By Byrke Sestok
Fixed and variable annuities have been popular offering by banks, insurance agents and other financial salespeople for decades. Whether you purchased an annuity with your after-tax savings through terrific advice -- or were a victim of improper sales tactics -- years, even decades have passed and it's likely that your annuity has grown substantially. Growth is great, but you may now have an income tax issue if you to start spending your money.
As a quick refresher, annuities purchased with after-tax money can grow tax-deferred until money is withdrawn from the annuity contract. Under most circumstances you must wait until age 59½ or older to take money out of your annuity. If you take the money out earlier (without following some special rules that will not be reviewed here) you will be penalized an additional 10% of gains over cost basis by the IRS. Withdrawals from annuities are taxable by the IRS under the Last-In-First-Out (LIFO) method. This means that all the gains must come out your annuity contract first as taxable income and then original investment dollars, or cost basis, can be withdrawn without tax. Additionally, the first out gains are taxed as regular income at your marginal tax rate, not the more preferential long-term capital gains tax rate.
For example, if you earn $250,000 and withdraw $50,000 from a non-qualified (not an IRA or retirement plan) annuity you will be taxed as if you earned $300,000. Married couples filing jointly (MFJ) in 2018 will be taxed at 24% marginal rate for additional $12,000 tax resulting in a net withdrawal of $38,000.
Recently, a new client came to us who purchased $3 million in annuities more than a decade ago. They have grown to $4.5 million with a LIFO gain of $1.5 million. The client should not cash these contracts out all at once because they would owe Federal taxes of $555,000 at his MFJ tax rate of 37%. Furthermore, the annuities this client purchased have internal fees of 3.40% annually ($153,000) so it makes a lot of sense to get out of the contracts but cashing them in means a massive tax hit. We will revisit this client later.
So What Can You Do About Taxes?
The following four options are viable strategies to reduce taxes on gains inside non-qualified annuities. First, we will examine each as a textbook strategy and second, I will share workable applications of these strategies with current products available today. If you're already up to speed on these ideas, feel free to skip ahead to the application section. Also, consult your tax adviser and certified financial professional before moving ahead with any of these strategies to ensure they fit your specific financial situation.
Annuitize your annuity: The original annuity was one where an investor exchanged a lump sum of money for a streaming income payment essentially buying himself a pension. All subsequently derived annuities offer this as an option for payout of an annuity. This is relevant because annuitized payouts, typically stated as monthly income, blend original cost basis of the annuity with gains on the annuity so that a portion of the monthly income amount will be return of principal and not taxable to you. This is known as the exclusion ratio.
For example, had you purchased an annuity for $100,000 and it is currently worth $200,000 Then your exclusion ratio would be 50% ($100,000 / $200,000) and the monthly payment calculated for you by the issuer would be 50% taxable 50% non-taxable.
In this example it is also important to note that annuitized payments typically continue for the annuitant's lifetime. After $200,000 of total payments received the annuitant will continue to receive the same monthly payment, however all cost basis has been returned and the monthly payments will be 100% taxable moving forward.
The big con against annuitizing your annuity is that you surrender your principal to the insurance company. Many annuitization options include a return of premium guaranteed option and a period certain option (where payments continue to a beneficiary should you die before 10 years of payments have been made to you). Typically, you will not receive any lump sum in the future.
Schedule multi-year withdrawals: Much like you may decide to sell a stock with significant capital gains over two or more calendar years you can do the same when planning withdrawals from your annuity to control taxation. Continuing with the annuity valued at $200,000 from above, our investor may decide to withdraw $20,000 per year for 5 years to spread out the LIFO gains over multiple tax years with the goal of remaining at the current tax bracket rather than jumping adjusted gross income into the next higher tax bracket.
This strategy offers an advantage over annuitization because our investor retains ownership of the remaining annuity contract value rather than surrendering it to the annuity issuer.
Tax-deferred exchange to a new annuity: Much has changed over the past 30 years with annuity offerings and a current annuity contract may better fit your current and future financial situation. Internal Revenue Code 1035 permits directly transferring the balance of your current annuity to a new annuity without realizing imbedded investment gains.
Before executing a 1035 tax-deferred exchange notify your tax preparer so that he can help ensure that the exchange is documented correctly. On many occasions I have witnessed annuity issuers incorrectly document 1035 exchanges on both sides of the transaction. Record keeping has improved greatly in the digital age, however if you do not catch an error now the next likely time will be when you take money out of the new annuity and the burden of proof will be on you if the IRS challenges you.
Tax-deferred exchange to a qualified long-term care insurance policy: The same Internal Revenue Code 1035 permits exchanging non-qualified annuity money to pay for long term care insurance. I will leave discussing the merits of long term care insurance for another story other than stating that having a plan for long term care expenses is more than ever a necessary part of retirement planning. Should your financial advisors and you decide that long term care insurance is appropriate 1035 exchanging annuity dollars for premium payments is a fantastic way to reduce your annuity tax liability. As you already know the 1035 exchange defers taxation so no tax is due in the year(s) of premium payment. What you should know is that long term care insurance benefits are paid out tax-free. By exchanging annuity gains into long-term care insurance you eliminate taxes owed.
Most long-term care insurance policies are paid by annual premium so the 1035 exchange process will likely be an annual exercise for you. You will also need to confirm that your current annuity issuer will process annual partial 1035 exchanges and that your long-term care insurer is equipped to accept them. Your existing annuity will have cost basis and gains reduced pro rata by the partial exchange amounts and again I stress the importance of accurate record keeping and involving your tax preparer.
One potential drawback of long term care insurance that must be mentioned is many individual policies do not offer any return of premiums if you never have a qualifying long-term care expense. Should you exchange into long term care and never use it your money is likely spent and gone.
Annuitizing Your Annuity
If you are entering retirement or already retired and seeking to recreate your paycheck, then annuitizing some or all of your annuity may be a wise decision. A certified financial planner can work with you to determine strategies to recreate your paycheck from your savings and investments and Social Security and any other guaranteed incomes you may have such as a pension.
If annuitization makes sense get payout quotes from your current annuity company and compare them to current single premium immediate annuities (SPIAs). For example, let's assume our investor with the $200,000 annuity ($100,000 cost basis) is age 70. At the time of writing our investor could purchase a SPIA annuity from Lincoln National Life Insurance Company with cash refund option (guaranteed to pay out at least $200,000 to the annuitant or beneficiaries) and receive a monthly income of $1,167.57, of which $720.39 would be taxable and $447.18 non-taxable return of principal (38% exclusion ratio).
This payment represents a 7.00% payout of the $200,000 gross amount annually. Our investor would need to live 14 years 4 months (age 84 1/3) to get into the insurance company's pocket. Ignoring the tax impact of taking the $200,000 out of the current annuity, if our investor invested that money in a portfolio it would be a challenge to withdraw income equal to 7.00% annually and have the investments last at least 14 years 4 months and increasingly more difficult each year beyond the investor's age 84.
Schedule Multi-year Withdrawals
Our investor, who earns $250,000, should consider spreading out withdrawals from his $200,000 annuity over 2 years if he wants to get all the money out of the annuity. The 24% marginal tax bracket for MFJ runs from $165,000 to $314,999. He therefore has 64,999 of room left before entering the next higher tax bracket of 32%, a sizable 8% jump, and coordinating with his tax preparer should take out this amount in tax year 2018. In 2019 he can take out the remaining $35,001 in gains and his full $100,000 cost basis. By spreading the withdrawals over two years he saves 8% Federal tax on the $35,001, or $2,800.08. If you are considering getting all the cash out of your annuity and have the time, do so over several years. The smaller the gap left between your gross income and the beginning of the next marginal tax bracket the greater the number of years it will take to use a similar strategy.
Tax-deferred Exchange to a New Annuity
I mentioned earlier that new annuities may suit our investor better than his current annuity. We already looked at 1035 exchanging into a SPIA for current income needs with tax-exclusion. All options in this section are 1035 opportunities.
Several insurance companies such as Lincoln National Life Insurance Company and AXA Equitable have obtained private letter rulings from the IRS that state specific annuities they offer can allow a pro-rata distribution of gains and basis on withdrawals. A drawback to annuitization is surrendering the principal in exchange for the streaming income payments. Permitting pro-rata withdrawals means you can retain your ownership of the balance of the annuity.
All major annuity providers offer variants of variable annuities (investment market participation) with guaranteed income or guaranteed withdrawal options. The choices are too many to review in substance in this article and if considered should be evaluated with a professional's guidance in conjunction with your retirement income plan.
Our client with the $.5 million worth of annuities does not need income anytime soon and he never should have been sold these annuities in the first place. The high fees associated with his variable annuities with guaranteed income riders provide no value because he has a substantial net worth and is highly unlikely to run out of money in retirement. We exchanged his annuities into investment only annuities with Jackson National Life Insurance Company and reduced his annual fee percentage from 3.4% to 1.5% resulting in cost reduction of $85,500 annually. When he retires we will examine how to blend multi-year withdrawals and private letter ruling annuities to get money out of the annuities in a tax-efficient manner. Since the annuity marketplace changes significantly every year I cannot say exactly what his future strategy will be.
Tax-deferred Exchange to a Qualified Long-Term Care Insurance Policy
I have frequently run into tax preparers who offer traditional IRAs to their clients for annual tax reduction and use annuities as the investment vehicle. In order to sell annuities a person must have a life, accident and health insurance license and frankly with a little studying most people could pass the licensing exam so it's an easy way to bolt on a revenue stream to an accounting practice while helping clients save on their tax return.
In one extreme example a client couple owned 14 different annuity contracts from 5 different issuers with balances ranging from about $9,000 to $45,000 as a result of making $5,000 traditional IRA contributions each year that the accountant could provide a tax deduction to the client. With all these small annuities with little tax landmines it made sense to use the highest gain contracts that permitted partial 1035 exchanges into long-term care insurance. We were able to apply for both spouses to Mutual of Omaha, receive a spousal discount for the purchase of two policies at the same time, and annually commute taxable gains to these policies. This couple also has no children so top-notch healthcare, if and when they need it, greatly outweighed their desire to bequeath assets after death.
A myriad of options exists to make better tax decisions with non-qualified annuities that have significant taxable gains. The routes you take should be based on a well-developed financial plan based on your family's financial goals and objectives. Before making any decisions consider consulting a seasoned CFP® professional who can discuss options applicable to your needs and review options under consideration with your accountant or tax preparer.
About the author: Byrke Sestok, CFP® is the president and co-owner of Rightirement Wealth Partners in White Plains, NY. He has been cited in various online publications such as Nasdaq, CNBC and MarketWatch. Byrke also serves as the chairman for Programs and Sponsorship of the Financial Planning Association -- Greater Hudson Valley chapter and is president-elect beginning 2019.