I recently met with a potential new client to discuss their retirement situation. Basically, the gentleman is in his late sixties, divorced and is not worried about leaving an inheritance. He came to me after attending one of those dinners where they talk about annuities and he wanted a second opinion. He was considering taking his 401K money which is the bulk of his portfolio, to buy an immediate annuity and then take a much smaller part of the portfolio, the money outside his retirement accounts, and invest that for long-term growth. He figured with the annuity distribution and his social security he would barely be able to cover his expenses. He would then invest his non-retirement money to provide for future needs. As he mentioned, he is very conservative and he liked the idea of guaranteed income. His first question to me was what I thought of his game plan.

As I reviewed his numbers and calculations, I mentioned to him that there was one glaring mistake he failed to take into consideration and that was taxes. As I mentioned that to him, he immediately said he was under the belief that an annuity was tax free. Unfortunately, I had to burst his bubble and tell him that the annuity was not tax free and that 100% of the money he received from the annuity would be subject to ordinary income tax. At that point in time I could tell he had a total misunderstanding of the taxation of annuities. Whether he misunderstood what someone told him about the taxation of annuities or someone out and out lied to him, the bottom line is that there is a tax consequence to annuities and its important to understand them before purchasing one.

The annuity the gentleman was buying was an immediate annuity which in his situation meant that the insurance company would guarantee him a set amount of money per year for the rest of his life. In his situation, he was receiving approximately $4,000 a month from the annuity and I explained to him that the entire $4,000 would be taxable to him. The reasoning is that the annuity was being purchased with the money from his 401K. When you purchase an annuity with pre-taxed money, the entire distribution is taxed to you. Therefore, since he was purchasing the money with pre-taxed money, 100% of the distribution is taxed. On the other hand, if you purchased an immediate annuity with post-tax money, money outside a 401K or an IRA, the taxation is somewhat different. In those situations, a portion of the money you receive is not taxed and is considered a return of principal while other monies are considered income and that is taxed to you. The calculation to determine what portion is taxable and what portion is not is relatively simple. The return of principal portion is your original investment divided by your life expectancy as determined by IRS tables. For example, if he invested $500,000 of post-tax money into the annuity and according to the IRS tables, life expectancy was twenty years, the return of principal portion, which is not taxes, would be $25,000 per year ($500,000 divided by 20). Therefore, if he received $48,000 in IRA distributions, $25,000 would be considered return of principal and $23,000 would be taxable income.

Taxation of immediate annuities is different than the taxation on deferred annuities. In a deferred annuity where you are not taking any income distribution, the money grows on a tax-deferred basis. There are no taxes until you begin taking distributions. If someone took $500,000 and purchased a tax-deferred annuity with post tax, non-retirement money and that money grew to $600,000, if at that point in time he closed out the annuity and took a distribution of $600,000, $500,000 would be considered return of principal and $100,000 would be subject to tax. On the other hand, if he did not close out the annuity in its entirety but took distributions, the first distribution would be considered the income portion and thus taxed. Once the income has been totally distributed, the remaining amount would be tax free as it is considered a return of principal.

Immediate annuities are not for everyone; however, it can play a part in someone’s retirement portfolio. Particularly if you are someone who does not have a pension and are looking for a guaranteed monthly distribution, an immediate annuity may fit the bill. That being said, it is important to remember that if you are going the immediate annuity route, the annuity is irrevocable and, therefore, before you invest the money, you have to make sure it fits your needs. In addition, it certainly pays to shop immediate annuities around. Different insurance companies have different rates and terms and it is important to get a competitive bid.

Good luck!

If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com.