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Drilling Down on Camouflaged Annuity Taxation

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A Fee by any other Name

[By Rick Kahler MS CFP®] http://www.KahlerFinancial.com

Rick Kahler CFPWe South Dakotans can be smug about the economic advantages of residing in our income tax-free state. While those advantages are big, we do have a few lesser-known taxes.

These include a 6% franchise tax on banks and a 4.5% energy minerals severance tax on mining and oil companies. Like many other states, we also tax life insurance premiums; our rate is 2.5%.

The Hidden Annuity Premium Tax

I recently learned about another “hidden” tax, one on annuity premiums. A recent article in Investment News lists the eight states or territories that have such a tax: California, Florida, Maine, Nevada, Puerto Rico, South Dakota, West Virginia, and Wyoming. The tax ranges from 1% in Florida, West Virginia, and Wyoming to a whopping 3.5% in Nevada. South Dakota’s rate is 1.25%.

If you have purchased an annuity while living in one of these jurisdictions, you’ve paid this tax. You may have not been aware of it, as there are many hidden fees associated with purchasing annuities.

The Fee that is a Camouflaged Tax

I learned about the tax when our client service specialist questioned a 1.25% expense charged by the company on a new “no load” annuity. I thought the company had charged a commission of some type to the account, which was puzzling since we don’t accept any commissions. After sorting things out, we discovered the fee was actually the 1.25% premium tax that South Dakota charges on every contribution going into an annuity.

Impact

While states charge the tax just once on new money invested into the annuity, it still serves to decrease the total return of the annuity. If you held an annuity for a year, the premium tax would reduce your overall return by 1.25%. If you held the annuity for 10 years, the overall impact would be much less, reducing the return by 0.125% annually.

Specifics

The states leave the method of collecting the tax up to the annuity company. Most annuity companies that pay a salesperson a commission to sell the product build the fee into the overall costs. This is often easy, since the upfront commissions can range up to 10% and annual expenses up to 7% a year. I have seen more than one annuity where the fees and commissions eat up the majority of any potential return. Many no-load annuities, like Jefferson National, charge the tax to their customers.

The States

If you live in a state that taxes annuity premiums, you might have the idea of buying an annuity in a non-taxing state. This isn’t an option, as companies must levy the tax based on your state of residency.

On the surface, there appears to be some good news for residents of Maine, Nevada, South Dakota, and Wyoming. Residents who purchase an annuity in a qualified plan like an IRA or 401(k) don’t pay the tax. That benefit is somewhat moot, as owning an annuity in a qualified plan is rare. It generally makes little sense for a tax-deferred qualified plan to own a tax-deferred annuity, especially considering the annuity fees.

***

Tax

***

Rule-Outs?

If you live in a state that taxes annuity purchases, should you automatically rule out annuities? Not necessarily. Just be aware you will have to pay the piper. For residents of South Dakota, Florida, and Wyoming, lawmakers argue that maybe the tax isn’t such a heavy burden since these states don’t have an income tax.

Assessment

Still, no matter how you want to figure it, a tax is a tax. It’s one more factor to consider in deciding whether a given annuity product is right for you. Whatever amount you pay in state taxes is just that much less of your money that goes to work for you.

Conclusion

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OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:

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