Review purpose of an annuity before cashing it in

I am confused on whether there are taxes on an annuity. Also, if you have a deferred annuity in a mutual fund, and it loses money, can you sell it and not annuitize it and take the loss on your tax return? I put $5,000 in and it is down to $3,600 because I had it in high-tech stocks.

- Brenda Kaufman, 63, Ellicott City, Md.


First, revisit why you bought the annuity in the first place. The essential protection offered by an annuity is a hedge against longevity. Low-cost, tax-efficient mutual funds are great for investment growth, but if your total portfolio isn't large enough to sustain you through a ripe old age, an annuity can offer the guarantee that you won't run out of money.

The give-up, of course, is the risk that you'll die sooner and won't be around long enough to make the annuity pay off.


As for taxes, your liability depends on whether the money used to buy the annuity was after-tax or pretax. If it was pretax, or a qualified plan from an employer, for example, payments are fully taxable when they are withdrawn but receive the benefit of perhaps years of tax-free compounding, said Patricia Colby, principal in insurance and annuity services for Vanguard Group Inc.

Annuities funded with non-qualified, or after-tax, contributions are taxed only on the earnings of the underlying investments. But if you surpass your life expectancy, Colby said, subsequent payments would in most cases be fully taxable because by that time they would be 100 percent earnings and zero principal.

States have different tax rules on annuities, so it pays to check those laws before investing.

Depending on all the details of your situation, including whether there are hefty surrender charges, it might make sense to exit the deferred annuity, claim the loss, reinvest in low-cost mutual funds and then consider an immediate annuity down the road if you'll really need the income, Colby said.

My husband and I are retiring in two years with a pension and Social Security of about $4,000 per month. We have around $400,000 in a 401(k), but we don't have a house. We want to move to Arizona. Should we buy a house from the money in the 401(k), or should we get a mortgage and pay it out of the 401(k)?

- Josef and Mira Cerny, Hainesville, Ill.

The Cernys are looking for a home in Tucson in the $230,000 price range and also have a home in Europe, where they plan to escape from Arizona's summers.

They indicated that their $4,000 monthly income should cover their living expenses, even if they take a mortgage out on their new home.


Given that limited information, Phoenix-area financial planner Carl Schopfer said he wouldn't recommend paying cash for the new home as this couple begins retirement.

"They'll have to pay regular income taxes on the money they take out of the 401(k), which could push them into a higher bracket, and it will be a significant hit to their investments," he said.

A better option would be to pay a substantial down payment, perhaps 20 percent of the purchase price. On a $230,000 home, that would leave a mortgage of $184,000, or annual principal and interest payments amounting to about $13,400.

They could then roll the remaining money from the 401(k) into an individual retirement account, invested roughly 60 percent in stocks and 40 percent in bonds, with the goal of earning at least 7 percent per year on the money.

"Of course, they should get a tax deduction on the mortgage interest, and that will further reduce the real after-tax cost of the loan," Schopfer said.

And if the couple's expenses turn out to be higher than projected, they should still be able to withdraw 4 percent to 5 percent of the IRA each year to cover the house payments, he said.


Even if they want to put more money into the house, he said, they should do so over several years, with a mortgage that has no prepayment penalties.

"It's a good time to buy a home in Arizona," Schopfer said. "The market has softened significantly over the past 12 months. I had a client that is moving here from Indianapolis that recently paid approximately 82 percent of the asking price for a home in the Phoenix area."

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