Biden’s Capital Gains Tax Hike Will Increase Demand for Annuities

The Biden administration announced its intention to seek higher Capital Gains taxes on high income households today. 1 This has been discussed since the day after his win in November 2020 in wealth management circles- I can’t tell you how many “planning for a Biden tax regime” investor summits I’ve been invited to since Fall 2020. It was shelved, somewhat, when it looked like Georgia’s Senate seats would lean Republican. They didn’t, and the rest is history. As of today, everyone’s on the same page in terms of what to expect of future Capital Gains rate if the administration is successful in altering them. This makes it possible to discuss candidly without speculating on what the regime would like to do, which is how I mostly like to operate as a planner.

Additionally, there is discussion of ending the step-up in basis that stocks and other investments receive when inherited. 2 That is, the current status quo is that if you have stocks in a taxable account and you pass away still holding on to them, your heirs don’t inherit the tax basis you had when you bought them. Their basis is stepped up to the current price when the asset is received. 3

These changes have the potential to greatly increase the attractiveness of Annuities. Annuities already offer a number of compelling features, and at Chaim Investment Advisors, we like them (with conditions, of course) even without an overhaul of how assets are taxed. These potential changes, however, move Annuities to the forefront of planning for wealthy investors as a tax savvy tool.

In less abstract and technical terms- surely many reading this article have not yet considered how their stocks will be taxed after they’ve passed them on- let’s look at an actual example of the current status quo and what’s changing.

Joe Nedib is an investor who keeps a lot of his money in taxable accounts. He already maxes out his 401(k) and wants to save more. He’s got $8,000,000 in a mix of Stock and Bond ETF’s paying out an average of 2.7% in Dividends and interest. Let’s assume nothing complex or interesting is being done to alter how this money is earned. His effective Capital Gains tax on earned income is 15% (he’s got some Muni bonds in the mix). He makes $216,000 annually in income from the portfolio and pays $32,400 in taxes on this income. Unfortunately, he’s only just started making a little over $1,000,000 and annually and also dies in the same year. His heirs receive the $8,000,000 portfolio with a basis of $8,000,000.

That means when they go to sell the assets in the portfolio, they won’t be paying Capital Gains based on the price the assets were acquired at. They’ll pay based on their new basis. If they make a $1,000,000 gain and sell everything, their taxes will be their Capital Gains rate times that $1,000,000. If Joe had done this himself, and his basis was not $8,000,000 but $3,400,000, he’d pay based on $5,600,000. That is a very large difference. At the Capital Gains rate we mentioned above- 15%- that’s $840,000 in taxes versus (let’s assume the heirs have the same rate for illustration’s sake) $150,000. Who sold the stocks and when made a $690,000 difference in this instance- an amount that is the better part of what many households save in their entire lifetimes.

Let’s assume all of the same facts for a minute, and we’ll assume some worst case scenarios for illustration’s sake for the future tax Law (they haven’t yet been finalized let alone passed). In this case, Joe decides to liquidate his portfolio before death at a round $8,000,000. When he goes to sell it all, this time he faces a $1.9 million tax bill. If he didn’t do this and his heirs happened to sell at $9,000,000, and also happened to trigger the highest rates mentioned, they’d pay a $2.4 million tax bill. That’s a drastic contrast to the $150,000 mentioned above.

I also haven’t figured in State taxes. If the kids happen to be in California when they trigger the above tax scenario, their tax bill will be closer to $3.1 million.

Of course this very rudimentary example shows precisely why very few people will expose themselves to this outcome. And that brings us to the Annuities topic.

Let’s set aside some of the more hysterical negative claims about Annuities for a moment. There are 3 major complaints people have about Variable Annuities in particular that are considered by finance professionals to be weighty, and that’s what we’ll be discussing here- though I expect a boost to all categories of Annuity, personally. The three complaints are:

1. Variable Annuities have high costs
2. Income from Annuities is taxed as Ordinary Income, which is less favorable than Capital Gains taxes on Stocks
3. Variable Annuities do not receive a step-up in basis on death

We’ve already talked a great deal about solving the first problem using Investment Only Variable Annuities enough on this blog. 4 5 6 The first problem is largely a non-issue if you’re working with advisors like Chaim Investment Advisors or other Fee Only Fiduciaries who use Variable Annuities. We already know how to make them cost very little ($20/month flat fee for Nationwide’s Monument Advisor annuity, for example).

The second problem sounds like it’s not going to be a meaningful difference between how Variable Annuity income and Capital Gains will be taxed for the wealthiest investors. If there is an equivalence between a low cost IOVA (Investment Only Variable Annuity) and a portfolio of Mutual Funds in how they’re taxed in terms of liquidations and income, IOVA’s become a great deal more attractive than the Mutual Funds in many- perhaps most- cases.

The loss of step-up in basis doesn’t make Annuities fully equivalent to stocks in taxation per se, but stocks don’t enjoy unlimited tax deferral on gains during their accumulation period. This is a very large factor in why legacy planning employs fewer IOVA’s than it likely will in the future. What we’ll see is a lot of tools to illustrate this differential- save on taxes now during accumulation versus taxes on non-stepped-up basis. These calculators already exist but there are plenty of scenarios where the step-up in basis is the deal breaker in favor of stocks. If that goes away, I can imagine a number of analyses that will suddenly show Annuities as the winner in estate planning.

In brief, the past decade has been a good one for Annuities as they’ve closed the gap in terms of becoming attractive compared to alternatives. With this new potential Law hitting the 2 remaining factors against Variable Annuities very hard, it’s difficult to imagine a world in which Annuities don’t have a renaissance- at least in the near term. Even Charitable Remainder Trusts, which will also become popular I imagine, already favor Annuities as a funding vehicle. Think of CRATs and NIMCRUTs– these are already known for their link to Annuities and indeed IOVA’s in recent years. To drive it home, even some of the Trust structures that aren’t Annuities themselves that will likely be used in light of this Law also favor Annuities as their core holding. 

Our practice has long been involved in parsing out the marginal benefits of using Annuities versus other vehicles for investing. There are many clients of ours whom the proposed Biden tax Laws will not impact, for sure. Nonetheless, we expect that some of the clients we’ve worked with where we leaned away from Annuities, we will be leaning in favor of them going forward should this become Law. There are dozens of cases where I’ve looked at the impact of stepped-up basis and differential taxation in liquidation, and it has been razor thin in favor of stocks and Mutual Funds.

If all of this describes you and you’re concerned about this, please feel free to get in touch and get up to speed on what Annuities are well ahead of the time when we need to worry about these changes. None of this is Law yet, and that leaves us in the time frame where we can casually discuss potentials and begin the process of considering impacts. Nonetheless, the time to start the conversation is probably now.