Would you like to be certain not to outlive your money AND make sure you leave something for your children or grand children. The answer is…..partial annuitization. It is a method of using your retirement financial resources to make your money last longer. So if you are concerned about not outliving your retirement savings, this post is for you.
Partial Annuitization is the Middle Road
Let’s consider Mr. Jones whose desire is to leave as much money as possible to his heirs. He lives very frugally so as not to use any of his principal. This strategy allows him to leave his retirement principal to his family. He sacrifices lifestyle today to leave a larger inheritance to heirs.
Now let’s consider Mr. Smith who is just the opposite. He has no heirs. He wants to have a great retirement and enjoy himself as much as possible. His desire is to spend his last dollar on the day he dies. He can accomplish that by annuitizing his entire retirement nest egg. He can simply by one or more lifetime annuities from insurance companies. For a single deposit, those companies will pay him a guaranteed monthly income for life, as long as he lives. He cannot outlive his money.
But what if you are not quite like Mr. Jones and not quite like Mr. Smith. You like the idea of having a second lifetime income, in addition to your Social Security, but you would like to leave something to your children. The answer to achieving this middle road is partial annuitization. Let’s take a look.
Partial annuitization is done by allocating some of your retirement nest egg to lifetime annuities and the rest of your nest egg to assets such as real estate, mutual funds, or stocks that you can pass on. The portion that you annuitize to receive a lifetime income also has some attractive tax advantages as you will learn.
An even simpler alternative for a conservative investor is to have all of their retirement nest egg in guaranteed annuities but choose to annuitize only some of the principal. The remainder will go to heirs. Let’s take a look.
Mechanics of Partial Annuitization
If you already own an annuity, many annuity companies will allow you to annuitize just a part of it. Even if you have only owned the annuity one year, insurance companies waive the surrender charge for early withdrawals when your withdrawals are by way of annuitization. In such a case, you could, as an example, annuitize $50,000 of a $100,000 annuity and allow the reminder to grow.
If you don;t already own an annuity, you could use the same mechanics as described in the previous paragraph or you could split your funds between an immediate annuity for payments now and a deferred annuity, for payments later.
Having two annuity contracts gives you a little more flexibility. if you need more income in the future, you could choose to annuitize or all part of the fixed annuity.
Partial annuitization also helps overcome the irrational resistance some people have to full annuitization as uncovered in this research
Tax Advantages of Partial Annuitization
Let’s take a look a the type of annuity that most investors own: fixed deferred annuities. These annuities are typical purchased when the investor is planning for retirement, say at age 50 – 60. The funds grow each year as interest is added. All of the reinvested interest is tax deferred so nothing is reported on the tax return.
For many such fixed annuity investors, it can be difficult to maximize income while minimizing annuity taxation. Here’s why. While fixed annuities do provide safety and higher rates than most other types of guaranteed investments, the tax on annuity withdrawals is ordinary income tax and therefore subject to the highest rates (up to 39.6% federal, currently). For example, if an annuity holder is in the 28% tax bracket, then a $100,000 fixed annuity paying 5% will result in $5,000 a year in taxable interest income and 28% of $5,000 comes to $1,400 of annuity tax. Therefore, the taxpayer will only receive $3,600 of after-tax income.
For example, if an annuity holder is in the 28% tax bracket, then a $100,000 fixed annuity paying 5% will result in $5,000 a year in taxable interest income and 28% of $5,000 comes to $1,400 of annuity tax. Therefore, the taxpayer will only receive $3,600 of after-tax income.
One possible alternative to this dilemma could be to annuitize a portion of the annuity contract and let the remainder continue to grow tax-deferred, thereby taking advantage of favorable rules for the annuity tax. This concept is similar to the ‘split annuity’ strategy, except that it can be achieved within a single contract (assuming that the annuity company will permit it). Of course, you may be more comfortable having several annuity contracts with different companies, and that is also fine.
In the case of owning several annuities, you allow some of them to grow indefinitely for heirs, like Mr. Jones, and the others you annuitize for lifetime income to enjoy, like Mr. Smith.
But what if you already have a significant chunk of your retirement assets in a deferred annuity you purchased in the past? You can use partial annuitization.
For example, the owner of a $100,000 contract paying 5% interest could annuitize $30,000 of the balance and let the remaining $70,000 grow tax-deferred. The annuity exclusion ratio would then be applied to the $30,000 annuitized portion, thus allowing for each payment to contain a partial tax-free return of principal. The contract owner will receive approximately the same level of income as before, but with a much lower tax bill. Meanwhile, the remaining $70,000 (the portion that is not annuitized) will grow, tax-deferred, to approximately $90,000 in five years, thus replenishing the contract value from within.
This $90,000 could be left to heirs or could annuitize any portion of that in the future for your own benefit.
Of course, several factors will enter into whether employing this principle is a viable strategy for you to reduce annuity tax, such as your level of income, tax bracket and whether you itemize deductions. Another factor to consider is whether your current fixed annuity contract will allow for partial annuitization, as some insurance carriers do not. If this is the case, then you will need to move the proceeds from your current annuity to a contract with another carrier that offers partial annuitization via a 1035 tax-free exchange.
Note that there are other strategies to reduce annuity tax that have to do with timing. For example, you can choose to take distributions from your annuity, which as explained are taxed at ordinary income rates, but do so only on years when your other income is low. Low income means low or no taxes making these low-income years the best years to make annuity withdrawals and pay little or no annuity tax.
Such a scenario might occur if you own a business. You encounter a period when business is bad and you have a loss. In that year, it is a good idea to take distributions from a fixed annuity (if you need the money). You will be in a lower tax bracket and thus pay a lower ordinary income rate on the distribution.
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