Last month this space was devoted to the benefits and drawbacks of using immediate annuities for retiring clients. My well-reasoned and humble conclusion was that the lure of “income you can't outlive” has to be balanced against the finality of locking your money up in an annuity.
This month, my column is focused on the tax benefits of the immediate annuity for retirees. As I noted last month, the best feature of immediate annuities is probably also the one least familiar to you and your clients. Thanks to a quirk in the tax code, using an immediate annuity may give your clients both higher income and lower taxes — catapulting the after-tax return on an immediate annuity well beyond what is offered by other conservative fixed-income investments.
The Tax Loophole
The key to getting lower taxes on higher income from immediate annuities is known as the “exclusion ratio.” When you place nonqualified client dollars into a single-premium immediate annuity, your client will receive checks based on the client's age, gender and amount of initial deposit, among other factors.
A portion of those payments will be taxed as ordinary income. But the remaining portion of each payment is considered return of principal and, therefore, is not taxed. This exclusion ratio is determined by the same factors that decide how much gross income the immediate annuity will generate and will be spelled out in the initial quote you receive from the insurance company.
One thing to note: Immediate annuities can be used for both qualified (i.e., an IRA) and nonqualified assets. But since the annuitized payments coming out of an IRA are fully taxable, your client will only receive the benefit of the exclusion ratio by using nonqualified assets to purchase an immediate annuity.
How big can the exclusion ratio be? Using last month's hypothetical example of a 65-year-old Florida man with $100,000 to put aside, a quote request returned a monthly payment of $706 for the client's life. In this man's particular situation, almost 60 percent of that payment (about $416) would be deemed to be principal returned and not subject to taxation.
More Dollars, Fewer Taxes
Getting such a large chunk excluded from taxes sounds pretty good and looks even better when you compare it to the alternatives. Last month we detailed the estimated annual income the gentleman cited above would likely get from investing $100,000 in a U.S. Treasury note, a municipal bond or an immediate life annuity from a major provider:
| Investment | Yield | Annual income |
|---|---|---|
| 20-year Treasury | 4.70% | $4,700 |
| 20-year AAA muni bond | 4.22% | $4,220 |
| Immediate annuity | NA | $8,472** |
| Source: Bloomberg **Source: www.immediateannuities.com | ||
Let's say your hypothetical client is in the 25 percent federal tax bracket (for 2006, this bracket applies to taxable income between $30,650 and $74,200 for single filers, and between $61,300 and $123,700 for married filing jointly). Here is the gross and after-tax income he would get from each of the investments mentioned above:
| Annual income | After-tax income | Investment |
|---|---|---|
| 20-year Treasury | $4,700 | $3,525 |
| 20-year AAA muni bond | $4,220 | $4,220 |
| Immediate annuity | $8,472 | $7,604 |
| (With $5,000 of income from the immediate annuity falling under the tax-free portion of the exclusion ratio.) | ||
Avoiding an Insidious Tax
But there is one more benefit to income from immediate annuities when compared to the options cited above: It reduces the amount of Social Security income that will be taxed. If your clients are collecting Social Security, income from other sources may cause their benefits to be taxable. The formula goes like this:
- One-half of the Social Security benefits
- Plus adjusted gross income
- Plus tax-free bond interest
If the final number falls into these categories, here's how much Social Security will be taxed:
| Filing status | Security formula result | % of Social subject to taxation |
|---|---|---|
| Single | $25,000 to $34,000 | 50% |
| Single | Over $34,000 | 85% |
| Joint | $32,000 to $44,000 | 50% |
| Joint | Over $44,000 | 85% |
Keen-eyed advisors will note that in the hypothetical example above, the Treasury bond kicks $4,700 into the formula and the municipal bond adds $4,220. But because of the exclusion ratio, the immediate annuity only puts $3,472 into the equation.
In other words, your client would get more income from the annuity, but pay less in taxes than he would with a traditional taxable fixed-income investment. And he will be less likely to pay taxes on Social Security benefits than he would with either a tax-free or a taxable bond. That's an arrangement that will make your client want to celebrate “Advisor Appreciation Day” 13 times a year — once each month when the check arrives and also on April 15.
Next month, in the final installment of the “Immediate Annuities — What to Love and What to Be Leery of” trilogy, we'll cover how you can use these vehicles to reduce the taxation on withdrawals from highly-appreciated variable annuities and the ethics and implications of using immediate annuities to help clients qualify for subsidized nursing home care.
Writer's BIO: Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com
Prime Candidates for Immediate Annuities
Although each client is unique, these are the characteristics of those more apt to opt for an immediate annuity:
- No heirs
Or, at least, no concern over the heirs' financial well-being. If a client is anxious about her payment stream expiring when she does, consider going with “period certain” instead of the life option or choose a combination of the two.
- Long life expectancy
If you and your client are choosing the “life” payment option, good health and better genes will increase the client's odds of beating the actuaries' estimates of her future date of death.
- Other assets to tap
Locking up all of a client's money in a pretty-much irrevocable immediate annuity could dry up her liquidity. Better to use just a portion of the available funds, and also consider opening a home-equity line of credit as an extra safety net.
- A big number on line 8a of the 1040
Dial up the client's tax advisor to see if income falling under the immediate annuity's exclusion ratio will put her in a lower tax bracket — or, better yet, reduce the likelihood of paying income taxes on her Social Security benefits.
- Investors with bond mutual funds
Especially if they are using these types of funds to generate income. If interest rates rise, they may face the unpleasant prospect of rapidly declining net asset values. If rates fall, the clients could see a corresponding drop in the funds' income distributions.