Split Funding an Annuity

Tax Issue

Taxpayers often use interest income to supplement earned income or retirement income. Interest income generated by bank savings accounts or certificated of deposit (CD) is subject to ordinary income tax at the taxpayer’s marginal rate.

When interest rates are low, taxpayers look for ways to generate the same amount of income as when interest was higher.

Applicable Tax Law

• Earnings on nonqualified annuities are taxed at ordinary income tax rates when withdrawn.
• Earnings on nonqualified annuities are tax deferred until withdrawn.
• Interest earned from bank savings account and CDs are taxed at the taxpayer’s marginal rate in the year earned.
• Taxpayers under age 59 ½ receive interest from an annuity payout without incurring an additional 10% penalty tax. In order to avoid the 10% additional tax, the annuity payout must come from an income annuity which begins paying out no later than one year from the purchase date of the annuity.

Tax Planning Strategies

By removing money from a bank savings account or certificate of deposit and placing the funds in two separate annuities, a taxpayer can generate income to replace the income that was being generated by the investments in the bank products. By using an income annuity, the taxable income is reduced when compared to using interest only from a bank product. The process of using two annuities is referred to as split-funding.

Income Annuity

An income annuity is a contract with an insurance company that offers the investor a guaranteed fixed payout for a set period of time. The set period of time could be for a certain number of years, such as five or 10, or it could be for the lifetime of the investor. The payout received by the investor includes interest earned on the investment, plus a return of principal. The payout of a period-certain annuity will return the entire principal, plus the interest earned by the end of the period. A period-certain annuity payout will make payments monthly or annually to the owner of the annuity or the beneficiary of the annuity if the owner dies before receiving all payouts. Because all principal will be paid out by the end of the period-certain time, there will be no value in the annuity at the end of the period. In fact, the process of annuitization involves selling the contract value to the insurance company in exchange for a guaranteed stream of income. So, once an annuity payout begins, the principal value cannot be accessed, only the guaranteed payouts are available.

An income annuity can be created by purchasing an annuity that is set to begin payments immediately. Also, a deferred annuity can be purchased and then annuitized at a later date.

Deferred Annuity. A deferred annuity is a contract with an insurance company that offers the investor the opportunity to earn money on an investment and to defer the tax on those earnings until the earnings are withdrawn. The earnings could be a fixed return, very much like a bank CD, by using a fixed annuity. The earnings could also be variable in a similar way to the variable returns on a mutual fund by using a variable annuity. With a variable annuity, there is no guarantee of earnings. In fact, the returns on a variable annuity could be negative.

Split-funding. An income annuity is used to generate current income for a fixed period of time. A deferred annuity is used to grow the account value of the deferred annuity. The objective is to have the deferred annuity grow to an amount that would replace the amount of principal depleted from the income annuity. By split-funding an annuity, an investor can obtain the same amount of income he or she would have otherwise receive and lessen his or her tax burden. See Example #1, next column.

Exempt from additional tax. Withdrawals of earnings from annuities are subject to ordinary income tax. In addition, taxpayers under age 59 ½ will pay an additional 10% tax on those earnings. However, if the earnings are paid out to the taxpayer as part of an income annuity, those earnings are not subject to the additional 10% tax. In order to not be subject to the 10% additional tax, the income annuity payments must start within one year of the annuity being purchased. See Example #2, next column.

Examples

Example #1: Penelope, age 65, needs $670 per month additional income. Currently, she has $220,000 in a CD earning 3.65%. This gives Penelope $8,030 of taxable income ($220,000 times 3.65%). Her CD is coming up for renewal and the interest rate will be lower. In addition to the potential of receiving less income, the $8,030 she has been receiving is being taxed at her 25% marginal tax rate.

Penelope is considering split-funding an annuity with the CD proceeds. She is looking to invest $70,000 in an income annuity that guarantees her monthly payments for 10 years. The income annuity would generate a monthly income of $671. Each payment from the annuity to Penelope represents a return of principal plus interest. The amount of principal paid out each month is determined by a complex formula that essentially calculates the amount invested divided by the number of payouts. The interest paid to Penelope is taxable. The return of principal is not.

Penelope invests the balance of the CD proceeds of $150,000 in a deferred annuity earning 4%. There is no tax on the earnings on the deferred annuity as long as the earnings are not withdrawn from the contract.

At the end of 10 years, the income annuity value will be decreased to $0. The deferred annuity value will have grown to approximately $220,00. In 10 years, Penelope can decide how she wants to allocate the $220,000 going forward based on the then-current interest rates, tax rates, and income needs. In the meantime, Penelope is receiving the incoe she needs and is paying taxes on a lesser amount of interest.

Example #2: Luther, age 54, establishes an income annuity. He receives monthly payments, including interest and return of principal. The interest earnings are subject to ordinary income tax but are not subject to the additional 10% penalty tax for early withdrawal.

Possible Risks

• Investing in an income annuity and a long-term deferred annuity exposes the investor to interest rate risks. If, for example, three years after the annuities are funded the e current interest rates go higher, the investor will be locked in to the lower interest rates.
• If an insurance company becomes insolvent, some or all of the benefits of an annuity contract may be at risk. Insurance is regulated by the states and most states have reserve requirements that need to be met by each insurance company before the insurance company can do business in the state. The reserve requirements offer an assurance to the insurance commissioners that the insurance company can perform on the guarantees offered in their contracts. In addition, most states have guaranty associations that require the insurance companies to pay into. The purpose of the guaranty associations is to provide for the administration of an insurance company’s guaranteed benefits in the event the insurance company becomes insolvent. State guaranty associations limit the amount of protection for each investor. For example, one state may limit the guaranty association protection for an annuity at $100,000 per investor for a particular insurance company. Depending on the amount the investor is using to fund a split-funded annuity arrangement, an investor may want to consider using multiple insurance companies to provide the income and deferred annuity guarantees.
• A life annuity offers the investor a guaranteed payout over the investor’s life. If an investor chooses a life annuity instead of a period-certain annuity, a risk exists that the investor would die before the payouts would have returned the principal amount. For example, if the investor invests $100,000 in a life annuity and dies the next day, no money will have been paid out. In contrast, with a 10-year certain annuity, the investor’s beneficiaries would receive payments for 10 years if the investor dies the day after selecting the annuity option.
• The payments made to the investor from an income annuity are referred to as interest plus return of principal. This is conceptual only as the principal no longer exists. Technically, what occurs in an income annuity is that the investor purchases an annuity contract with the principal amount. The contract is then annuitized, or sold back to the insurance company, in return for a guaranteed income stream. Once the contract is annuitized, the principal no longer exists and there is no access for the investor to any amount of money other than the monthly income stream.
• Split-funding an annuity requires commitment. Once an annuity contract is annuitized, an investor cannot change his or her mind. A deferred annuity strategy only works if the investor commits to the term of the annuity. Withdrawals of interest and principal will deplete the value of the deferred annuity.
• Withdrawals from a deferred annuity are taxable and may be subject to the additional 10% tax is withdrawn before age 59 ½.
• Insurance companies can generally offer a slightly better rate for longer term investments because they know the money will be locked in to the investment for a longer period of time. If the investor withdraws money before the deferred period, the annuity contract may be subject to surrender charges. In addition, in order to guarantee a certain interest rate, insurance companies will invest the money internally over a long period of time. Amounts withdrawn may be subject to market value adjustments (MVA). The MVA represents the change in interest rate from the original invested amount to the then-current interest rate at the time of withdrawal. An increase in the interest rate will cause the MVA to reduce the net amount available for the investor to withdraw.

• An investor may be tempted to split the deferred annuity after the original income annuity is depleted. This can be done; however, the tax situation will be much different than the original split. In our example, Penelope invested $150,000 in the deferred annuity. If, after 10 years, she splits the $220,000 principal balance, each annuity will receive a pro-rata basis of the original deferred annuity. This will result in the new income annuity generating higher interest amounts than the first income annuity generated.
• Investors can select a variable annuity instead of a fixed annuity to fund the deferred annuity. With this selection, comes the additional risk of market fluctuations within the sub accounts of the variable annuity.
• For income annuities that begin the income payout later than one year after the annuity is funded, distributions before age 59 ½ are subject to the 10% additional penalty tax.