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Immediate Annuities

Over the last two months we've covered the ins-and-outs of single premium immediate annuities (SPIAs).

Over the last two months we've covered the ins-and-outs of single premium immediate annuities (SPIAs). December's column discussed how retirees can use immediate annuities to get a higher level of predictable income than what's offered by other conservative investments. January's piece showed how the “exclusion ratio” for each payment can enhance that higher income with lower taxes — and help reduce the onerous taxation of Social Security payments.

This month brings the discussion of SPIAs to a merciful close with some additional ways that advisors are using immediate annuities to help clients reduce taxes and boost health insurance coverage. But forewarning is fair warning — the first solution doesn't come without drawbacks and the second one might have you and your clients tiptoeing through an ethical and legal jungle.

Getting Past the Gains

According to data from the National Association for Variable Annuities and Morningstar, assets in tax-deferred variable annuities mushroomed from $502 billion in 1996 to $1.2 trillion at the end of 2005. Some of this growth came from new money added to the accounts. But a good portion of the growth was due to positive investment returns, made even larger by the fact that Uncle Sam wasn't able to ding the dollars along the way.

Yet more money can lead to more taxes for variable annuity holders who want to cash in on the gains they've made. If a variable annuity was purchased after Aug. 13, 1982, any withdrawal of gains is classified as “earnings” and taxed as ordinary income. Once withdrawals deplete the earnings portion of the account, the IRS considers the rest of the money taken out to be tax-free principal.

Until the earnings portion is depleted, though, variable annuity withdrawals may boost your clients into a higher tax bracket than they would otherwise inhabit. Especially if they are on the cusp of the 25 percent tax bracket: For 2007, the line is drawn at $31,850 of income for single filers and $63,700 for married filing jointly.

Let's say your now-65-year-old clients put $100,000 into a variable annuity 10 years ago and it's grown to $250,000. They're ready to reap what you and they have sown and ask you to start sending them $1,400 per month from the annuity to (barely) pay for the gas that powers their motor home.

But once this income is put on top of the other earnings, interest and pension checks they are already receiving, it's likely that at least a quarter of that $1,400 monthly payment ($350) will have to go to Uncle Sam, leaving them with a shade over $1,000 per month. And if the amount remaining in the variable annuity doesn't grow rapidly enough to offset the withdrawals, the account could dwindle to nothing, forcing your clients to forgo that RV and resort to hitchhiking.

But your clients may be able to tap money accumulated in the variable annuity without rocketing up the tax bracket ladder by converting the account to an immediate annuity. According to a quote from, a 65-year-old couple from Florida could get roughly $1,450 per month on a $250,000 deposit for as long as they live.

Considering the payment stream will end when the clients die, and the remaining investment will disappear, that deal doesn't look too great. But the appeal becomes more apparent when you bring taxes into the equation, because immediate annuities are subject to an “exclusion ratio” — or the portion of the payment from an annuity that is determined to be principal and, therefore, tax-free.

The couple in question would get more than $300 of each immediate annuity payment treated as principal and, therefore, excluded from taxes. If they were still in the 25 percent federal tax bracket, their monthly net would be around $1,160. The benefit of the exclusion ratio is even more crucial if it helps keep them below the 25 percent tax bracket and/or prevents their Social Security from being taxed.

The big drawback to turning a variable annuity into an immediate annuity is that if it's paid out based on the clients' life expectancy, the payment stream will expire when the clients do. The clients may not care about this (after all, they'll be dead), but their children may not be so indifferent to a diminished inheritance. A fixed-period annuity would then be a better a solution — albeit one that would carry higher costs or a lower payout.

Medicaid Maneuvers

Another strategy involving immediate annuities is looking dicier all the time. For years, some advisors have advocated that seniors who are about to enter a nursing home should deposit as much wealth as possible into a fixed-period immediate annuity, ostensibly to qualify for more public assistance than would otherwise be available. Regardless of whether the patient leaves the nursing home vertically or horizontally, in theory, the patient and/or a surviving spouse would continue to benefit from the remaining annuity payments.

Advisors may be comfortable with the ethics of this strategy, but the regulators are doing all they can to discourage the practice. Over the past several years, rules were put in place that determined that immediate annuities could only be considered “qualified” transfers if the contracts were irrevocable and based on a term no longer than the life expectancy of the patient.

At this time last year the rules were made even more stringent. The Deficit Reduction Act of 2005, which became effective in February 2006, decreed that in order for a pre-nursing home deposit to an immediate annuity to be considered proper, the state funding the patient's Medicaid care would have to be paid the remainder beneficiary of any annuity payments until it received reimbursement for all of the Medicaid funds spent on behalf of the patient.

Giving advisors the benefit of the doubt, they may have used this strategy to help clients in dire straits. But, driven by noble intentions or not, advisors who wish to help clients cover potential long-term care costs in the future would be wiser to discuss how a long-term care policy works today and leave Medicaid planning to attorneys who specialize in the field.

Writer's BIO: Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future.

SPIAS: The Payoff

(Monthly income per $1,000 in premium on single premium immediate annuities)

December 2006 September 2006 December 2005
Male, Age 65 $6.40 $6.40 **
Female, Age 65 $6.00 $6.08 **
Male, Age 75 $7.83 $7.86 $7.74
Female, Age 75 $7.42 $7.45 $7.33
** Historical data on Age 65 SPIA not available
Source: SPIA factor averages are derived from top 40 companies surveyed in a study completed by
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