Taking The Sting Out Of Annuity Taxes

Your client is sitting on a pile of money in a deferred annuity, and now wants to limit the income tax damage upon withdrawal. What are the options?

Based on IRS rules, an annuity policyholder owes taxes on the earnings upon withdrawal, at personal income rates (not the more generous dividend of capital gains rates) but not on the principal. Generally, the taxable earnings must be distributed first.

This means that a policyholder, who invested $100,000 in a variable tax-deferred annuity and saw it grow to $150,000, would owe income taxes on the first $50,000 withdrawn.

 There is a way around the tax mess, suggests Graydon Coghlan, president of CFG Wealth Management, La Jolla, Calif.

You can use what the IRS calls 1035 tax-free exchange, largely aimed at letting policyholders move money from one deferred annuity to another tax-free. Or a partial exchange can be made from a deferred to an immediate annuity, according to the Insured Retirement Institute, Washington, D.C.

Tax experts cite recent IRS regulatory guidance (IRS Revenue Procedure 2011-38, covering partial exchanges) as the basis for suggesting this two-step process could lessen the tax blow.

According to the newsletter Tax and Business Alert, published by Thomson Reuters, the strategy works like this: First, the client makes a partial withdrawal from the original annuity by completing a partial 1035 exchange into another annuity with another provider. Next, he or she surrenders either annuity contract at least 180 days later.  

Be advised, however, that the new annuity from the 1035 exchange likely will have back-end surrender charges. So the older annuity probably is best surrendered first. 

Here’s an example: Say a policyholder’s $50,000 initial investment in a variable annuity has grown to $200,000. If the policyholder withdrew $100,000, he or she would owe income taxes on $100,000 since annuity gains are taxed first.   

However, with the 1035 exchange, the client instead could put half of that $200,000 into a new annuity with another provider via the 1035 tax-free exchange. As a result, the policyholder’s original $50,000 principal or tax basis is split proportionately, $25,000 in each.

Now, say the policyholder surrenders the annuity with no back-end surrender charge more than 180 days after the 1035 tax free exchange: This gives the policyholder a distribution of $100,000. But of that, only $75,000 rather than $100,000 is taxable as ordinary income. Reason: Thanks to the tax basis split between two annuities, another $25,000 is considered the tax-free return of the principal or tax basis.

A few words to the wise: Be sure your client is older than 59 ½. Otherwise the policyholder pays an early withdrawal penalty of 10% in addition to the ordinary income taxes on distributions. Alsoa policyholder can’t do the partial 1035 exchange with the same insurance company. Otherwise, the IRS considers it one contract and the client pays taxes on the full amount withdrawn.

This strategy works for those that have a large sum in an annuity,” says Coghlan.

Other options to curb annuity taxes:

• Many fixed-interest deferred annuities let policyholders withdraw 10% of their principal each year tax-free.
• You could roll a client’s entire maturing annuity into a new one via a 1035 tax-free exchange to postpone the tax bill.
• There is a spousal rule that may allow the surviving spouse of a deceased policyholder to continue the annuity contract as the new owner. If no money is withdrawn, there is no tax penalty. This rule, however, is limited to spouses, not to other relatives or business partners.
• A deferred variable annuity policyholder could take regular withdrawals from the mutual funds for monthly income. This can stretch out the tax bill over the years.
• Those nearing retirement could annuitize the contract and get insurance company guaranteed lifetime monthly income. They would pay taxes based on the IRS exclusion ratio, which results in about 50% to 60% of the income taxed as earnings. The rest is considered return of principal. But be advised at today’s low interest rates, a 65 year-old would get about $550 in lifetime monthly income on a $100,000 investment.  A few years ago, when rates were higher, the policyholder could have received $650 monthly for life.