Tax treatment of Annuities

Curtis Cloke

In addition to the guaranteed income and high payout rate, the tax treatment is often a vastly underrated advantage of annuities. The tax exclusion ratio found in annuities renders only 5 percent to 25 percent of the payments subject to tax, while the remaining 75 percent to 95 percent is the return of principal. Consider if a client tried to fill this gap with growth or yield from stocks, bonds and mutual funds. First, to generate enough income to live on would require an inordinate sum, since it takes a $350,000 investment at 10 percent growth to create $35,000 of annual income. Regardless, this “non-guaranteed” income would also be subject to tax.

If invested in a stock mutual fund, all of a client’s $35,000 annual return on investment is subject to tax. At 15 percent, that tax would be $5,250. Compare that to receiving an annual payout of $35,000 from a SPIA or DIA. In this scenario, the total tax would be reduced from $5,250 to $1,050, assuming an 80 percent exclusion ratio. This tax savings is due to what I call FIBO® (First In/Blend Out). Each annuity payment is a blend of income and principal, unlike other types of investments where income is taxed up front.

With the savings created from lower taxes and delaying Social Security, retirees now have options regarding how they can structure the rest of their investment portfolio in developing their retirement plan. Two possible options for some of the remaining portfolio could be to invest in a deferred income annuity with a 15-year delay and a COLA-adjusted payout or a variable annuity (VA) with a guaranteed lifetime withdrawal benefit (GLWB).

With our new plan, the Social Security payments would kick in at age 70 and, since the payments are larger, many retirees may find they have more than enough income to cover basic expenses in their 70s. By investing in the DIA or VA with GLWB, they could help protect their financial future from inflation or hedge the risk of high medical costs associated with living into their late 80s or 90s. Also, any growth within these annuities is tax-deferred, which can help reduce the tax burden on their Social Security benefits.

Consider that with just $50,000, a 70-year-old male could purchase a deferred income annuity so that starting at age 85 he would receive $13,100 every year for the rest of his life. To counter the objection of loss of deposit in the event of early death, we include an installment refund payout option so if he died before he began receiving income, his beneficiaries would receive a death benefit for the full amount of the $50,000. Even if he died in the first few years of receiving income, he would receive a death benefit for the remaining balance of the $50,000 investment. By age 90 he will have received a sum of $65,000 of annuity payments and if he lives to age 100 he will have received nearly $197,000.

 

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