Annuities Part II:  The Distribution Phase

by Glenn J. Downing, MBA, CFP®

As I noted in Part I, an annuity is a complex financial animal.  It can be used as a tool to accumulate funds on a tax-advantaged basis.  It can also be used efficiently to distribute funds in later years, which is my focus here in Part II.   

A Stream of Payments I Cannot Outlive

This is the very definition of the word annuity.  If I want that stream of payments, I can either purchase it from the annuity company, or I can annuitize an annuity contract I already have.  In either case I make an irrevocable choice to turn over control of my principal to the annuity company in exchange for this stream of payments. 

Annuitize the Contract

What’s the Risk? 

That I annuitize a lot of money, get hit by a bus, and the annuity company keeps the remainder.  That is called the single life option, which yields the highest payout.  To mitigate against this risk, I chose a payout option:

• Joint and survivor. This option would pay a fixed amount out to both me and my spouse over our joint lives.  Any money remaining at the second death is lost to the annuity company.
• A refund annuity. In this case, any remaining funds in the contract at the death of the annuitant is paid out to a beneficiary.  This can be a lump sum, or as an installment refund – meaning the payments continue on the annuitant’s schedule, but to the beneficiary, until all the funds are paid out.
• A period certain annuity. The contract will pay out for, say, 20 years, whether to me or to my beneficiary.  I would set the number of years to assure that the entire principal is paid out. 

Another risk is interest rate risk.  Say I annuitized a sum of money now.  The annuity company will look at my life expectancy and the current interest rate environment to give me a quote.  What would happen in, say, 5 years when current money rates might be up 5%?  Nothing will happen; that’s the point.  You will be paid out according to your contract.  Someone purchasing a new contract with the same assumptions as yours might indeed have a higher payout. 

 What are the taxation issues?

•  With a contract that is annuitized, each payment is part return of original (after-tax) principal paid into the contract, and part investment gain. The taxable gain is calculated using an exclusion ratio.  That is the original principal in the contract divided by the total dollar amount to be paid out.  So if, say, the exclusion ratio is 80%, only 20% of each payment will be taxable.  Since there is not a lot of gain there, I can see that this must not be a very old contract.  Once the annuitant has outlived his life expectancy, the total amount of each payment is taxable. 
• All taxation is ordinary income – not capital gains. See my previous blog post on ordinary income vs. taxable gains taxation. 
• In certain cases annuitizing a contract can help preserve Social Security from Taxation. In an annuitized contract, only the taxable portion of the payment is included in the provisional income formula. 

 Withdraw Money as you Need It

 Many people are uncomfortable with the irrevocably giving up control of a lump sum of money.  Instead, they simply draw money out of the contract as needed.  This can be done occasionally, or on a periodic basis.  An annuity is not an investment account, however:  each non-periodic withdrawal will require a form to be submitted to the annuity company, and it can be several weeks before you see your funds. 

What are the Taxation Issues?

The taxation is different here:  no exclusion ratio.  The contract distributes all the gain first, fully taxable, and then the basis.  For example, you have a contract worth $100,000.  You’ve paid in $64,000 and have $36,000 gain in the contract.  You decide to take $1000 monthly distributions.  You will have 36 fully taxable $1000 payments (just to make the math easy, assuming no further earnings).  With the 36^th payment all the gain in the contract is distributed, so all remaining payments are free of taxation. 

What Happens When I Die? 

The annuity contact passes to your named beneficiary.  There is no step-up in basis, however.  An annuity contract is not capital gains-type property, so there is no step up.  Your beneficiary will inherit not only the contract value but also your basis, and will therefore have an immediate tax issue. 

This is sort of a high-class problem, as I see it.  If dad wants to leave a sum of money set apart for a child, an annuity is a good place to put it – dad won’t have to pay any taxes on the gains.  In this case the child who inherits the contract will pay the taxes.  This is a very different tax situation from the investment account that dad opens, registered as a Transfer on Death to the Child.  In this case dad will pay the taxes on the gains.  These can be minimized by investing in non-dividend paying investments that would produce a lot of ordinary income, and by holding investments.  If there are no sales, then no gains are realized, and the whole account value gets stepped up at dad’s death.  Once again, this is another big trade-off. 

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