How to Turn an Annuity Policy into Monthly Income

Strategies & Trends

Tax & Estate

Issues

How to Turn an Annuity Policy into Monthly Income

by Richard W. Duff, J.D., CLU

F inancially successful people tend to bf intrigued by tbe investment possibilities i)t payout annuities. 1 he idea ofan income "you can't outlive" is particularly attractive at a time when people are concerned about Social Security going bankrupt. According to surveys, most policyholders intend to convert their accumulation contracts to income later on.

In this article, the first in a series of three on payout annuities, 1 will compare tbcm with some alternative asset liquidation arrangements. You'll learn how annuity rates of return are improved when the payee lives longer than anticipated. In the second installment, I'll explain how to calculate IRS exclusion ratios and how these are affected by deaths before and after an annuitant's expected lifespan. Finally, in the third article, ['11 describe some circumstance.s where payout annuities are especially useful in the financial plan.' Let's imagine Harry Jensen, age 65, comes to you for advice. He is a successful, optimistic investor who pays close attention to the numbers. He has inherited $IOO,()O() in cash and equities, and wants you to recommend an optimum cash flow program for him and his family. You prepare the following cash flow and financial analysis for Harry Jensen.

Cash Income Versus Gradual Liquidation o f Safe'Capital For a Specific Period

If you invest $l()(),0()0 in so-called "safe"

44The idea ofan income "you can't outlive" is particularly attractive at a time when people are concerned about Social Security going bankrupt.

investments (CDs, Treasuries ami high grade bonds), you'll probably earn at least six percent annually--about $485 a month. You will have full access to the principal, and receive $5,820 annually over your 20-year IRS life expectancy--a total payout of $116,400.

If you want to maximize cash flow, however, a capital liquidation program offers some interesting possibilities. Let's say, for instance, that you systematically liquidate that $ 100,{)00 over a 20-) ear period. Then, your income will come from both principal and interest. Assuming six percent is consistently earned on the unpaid balance, your monthly payment will be about $700. You'll receive $8,400 each year over a 20-year period for a total payout of $168,000.

Here are the disadvantages. If \'ou outlive the 20-year period, all payments will cease and your capital will be gone. You"ll probably have less aece.ss to principal in the event of emergencies. The liquidation plan is taxed as a "debt repayment program"--primarily an agreement to pay interest--where most of your first year's payment is taxable income. Gradually, most of each payment becomes tax-free principal, and in the last year virtually all

the payment i.s tax-free. And any plan that gradually amortizes a sum of capital requires some extra time ;IIR1 iniinaijement---perhaps more trouble than it s worth.

Cash Income Versus Gradual Liquidation o f Equity'Capital For a Specific Period

If you invest $100,000 in equities, such as a mutual fund withdrawal plan, a higher assumed liquidation rate of return may be possible. For example, if a reasonable rate is 12 percent annuall), you can anticipate a $1,100 average monthly payment-- $1 3.100 each year over a 20-ycar period for a total payout of $262,000. I lere's an added benefit: Some of the taxable portion may be taxed as a long-term capital gain instead of ordinarj' income.

On the downside, you'll be taxed heavily in the early years. Here, too. you'll only have limited access to your money and will liquidate the original capital after 20 years. I here's also more risk, as is generally the case when the goal is stock market-like returns.

Joumal ofFinancial Planning/November 2000

Tax & E s t a t e I s s u e s

Gradual Liquidation of Capital from a Fixed Payout Annuity for a Specific Period

l^et's say you tnuisfcr $|{K),(XK) to an insurance company th:U agrees to pav a 2()-ye;ir annuity of $7tK) a month--assuming a six [x;rccnt ratt of return on the unpaid balance. When you systematically lii|iii(iatc prlncipiil and interest fioiii an annuiiv Loiunict in accordance with the customary practice of insnrariCL' companies, tax law gives a spcci;il advantage. I he principal is amortized on a le\el basis over the [layee's lite expectancy (or a guaranteed period of time, if less),

Kor example, if $1(H),(K)O is invested in a 2()-ye;ir payout annuity. $5,000 ($IO(}.O(K) ^ 20) is ta.x-free principal each year, ('ontrast this with a personal "debt repayment" proyrani where most ofthe income is taxable the first year and taxfree in the final year.

The result; Since taxable income is less in the early years ofan annuity, you have the use of some tax savings for the balance of ilie pa}'out period. If a 2()-year fixed annuity pays 6 percent on the unpaid balance {an attainable Dbjcctive in niid-20(KJ), this is actually etjiial to about 6.5 to 7 percent jiaid in a debt repayment plan. Similarly, a 2()-year variable annuity that pays, say, 12 percent on tlie unpaid balance is etjuivalent to a mutual fund ?itbdrawal plan crediting from 1 i to 14 percent.

Payout annuities have another advantage. There are no management or monitoring issues. Your investment is managed professionally, and the payments keep coming as promised,

Gradual Liquidation of Capital from a Fixed Payout Annuity for a Specific Period, Life Income Guarantee

iilly insured amiuities also have a special option no other investment

offers. For an extra premium fee, you can add a lifetime feature to a fixed-period payout policy.

For e.xample. let's say a $100,000 single premium pays a male, age 6S, a $700 monthly income for 20 years. For an extra premium of about $5,000, this insurance company probably will guarantee payments for his lifetime, if longer, In other uords, a $105,000 premium may promise a Tninimiim of 240 monthly income checks and a nia.\imum measured by tbe payee's actual lifespan.

Table I shov\s liov\ this rate of return improves if you live more than 20 years. (It assumes, for convenience, that a $100,000 investment will be sufficient to pay out a $7(K)-a-month 20-year annuity with a lifetime guarantee.)

Consec|Uently, if you live until age 100, you'll receive A total payout of $294,000, and this includes a 7.75 pereent rate of return on the unpaid balance--a 1.7.i [icrcent increase from the 6 percent rate promised in a basic 20-year fixcd-jieriod anniiit)'.

Gradual Liquidation of Capital from a Life-Only Fixed Annuity, No Specific Period

An insuranee company will increase \ our monthly payment even more if you'll assume a major risk--that is, the pavments eease if you meet an untimely death. Let me explain: If a 20-year fixed [>criod annuity, w ith a lifetime guarantee, pays you $700 a month, a life-only annuity will probably pay $H0() a month. In other words, for your assumption of the mortality risk, the payment is increased by $tOO monthly, nearly a 15 percent guaranteed income bonus for as long as you live.Tiible 2 shows how this rate ot return improves with increased longevity.

Voila! If you'll assume this risk ol dying t(K) .soon, compare these rates of return with I'able 1, which promises a

Journal ofFinancial Planning/November 2000

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If You Live... ...11 years, 11 months 20 years (85) 25 years (90) 30 years (95) 35 years (100) 40 years (105)

Total Payout I $100,000 t $168,000 I $210,000 $252,000 $294,000 $336,000

Equivalent Annual Rate of Return on Unpaid Balance

0% 6% 6.75% 7.5% 7.75% 8%

.sL'If-managcd and commercial annuity pr()j,Tams. It'.s even po.ssihlc to build hack the client's original cash l)y reinvesting some of this income in a separate inve.stment plan. Of course, everything,' depends on the client's objectives, facts and circumstances.

In the second installment, Harry Jensen asks you to prepare a report for his ta.\ advisor. You'll explain how jwyoiit annuities are taxed in the finaneial plan. Some surprises await. Stay tuned.

If You Live... ...10 years, 5 months 20 years (85) 25 years (90) 30 years (95) 35 years (100) 40 years (105)

Total Payout I $100,000 $192,000 $240,000 $288,000 $336,000 $384,000

Equivalent Annual Rate of Return on Unpaid Balance

0%

7.5% 8.375%

9% 9.25%

9.5%

guaranteed annuity period of 20 years. The conclusion: Life-only annuities can pay out some real money if you live longer than the longevity tables predict.

Once more, be aw are that payments stop if you die prematurely. Life-only annuity' contracts are for optimistic, healthy people who have prepared adequately for their loved ones outside the annuity program.

Gradual Liquidation of Capital from a Variable Annuity

investments in the annuity account. When you take a variable payment, the

first check is usually smaller than offered by a fixed annuity. .?\s the investments change in value, the payout rate can vary dramatically.

For instance, let's say a fixed annuity pays a 65-year-old male $XO(J monthly as long as he lives. A variable annuity' might begin uith a $625 monthly payment. Then, assuming a gradual, steady, eight percent earnings rate, the payments will increase to about %^)50 monthly after U) years and to $1,4UU or so after 20 years.

A variable payout annuity also can be for (1) a fixed period. (2) a fixed period with a lifetime guarantee or (.^) merely for a lifetime. It is called a variable payout annuity because vour checks flitctuate with the

Summary

I've shown how to improve cash flow by systematically liquidating capital using

Endnote

This is an abridged version of my special repc)rt, "1 low to Turn an Annuity Piilicy into a Monthly Income," and is printed witli permission. For moic information on this subject, look for my forthcoming CD ROM, "How to Be a Professional Annuity Advisor," sponsored by MKS Investments, Boston, Massachusetts 02116-3741.

Richard W. Duff. J.D.,CLU.isa financial advisor in Denver, Colorado, and is a principal in First Financial 'Resources. He can If reached by phone at (303) 765-3599. by fax at (303) 691-0474. ot by e-mail atRWDuffCLU@.

Joumal ofFinancial Planning/November 2000

Stratesiies & Trends

Tax & Estate

Issues

How to Turn an Annuity Policy Into Monthly Income, Part II

by Richard W. Duff, J.O., CLU

I n my November 20(K) column, I described a cash flow and financial plan to optimize a $100,000 inheritance for a client. I iarry Jensen. In particular. I compared the gradual liquidation of cash with systematic payments from an annuity policy. The conclusion: An annuity wins every time because it is taxed on a level basis usmg an exclusion ratio.

In this article, the second in a series, you prepare an analysis for Harry's tax advisor. In question and answer form, it shows how income and transfer taxes affect installments from an annuity contract.' We presume that Harry Jensen, age 65. acquires a single-premium payout annuity in 2001.

How Income Taxes Affect a Life-Only Fixed Annuity

Let's say a single-premium $100,000 lifeonly fixed annuity pays $800 a month Starting at Harry's age 65 when his Internal Revenue Service (IRS) life expeetancy is 20 years. Mis annual payout is $9,600, and the 20-year expected return is $192,000. Once determined, his $100,000 investment m the contract is divided hv this expected return to obtain an cxcUision ratio (lA hich may he expressed as a fraction or as a percentage). Then, this ratio is applied to find how much of each annuity payment is tax free; the halance. of course, is ineludable in gross income.

The result: $100,000 ^ $192,000 tells us that 52.08.^ percent ($5,000) of the $9,600 in annual pa\'outs is tax free, and 47.917 percent ($4,600) is taxable.

4 4 A word of caution: Since Roberta may not be aware of the estate taxes paid by Harry's personal representative, Harry might leave a note in the policy alerting her to the deduction.??

What happens if Harry lives beyond his life expectaney of 20 years and fully recovers his investment in the eontract?

If Harr)\s annuit)' starting date had been before January 1, 1987, he would have continued receiving $9,600, of whieh $5,000 is always tax-free even though his policy had completely returned the $100,000 investment.

However, since Harry's annuity staning date is after December 31, 1986, $5,000 is excluded annually only until his investment in the contract is recovered-- in this instance, when 240 monthly payments are received, i'hereaftcr, each payment is fully ineludable in I larry's gross income.

What happens if Harry dies before recovering his investment in the contract? ? If 1 larry's annuit)' starting date had

been before July 2, 1986, there would have been no tax loss because he had received all that was expected. ? However, since Harry's annuity starting date is after July 1, 19H6, there is a special tneome tax deduction available on his final income tax return. For example. Harry dies after 12 years. He bas recovered $60,0t)() ($5,000 x 12) tax-free. The result: the deduction is

$40,000 ($100,000 - $60,000). It is listed as a net operating loss us if attrib utable to a trade or business.

How Income Taxes Affect a Payout Annuity for a Specific Period with a Lifetime Guarantee

Assume Harry selects a monthly $700 payment for 20 years with a lifetime guarantee. His annual payout is $8,400, his 20year expected return is $168,000, and his investment in the contract is $100,000. Unlike a mere life-only annuity, however, his exclusion ratio is niodified to reflect the period eertain of 20 years. Here's how: From Reg. Section 1.72-9, Table VII, the value of the 20-)'ear guarantee is 18 pereent {$18,000) of the $100,000 single preniiiiTn, and tliis must be subtracted from $100,000 to obtain an "adjusted" investment in the contract.

The result: After the adjustment, Harry's investment in the contract is $82,000. His exclusion ratio is $82,000 H$168,000; thus, 48.H1() percent ($4,100) of eacb $K,400 annual payout is tax free, and 5 L19() percent ($4,300) is taxable.

Journal of Financial Planning/March 2001

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What happens if Harry lives beyond age 85 and eontinues receiving payments, after the period certain under his eontract has expired?

Ixt's say Harry receives guaranteed payments for 20 years, and he eontinues taking $8,400 annually under the eontract with its lifetime guarantee. When the 20th year expires, he has received $168,000 (20 X $8,400), of whieh $82,000 ($4,100 x 20) was tax free and $86,000 ($43,000 x 20) was taxable under the exclusion ratio. Since he hasn't received tax-free payments totaling $100,000, a $4,100 ptirtion of each additional annual payout is tax free up to when all tax-free amounts equal $100,000.

What happens if Harry dies before reco\ ering his in\'estment in the contract (and hi.s son, Robert, is the beneficiary of any remaining payments)?

Let's say Harry dies in 2010 after receiving annual amounts of $8,400 for 10 years--a total of $84,000 ($41,000 tax free and $4.!,000 taxable). Robert receives an ailditional $84,0{)(l over the next ten years.

You'd think Roliert "steps into Harry's shoes" and receives exactly $41,000 taxfree and $4.^,000 taxable during the ten remaining years. Fortunately, it's better than that. Here's what happens.

What Robert receives is 100 percent tax free, until Harry's investment in the contract has been completel\- recovered, riu'n. all payments are fully taxed. Note: If I larr)'s polic}' is a jK'riod certain annuity, without a lifetime feature, Robert does exclude the same portion of each pa)'ment as originally computed.

A bonus: The ($18,(XX)) value of Harry's 20-year refund guarantee is not subtracted when detennining his unrecovered investment in the contract. Note: If Rol>ert receives a cash refund, it works the same way. He will not have any taxable income unless his lump sum, when added to what I larry received tax free, exceeds $100.0(X).

A potential extra bonus: If Harry (and Kohert) don't receive tax-free amounts ei.|ual to Harry's $100,000 investment in

the contract, the unrecovered amount is eventually deductible on Robert's personal tax return.

Are income taxes on annuity values reduced if I larry's estate pa) s a federal transfer tax? Yes! If Harry dies (1) owning an accumulation annuity or (2) there are payments remaining from an annuitized contract, the policy's fair market value is included in his estate tax ba.se. F.ventually, his beneficiary can claim a deduction for estate taxes paid on any profit in the policy.

F'^jr instance, assume death occurs in 2001 w hen Harry's accumulation policy (premium cost basis of $500,000) is worth $1 million. His taxable estate is $3 million, and the estate taxes are $1,070,250. (Without the $500,000 of profit in the policy, his taxable estate is $2.5 million and the estate tax is $805,250, a reduction of $265,000 in tax). Harry's beneficiary is Roberta, age 65, who has a 20-year IRS life expectancy. If she takes a lump sum, she elaims $265,000 as a deduction on her ineome tax return. This shelters a portion of $500,000 in income and saves income taxes of $106,000 in a 40 percent bracket. If she annuitizes the policy, say over 20 vears, slie'll deduct $15,250 eaeh year.

A word of caution: Since Roberta may not be aware of the estate taxes paid by Harry's personal representative, Harry might leave a note m tbe policy alerting her t(j the deduction.

Variable Immediate Annuity

Let's assume Harry acquires a $100,000 single-prcminm immediate life-only variable annuity. Payments start at $600 a month ($7,200 the first year), and change over time, depending on the investment returns of bis underlying funds.

I larry's exclusion ratio is determined as follows: Since his life expectanc)' is 20 years, the expected retum is simply $5,0(X) (his $100,(KJ0 investment divided by 20). The balance of each year's payout is taxable.

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