Q.: Dan, the recent statement for my nonqualified annuity shows opening value $100,161.67, purchase payments since 6/2010 $117,374.92, and cash surrender value of $203,781.44. I want to get rid of this annuity but stay within current tax bracket 24%. How can I accomplish this? What are my options? Any suggestions?
Thanks for your help on this matter,
A.: Mary, the key number for assessing tax liability is “basis” which is basically the after-tax money in the account. Though they are often the same, the basis can be different than “purchase payments.” The fact that this contract has a purchase payment amount that is not a nice round number makes me suspect that the basis may be different. The annuity company should have basis information but if not, there are ways to hunt it down.
You have many options to get rid of the annuity, but today I’ll only cover a few of the more common ones selected.
First, a brief explanation of the taxation of distributions from a nonqualified annuity is in order.
To make the numbers easy to follow, say the basis is $50,000 and the value is $200,000. This means $50,000 was taxed before being deposited in the account and will be nontaxable basis when removed. The other $150,000 is earnings. If you simply surrender the contract, you will get a check for $200,000 of which the $150,000 of earnings is taxed as ordinary income.
If you only take say $25,000 out to stay in the tax bracket you are targeting, all $25,000 is deemed to be earnings and is taxable. You would then have a $175,000 contract with the same basis of $50,000. Any withdrawal you take is always deemed earnings until there are no more earnings in the contract. At that time the basis can come out and is not taxed.
So, if $25,000 was the amount that kept your income at the level you want, it would take you 6 years to distribute all the earnings, assuming the contract does not earn or lose any value during that time.
If you will take the funds out over time, one option to consider if you do not like the contract you own is to transfer the funds to a new annuity via a “1035 exchange.” You incur no taxes on such an exchange. An exchange won’t solve your tax issue or change the basis, but it could help if you don’t like the current product.
You should be aware of any surrender fees on the current and any new contract if you exchange. Twenty years ago, most annuities had high surrender fees that applied for many years. These days there are many contracts that do not impose surrender fees and are very low cost.
There are not many ways around the taxes. You could pass the taxes at your death to someone else by naming them beneficiary. The obvious downsides to that are you must die for the money to transfer to them and you don’t get to use the funds in the interim. Nonetheless, for some this is OK because they don’t need the money to live off and they are leaving the money to someone in a lower tax bracket or to charity (zero tax bracket). There is no ability to directly gift the earnings during your lifetime without the earnings becoming taxable income to you first.
You could exchange this annuity into an annuity/long-term care combination product. This will make the earnings nontaxable if used for certain long term care expenses. An obvious downside here is you must decline to the point you need that kind of care. Nonetheless, if paying for LTC is a concern, this pot of money might work as a set aside to cover those costs. You should not expect these combo annuities to grow much in value due to the costs of the underlying LTC insurance built into the contract. Annuity contracts can be complex, so it is important to work with a specialist.
Lastly, you could “annuitize” the contract. This is basically changing the contract from a pot of money into a contractually obligated income stream for a specified period or your lifetime. This will not avoid the taxes but will spread the taxable income out over a longer period. I’m running long so I’ll save more explanation on annuitization for another time.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.