EDITOR'S NOTE: This article was originally published in the January 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.
Deferred annuity owners have a new option: a simple way to carve up the cash, transforming part into an immediate annuity to produce a regular stream of income while leaving the rest to grow tax-deferred. And considering today's rock-bottom interest rates, an easy option to "annuitize" just part of a deferred annuity buys owners important flexibility.
Before the new rules took effect January 1, splitting a deferred annuity could be costly and cumbersome. One option to partially annuitize was to surrender the contract, which might trigger hefty surrender charges, and buy an immediate annuity with part of the money. Another route was to exchange the deferred annuity contract for two annuity contracts -- one to annuitize and one to leave alone. Or you could withdraw a portion of the balance to purchase an immediate annuity, but that withdrawal would likely be 100% taxable.
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Under the new law, you can simply take your deferred annuity contract and carve out a piece to annuitize. The immediate annuity will be a supplemental contract, and you can maintain the balance as the original deferred annuity. "What this means, and was meant to do, is that you can get an income stream, but allow some of the money to grow -- to outpace inflation," says Richard Byrne, vice-president of retirement income for MassMutual. The new provision applies only to deferred annuities purchased with after-tax money and held outside of retirement plans.
Better Tax Treatment
An important part of the new rule makes it clear that favorable tax treatment applies to the immediate annuities created by the split. Because you invest after-tax dollars in a deferred annuity, you have a cost basis in the contract equal to the amount you invest. But it had been unclear as to when the basis would come into play when figuring tax on a partial distribution. Byrne says the IRS had treated partial annuitizations as a withdrawal. And that means the IRS treated it harshly.
The tax law treats payouts from annuities in two ways. If you simply withdraw cash, the IRS considers the first money you receive to be earnings, fully taxable in your top tax bracket. Only after you have withdrawn and paid tax on 100% of the tax-deferred earnings do you begin dipping into your basis tax-free. But when the contract is annuitized to make lifetime payments, part of each payment is considered a tax-free return of the owner's investment, and the rest is taxable earnings.
The new law clarifies how the tax rule works for partial annuitizations, says Drew Denning, vice-president of income solutions for the Principal Financial Group. "You can use a prorated portion of the basis," he says.
Let's say you invested $50,000 in a deferred annuity that is now worth $100,000 and you want to annuitize $50,000. Half of the balance -- and half of your basis ($25,000 in this example) -- would transfer to the immediate annuity. As long as you annuitize for ten years or more, you'll gradually recover your basis via a tax-free portion of each payment you receive.
Eventually you would still pay the same amount of tax, but being able to distribute the cost basis disperses the tax burden on the payouts instead of paying all the tax upfront. "You still pay tax on the gains, but it is spread over time," says John Little, senior vice-president of federal affairs for the Insured Retirement Institute, a trade association.
Don't worry about figuring out the tax-free and the taxable parts of each payment. The insurance company will figure that for you and report it on a Form 1099 for tax time. The calculation is based on an exclusion ratio that factors in your basis and the total amount you're expected to receive over the life of the annuity.
Meanwhile, the money left in the deferred annuity will continue to grow tax-deferred, until you decide to withdraw it or make another partial annuitization. "You can do it multiple times," says Byrne.
If you partially annuitize at age 65, you could do it again, perhaps every five or ten years. Even if you annuitized the same amount each time, each partial annuitization would have a slightly higher payout because of your older age. And if interest rates go up, all the better. Essentially, you could use partial annuitization to create a ladder of income streams carved out of the original contract.
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