By Robert Klein, CPA
President Biden’s American Families Plan includes proposed increases in the top marginal income tax rate from 37% to 39.6% and the top long-term capital gains tax rate from 23.8% to 43.4% for households with income over $1 million. Both changes would negatively impact investment returns for affected individuals.
Stock market-based investment strategies, with their exposure to higher ordinary and long-term capital gains tax rates are being reevaluated by investors and financial advisers alike. One strategy that is attracting more attention that will be virtually unscathed by the proposed tax increase is longevity insurance, more commonly known as fixed-income annuities.
Three Types of Fixed Income Annuities
Fixed-income annuities provide sustainable lifetime or term certain income and, as such, are well suited for retirement income planning. There are three types of fixed income annuities: single-premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs) with income riders.
Each of the three types of fixed income annuities serve a different purpose within a retirement income plan. Two of the three options, SPIAs and DIAs, are tax-favored when purchased in a nonqualified, or nonretirement, account. This makes them an excellent choice for those in higher tax brackets who are seeking to maximize after-tax sustainable income.
SPIAs can be an appropriate retirement income planning solution if you are retiring soon or are retired and have an immediate need for sustainable income. Income distributions can be as frequent as monthly or as infrequent as annually (depending on the options available from the insurer), as long as the first benefit is paid within one year of the contract’s purchase date.
DIAs are a better fit than SPIAs in most retirement income planning scenarios due to their deferred income start date. Deferral of your income start date increases the amount of your periodic income payment since the insurance company will be making payments to you for a shorter period of time assuming a lifetime payout.
100% of income distributions from FIAs with income riders are taxed as ordinary income whether they are in a retirement or nonretirement account. While their flexible income start date and potential death benefit are attractive features, income tax savings is not a strong suit of FIAs with income riders.
DIAs and SPIAs Unique Income Tax Advantage
DIAs and SPIAs enjoy a unique income tax advantage when they are purchased in a nonretirement account. Unlike FIAs with income riders that distribute ordinary income that reduces the accumulation value of the annuity contract, DIAs and SPIAs are annuitized.
The annuitization period is defined by the contract and is either a defined term, e.g., 10 years, or lifetime. Lifetime DIAs and SPIAs provide for an optional minimum payout period or lump sum payable to the annuitant’s beneficiaries to guarantee a minimum total payout.
The income tax advantage of DIAs and SPIAs is attributable to the allocation of each annuitized payment between income and a return of premium. The portion that is deemed to be a return of premium is your cost, or basis, and is nontaxable. Annuitization is analogous to amortization of a mortgage. When you make a mortgage payment, each payment is allocated between deductible interest and nondeductible principal.
In the case of a DIA or SPIA, the amount of each payment that is considered to be a nontaxable return of premium is calculated by applying an “exclusion ratio” to each monthly payment. The exclusion ratio is actuarially calculated by dividing the investment in an annuity contract by the total expected lifetime payments.
SPIA Tax Savings Illustration
To illustrate the income tax advantage of nonretirement DIAs and SPIAs, suppose you are a woman, and you purchase a SPIA for $100,000 when you are 65 years old. Let us further assume that the insurance company determines that you have a 22-year life expectancy, and they will pay you $475 a month for the rest of your life. Your lifetime payments are expected to total $125,400 ($475 x 12 x 22).
Your exclusion ratio is calculated by dividing your premium, or investment, of $100,000 by your expected lifetime payments of $125,400. The result is that 79.75%, or $379, of each of your monthly payments of $475 will be nontaxable for the first 22 years. 20.25%, or $96, of each monthly payment will be taxable. Even though your annual payments will total $5,700, the insurance company will report taxable income of only $1,154 for the initial 22 years.
What happens if you survive your 22-year life expectancy? You will continue to receive monthly payments of $475 for the rest of your life, however, 100% of your monthly payments will be taxable as ordinary income. This makes sense since your nontaxable payments for the first 22 years will have totaled $100,000 which is equal to your original investment.
Nonretirement DIAs and SPIAs Can Optimize After-Tax Retirement Income
DIAs and SPIAs, like all fixed income annuities, provide sustainable lifetime income. When purchased in a nonretirement account, they distinguish themselves further as a retirement income planning solution since their after-tax income is predictable.
Income tax rates have minimal impact on the amount of after-tax income from DIAs and SPIAs due to their exclusion ratio. Furthermore, any increase in marginal income tax rates will not affect most annuitants’ after-tax periodic payments until the cost basis has been recovered. As illustrated, this will not occur until the annuitant survives her life expectancy beginning on the annuity purchase date.
The ability to optimize after-tax income from nonretirement DIAs and SPIAs can also result in spillover income tax and other savings. This includes the potential reduction of taxable Social Security benefits, reduced exposure to the 3.8% net investment income tax, increased potential deductibility of medical expenses, and the opportunity to reduce marginal income tax rates and Medicare Part B premiums. Each of these things individually and collectively can result in additional increased after-tax retirement income for the duration of retirement.
Nonretirement fixed income annuities, with their sustainable lifetime income and tax-favored status, offer a timeless tax and retirement income planning opportunity.
About the author – Robert Klein
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the writer and publisher of Retirement Income Visions™, a blog featuring innovative strategies for creating and optimizing retirement income that Bob created in 2009.
Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies, including fixed income annuities, Roth IRA conversions, and charitable remainder trusts, to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions determined by each client’s needs.
Retirement Income Center has established relationships with various highly respected professional organizations and platforms to provide the firm’s clients with its comprehensive array of fee-based planning, management, and protection services.
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