Owners can use the exclusion ratio treatment a SPIA provides to spread out their tax liabilities over a period of years or their lives.
How A SPIA Can Enahnce A Person’s Retirement
When you are getting close to retirement, it is important to start thinking about the different ways you can use your money to make the most of your golden years. One option that is growing in popularity is the nonqualified immediate annuity. This type of annuity has a lot of benefits that can make your retirement more comfortable and enjoyable. In this guide, we will discuss five reasons why a nonqualified immediate annuity might be right for you!
What is a Nonqualified Immediate Annuity?
A nonqualified single-premium immediate annuity or SPIA is an annuity contract that converts a lump sum of “after taxed” money (life insurance cash value, checking and savings, and Certificates of Deposit) into a stream of annuity payments for either a fixed period of time or a lifetime.
Related Article: What is a Nonqualified Annuity?
Annuity Contract Structure
- Owner: The person who has all rights under the contract.
- Non-Natural Owner: A non-natural entity (such as a trust or corporation) may be the owner of the SPIA. Make certain the objectives of the non-natural entities are met when utilizing the SPIA product.
- Joint Owner: The person who has all rights under the contract (generally a spouse or person sharing an interest in the assets).
- Annuitant: The person selected by the owner(s) and the measuring life or lives for the annuity payments.
- Joint Annuitant: The person selected by the owner(s) and the second measuring life used after the first annuitant’s death.
- Beneficiary: Selected by the owner(s) to receive any death benefit proceeds or remaining annuity benefits.
Tip: Name a contingent beneficiary to avoid paying the owner’s estate potentially should the primary beneficiary predecease the owner and the beneficiary designation is not updated.
Single or Joint Annuitant(s)
- Single Annuitant: Insures annuity payments over the sole annuitant’s life expectancy.
- Joint Annuitant: Insures payments over both lives.
SPIA Established by 1035 Exchange
- To qualify for a tax-free exchange under section 1035, the owner(s) and annuitant(s) on both contracts must mirror each other also known as “like to like“.
Life insurance 1035 exchange to an annuity:
- The owner(s) must be the same
- Insured(s) must be the same as the annuitant(s)
Annuity 1035 exchange to an annuity:
- The owner(s) must be the same
- Annuitant(s) must be the same
Annuity Non-Qualified Taxation
Exclusion Ratio
The taxable portion of each annuity payment is determined by the exclusion ratio. An exclusion ratio is expressed as a percentage and applied to each annuity payment to determine the portion of the payment that is excludable from taxable ordinary income.
After all the cost basis has been distributed, 100% of the annuity payments will be considered taxable ordinary income to the owner(s).
Annuitization Vs. Withdrawals
Lifetime withdrawals from an income rider and annuity payments from annuitizing your contract are 2 different methods of generating income from an annuity.
- The exclusion ratio will be applied if you annuitize the contract.
- LIFO (Last In, First Out) will be applied if you pocket lifetime withdrawals.
Last In, First Out (LIFO)
LIFO basically means any interest credited is applied to your annuity “Last,” and your original investment is applied to your annuity “First.” So with LIFO, your interest will come out first via withdrawals.
In a nutshell, you haven’t paid taxes on the interest you’ve earned thus far. So when you take income from your nonqualified annuity, the IRS wants the taxes paid on the interest first.
This means 100% of your retirement income (monthly, quarterly, semi-annual, or annual withdrawals) is 100% taxed until you’ve exhausted all of your gains from the annuity.
After you have exhausted all of your gains, your withdrawals are not taxable.
10% Early Distribution Federal Tax Exceptions
SPIA funded with cash: Regardless of the owner’s age or the annuity option selected, the payments will not be subject to the additional 10% federal tax for early distribution.
SPIA funded with a 1035 exchange: Payments may be subject to an additional 10% federal tax for early distribution if the contract owner is younger than age 59½ UNLESS an exception applies, most commonly:
- Life-contingent annuity payments
- Disability
Premium Tax
The amount and method of charging a premium tax vary by the state issuing the SPIA contract and the type of premium (qualified vs. nonqualified).
1035 Exchange (The Transferring of Monies)
- Full 1035 exchange: When a person purchases a SPIA via a full 1035 exchange, the cost basis and earnings are transferred with the contract.
- Partial 1035 exchange: When a person purchases a SPIA via a partial 1035 exchange, the cost basis and earnings are moved on a pro-rata basis.
The Death Benefit For Beneficiaries
Life/Joint Life
No annuitization payments will be made to the beneficiary upon the last annuitant’s passing.
Life/Joint Life with Period Certain OR Period Certain Only
If the Period Certain has yet to be attained by the annuitant’s or last annuitant’s passing, the beneficiary will continue receiving the remaining annuitization payments until the Period Certain expires.
Life/Joint Life with Cash Refund
If the total premiums have yet to be fully paid out by the annuitant’s or last annuitant’s passing, any remaining premium amount will be paid to the beneficiary as a lump sum.
Life/Joint Life with Installment Refund
If the total premiums have yet to be fully paid out by the annuitant’s or last annuitant’s passing, any remaining premium amount will be paid to the beneficiary in installments.
Taxation To Beneficiaries
Joint Life, Life with Installment Refund, and Period Certain payments: All distributions to the beneficiary will continue to receive the same exclusion ratio treatment.
Life with Cash Refund and Life with Period Certain payments: All distributions to the beneficiary receive “first-in, first-out (FIFO) treatment,” which means that the cost basis will be distributed first, and the taxable earnings will then be distributed after the cost basis has been depleted.
Estate Tax
When Does It Apply?
May be applicable:
- All annuity options that have guaranteed payments yet to be paid generally such as the
- Period Certain,
- Life With Cash Refund,
- Life With Installment Refund, or
- Joint Life contracts.
- The cost of a comparable contract at the time of death is included in the contract owner’s estate.
- Marital deduction: Any remaining payments that go to a surviving spouse may qualify for the marital deduction.
- Income in respect of decedent (IRD): An IRD deduction may be available for the beneficiary if the estate tax is paid.
May NOT be applicable:
- Single Life: Because there are no residual payments upon the contract owner’s passing, provided the owner and annuitant are the same, there is nothing to include in the owner’s estate.
Planning Opportunities
Taking Distributions Before Age 59½
Because distributions coming from an SPIA funded with cash are exempt from the additional 10% federal tax for early distribution, an SPIA can be a unique and useful tool to generate income before age 59½.
Even if the SPIA is funded via 1035 exchange, the payments will still be exempt from the additional 10% federal tax for early distribution if the annuity option selected is life contingent.
Bridging the Gap to Social Security Benefits
Early retirees can use a Period Certain SPIA to delay taking Social Security benefits (to accumulate a higher Social Security benefit amount) and bridge the gap between retiring, and the time they start collecting benefits.
Funding Liabilities
Owners can use an SPIA to fund payment of a life insurance policy, long-term care, trust, or other obligation that will last for the remainder of the owner’s life or for a specified period of time.
Tax Management
Owners can use the exclusion ratio treatment an SPIA provides to spread out their tax liabilities over a period of years or their lives. This may particularly appeal to more affluent retirees because part of each payment is a return of principal and would not be considered taxable ordinary income.