Do you own any investments that offer all of the following five benefits?:
- Guaranteed lifetime income payment beginning at a future date chosen by you
- Return of your investment if you die before income start date
- Income payments can be insured for a specified number of years or until original investment has been returned
- Nontaxable until income start date
- 25% to 65% of each income payment excluded from taxation
There’s only one type of investment that offers all five advantages – a nonqualified, or nonretirement, deferred income annuity, or DIA. The first four benefits, which are individually and collectively very attractive as part of a retirement income planning strategy, are also provided by qualified, or retirement plan, DIAs. Unlike nonqualified DIAs, however, qualified DIA income distributions, including those from qualified longevity annuity contracts, or QLACs, are fully taxable.
Deferred Income Annuities vs. Single Premium Immediate Annuities
Benefit #5, exclusion of a portion of each income payment from taxation, is provided by nonqualified single premium immediate annuities (SPIAs) as well as DIAs. SPIAs can be an appropriate retirement income planning solution if you’re about to retire or are already retired and have an immediate need for sustainable lifetime income. With a SPIA, income distributions begin one month after purchase assuming a monthly periodic payment and no later than one year after purchase if you opt for annual payments.
Although they aren’t as prevalent in the marketplace, DIAs are a more appropriate retirement income planning strategy than SPIAs in most situations due to their deferred income start date. Whether you’re 40 years old and won’t be retiring for 25 years or you’re 65 and want to defer your income start date for five or more years, one or more DIAs can meet your need. Deferral of your income start date increases the amount of your periodic income payment since the insurance company will be making payments to you for a shorter period of time.
Exclusion of Portion of Each Income Payment from Taxation
DIAs and SPIAs offer a unique income tax advantage when they’re purchased as a nonqualified asset vs. inside a retirement plan. A portion of each income payment, generally in the range of 25% to 65%, is excluded from taxation.
How does this work? When you receive income payments from an annuity, in addition to earnings, you’re receiving a return of your premium, or investment. Any time that you receive a return of a nonqualified investment, this is considered to be your cost, or basis, and is nontaxable.
The amount of your income payment that’s nontaxable is determined using an “exclusion ratio.” This is calculated by dividing the investment in the annuity contract by the total expected lifetime payments in the case of a lifetime DIA. The latter is an actuarial calculation based on the life expectancy of you and a joint annuitant if applicable.
As an example, let’s say that you invest $100,000 in a lifetime DIA and your expected lifetime payments are $150,000. 66.7 percent ($100,000 divided by $150,000) of each payment will be tax-free until you receive $100,000. Once your payments total $100,000, 100% of each of your additional payments will be fully taxable.
Taxable Amount Determined by Purchase and Income Starting Ages
How is the taxable portion of each nonqualified DIA or SPIA payment determined? The younger you are when you purchase your DIA or SPIA and the longer you defer your income starting age in the case of a DIA, the greater the taxable percentage of each payment. Although, as stated earlier, you will increase the amount of each of your income payments with a DIA the longer you defer your income start date, you will also increase the taxable percentage.
The best way to illustrate this is with an example. Using actual payouts from a highly-rated life insurance company’s current lifetime deferred income annuity offering, the following is a table showing the taxable percentage of each monthly income payment assuming the following eight parameters:
- Male and female joint annuitants.
- Male is three years older than female.
- Male purchase age varies in increments of five years from 45 to 60.
- Female purchase age varies in increments of five years from 42 to 57.
- Male income starting age varies in increments of five years from 65 to 75.
- 100% of income continues upon death of first annuitant.
- Return of premium in the event of the death of both individuals prior to the income payout starting date whereby beneficiaries will receive 100% of the original investment.
- 10-year certain payout in the event that both individuals die after payments begin and before 10 years of payments have been distributed. The annuitants’ beneficiaries would continue to receive payments for the remainder of the 10 years.
|Nonqualified Lifetime Deferred Income Annuity|
|TAXABLE INCOME PERCENTAGE|
|Male and Female Annuitants With Return of Premium and 10-Year Certain|
|Purchase Age||Male Income Starting Age|
Per the table, the taxable portion of each payment ranges from 38.3% to 73.7% (26.3% to 61.7% is nontaxable) depending upon purchase and income starting ages. Assuming an investment of $100,000, the monthly lifetime income payments range from $510 assuming a male purchase age of 60 and male income starting age of 65 to $1,707 assuming a male purchase age of 45 and male income starting age of 75. The annual lifetime and taxable payment amounts would be as follows for these two extremes:
Male purchase age of 60 and male income starting age of 65:
Total annual payments: $6,117
Total taxable annual payments: $2,343 (38.3% x $6,117)
Male purchase age of 45 and male income starting age of 75:
Total annual payments: $20,487
Total taxable annual payments: $15,099 (73.7% x $20,487)
Unique Tax-Favored Sustainable Income Strategy
If you have a sustainable income need and it isn’t immediate, one or more nonqualified deferred income annuities, or DIAs, can provide a unique tax-favored solution. While this post addresses lifetime DIAs, you can also purchase term, or period certain, DIAs that provide income streams for a specified number of months or years. This is a more sophisticated strategy that can be used to meet projected changing retirement income needs in different stages of retirement.
Finally, an inflation factor can be applied to DIA and SPIA income payments that will increase the amount of each payment each year. This will, however, reduce the initial payment amount accordingly.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.