the variable annuity, financial experts say they face paying a considerable amount for taxes instead of enjoying tax exemption.

Varying tax rules

In most cases, beneficiaries and heirs inheriting an annuity choose a lump sum payout. Taxation would be much easier and simpler if this is the case. Beneficiaries simply have to attend to their tax obligations on everything above the amount of the original annuity cost.

The original premium payment amount is considered and treated as tax basis, thus, making taxable income an exclusion.

In some cases, however, an exception is afforded to those who are receiving guaranteed payments bound by their inherited annuity contract. If this is the case, then the first amount received can be treated as tax-exempted.

However, expect taxation above that amount. This can be a big advantage, bringing in welcome benefits for those inheriting an annuity, as it reverses the usual taxation rules.

Again, bear in mind that inheriting an annuity can sometimes be complicated. Some of the complications may even be brought about by the confines and stipulations of the specific inherited annuity itself.

Thoroughly understanding all the taxation rules and requirements and taking into consideration their implications on the beneficiary’s inheritance, will no doubt help in preparing better and opt for the most beneficial option: the least-taxed option that allows beneficiaries to fully enjoy the money from a loved one.

Annuitants don’t need to go through all the preparation and management of their annuity alone. If annuitants are still unclear or unsure about the specifics, they can always consult with and engage the services of their trusted accountant, financial advisor, and/or lawyer with proven expertise on annuities, step ups, taxation, and other relevant considerations.


How to get a step up in basis on an annuity
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Julianne Leybag

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