As Americans live longer in retirement — often for several decades — it becomes more challenging to plan for a consistently high standard of living. In addition to maintaining retirement income, you may also want to pass on some wealth to your family. To achieve both of these goals, consider a split annuity.
First, you need to understand what an annuity is. This tax-advantaged investment contract is usually offered by insurance companies and other financial services providers. You pay either a lump sum or annual premiums, and, in exchange, the provider makes periodic payments to you for a term of years or for life. For purposes of the split annuity strategy discussed below, we will focus on “fixed” annuities, which generally provide a guaranteed minimum rate of return. Other types of annuities include “variable” and “equity-indexed,” which may offer greater upside potential but also involve greater risk.
Annuities can be immediate or deferred. As the names suggest, with an immediate annuity, payouts begin right away, while a deferred annuity is designed to begin payouts at a specified date in the future. From a tax perspective, annuity earnings are tax-deferred — that is, they grow tax-free until they are paid out or withdrawn. A portion of each payment is subject to ordinary income taxes, and a portion is treated as a tax-free return of principal (premiums). The ability to accumulate earnings on a tax-deferred basis allows deferred annuities to grow more quickly than comparable taxable accounts, which helps make up for their usually modest interest rates.
Annuities offer some flexibility to withdraw or reallocate the funds should your circumstances change. But keep in mind that — depending on how much you withdraw and when — you may be subject to early withdrawal or surrender charges. Most annuities provide some exceptions to these charges under certain circumstances, such as withdrawals attributable to disability, loss of employment, or death of the annuity owner. Withdrawals before age 59 1/2 may also be subject to 10% tax penalties.
Two Annuities, One Investment
A “split annuity” may sound like a single product, but in fact it simply refers to two (or more) annuities, usually funded with a single investment. In a typical split annuity strategy, you use a portion of the funds to purchase an immediate annuity that makes fixed payments to you for a specified term (for example, 10 years) and apply the remaining funds to a deferred annuity that begins paying out at the end of the initial annuity period.
Ideally, at the end of the immediate annuity term, the deferred annuity will have accumulated enough earnings so that its value is equal to your original investment. In other words, if the split annuity is designed properly, you will enjoy a fixed income stream for a term of years while preserving your principal.
At this point, you can reevaluate your options:
- Start receiving payments from the deferred annuity
- Withdraw some or all its cash value
- Reinvest the funds in another split annuity or another investment vehicle
Deferred annuities often allow you to withdraw some of their cash value penalty-free. But depending on how much you withdraw or reinvest, you may be subject to early withdrawal penalties or surrender charges.
Meeting Dual Needs
You do not need to sink all of your retirement savings into a split annuity — nor is it recommended. After all, other retirement and estate planning vehicles generally offer better rates of return and lower costs. However, a split annuity can meet multiple needs with one package. Contact us for more information.
© Copyright 2022 Thomson Reuters.
Disclaimer of Liability
Our firm provides the information in this article for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this blog are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.