Leveraging the accumulation and payout advantages that annuities can offer
by Mike ReidyMr. Reidy is VP, Head of RIA Distribution for Security Benefit. Visit securitybenefit.com
Outliving their income is often the main concern for your clients in retirement. While there are a number of vehicles available to help provide income, annuities have come back into focus as a viable option given their unique characteristics, including the availability to provide income over clients’ lifetimes or a set period of years. However, while many advisors consider annuities to be tax inefficient when it comes to income planning, there are two tax efficient methods that certain annuities provide during retirement.
An optional feature offered with many annuities is a Guaranteed Lifetime Withdrawal Benefit (GLWB). It provides your client with a set, guaranteed amount of income for the rest of their life, or both the client and their spouse’s lives, even if the annuity’s accumulation value eventually reaches $0 as a result of the GLWB withdrawals.
The income amount is based on several factors including:
- Your client’s benefit base, which is made up of their purchase payments and in some riders credited interest as well.
- The choice of income for the client’s life or the client’s life and his/her spouse’s life (made when the client is ready to elect income).
- The actual lifetime withdrawal rate based on the client’s age (or the younger person’s age if a joint payout is elected).
It’s important to note that with this optional feature, the longer your client waits to take income (until the pre-set maximum), the higher the benefit base can grow resulting in more income during retirement. However, there is usually a maximum age and length of contract years for the benefit base “roll-up.”
Tax Implications of GLWB
Typically, GLWB income payments are withdrawn first from an annuity’s interest credits, which are taxed as regular income, and then from an annuity’s cost basis, which is not taxed. This means your client typically incurs a large initial tax burden that decreases over time as he or she receives income payments. To smooth this out, some GLWB riders offer an annual income payment that is comprised of a portion of your client’s cost basis (non-taxable) and a portion of the annuity’s growth (taxable). This election may allow your client to treat part of their annual income payment as a non-taxable return of the cost basis from their annuity.
However, once the cost basis has been fully recovered, all annual income payments thereafter will be fully taxable. There are certain conditions that must be satisfied in order for this “exclusion ratio” tax treatment to be available such as (1) once GLWB payments begin, they cannot be stopped; (2) any death benefit payable must be taken as a lump sum; (3) the owner and/or annuitant of the contract cannot be changed.
Put another way, this approach spreads out the income tax on your client’s annual income payments over a period of time and may provide some valuable tax advantages depending on your client’s needs and particular situation. The actual tax impact will be based upon several factors including:
- the cost basis in your client’s annuity contract,
- the interest credited to the annuity,
- the tax rates applicable to your client,
- the length of time your client receives annual income,
- the tax laws and regulations applicable at the time your client receives the income, and
- withdrawals in excess of their annual income, including those to pay advisory fees.
Higher After-tax Income Earlier in Retirement Through a Fixed Period Annuity Option
With the second approach, a fixed period annuity option, your client’s income payment is again comprised of a portion of their cost basis (non-taxable) and a portion of their annuity’s interest credits (taxable). As with the first approach, this spreads out the income tax on your client’s annuity payments over a period of time so they are only taxed on a portion of their gains each year.
A fixed period annuity option offers specific payout periods for the contract. When the annuity distribution period begins, your clients can choose distributions over set periods of time (in years). This option is often chosen by the client to cover a period of time during which they don’t expect to receive other benefits or income. For example, your client may choose this payout option for the start of their retirement when they are no longer receiving a regular paycheck, but before some retirement benefits or other benefits have started or they want to put them off for a time.
The total amount of money distributed over the payment period is based on several factors including purchase payments, investment gains or losses in the case of a variable annuity, and the length of the fixed period (shorter time frames would mean larger payments to your clients versus longer time frames).
With a fixed period annuity option, there are some unique features to consider:
- Your client can choose to receive payments for a fixed number of years, usually between 5 and 30.
- Each payment is calculated by dividing the contract’s accumulated value prior to payment divided by the remaining number of payments.
- Your client may be able to take additional withdrawals as needed, though withdrawal amounts beyond their scheduled payments are fully taxable.
- May preserve access to your client’s contract value while receiving payments.
- May preserves the option to convert to a lifetime payout approach.
- May allow your client to surrender their contract for its then-current contract value.
With this approach, the contract value may have the potential for growth during the payout period so each year’s payment may also increase based on your client’s then-current contract value and the time remaining in their payment period.
Financial professionals are rediscovering the distinctive options that annuities offer in meeting client income needs in retirement. Of course, they can be used effectively as accumulation vehicles as well, so the combination of growth and guaranteed income could prove helpful to clients before and after they retire.