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Tapping An Annuity

Tapping An Annuity

Five wise ways for retiring clients to make an annuity withdrawal.

Most of the attention that advisors and providers devote to non-qualified tax-deferred annuities is focused on initial deposits made to the accounts. But retiring clients who already have money in annuities are likely to be more interested in the most efficient methods of getting the money out, either now — or later. Here are some of the withdrawal options for annuity owners, including a review of some recently-added alternatives.

  1. Cash It In

    The seemingly-simplest option is to redeem the annuity account for the current value. However, there are several potential pitfalls in the process. First, you and the client should be aware of any surrender charges that may still be in place, including the current costs, future schedule of charges, and when the redemption fees disappear completely.

    After the hurdle of surrender charges has been addressed, you should examine any potential death or living income benefit inherent in the contract, especially if it exceeds the current account liquidation value, and will be voided if the money is withdrawn in a lump sum.

    Then there is the potential tax implication of the liquidation. An annuity that is cashed out for an amount less than the original deposit amount will likely incur no taxable gain (and may even be a deductible loss).

    But any withdrawals from a profitable annuity are considered to be gains, which will be taxable as ordinary income. Once the “profit” portion is exhausted, the rest of the money taken out will be designated as non-taxable principal by the IRS.

  2. Annuitize It

    One method of mitigating the immediate tax damage of liquidating a highly-appreciated annuity is to convert it to an immediate annuity.

    The annuity buyer can choose from several different payout options based on various time frames, including a guaranteed number of years, over the lives of the client and any intended joint beneficiaries, or some combination thereof.

    Once the client establishes the annuitization schedule, each payment will be proportionate with the mix of gains and principal. So a client who initially put $100,000 into a non-qualified annuity that is now worth $150,000 would have $50,000 taxed as ordinary income if he were to choose to liquidate the account immediately.

    But if he were to annuitize the payment over, say, a guaranteed period of 15 years, according to the calculator at, he would receive $1,082 per month, of which only $357 would be taxable income.

    The potential tax and income benefits of annuitizing the appreciated annuity have to be measured against the loss of access to the lump sum, plus the rock-bottom fixed interest rates currently offered by immediate annuities.

  3. Long-Term Care Coverage

    Thanks to the Pension Protection Act of 2006, beginning in 2010 owners of non-qualified tax-deferred annuities with deferred gains are able to avoid taxation on withdrawals used to pay for a qualified long-term care insurance policy.

    They may also be able to simultaneously and proportionately reduce the amount of taxable gains left in the annuity.

    In the example cited above, the owner of the annuity now worth $150,000 would pull, say, $3,000 out of the account to pay the annual premiums on a long-term care insurance policy.

    The $3,000 withdrawal would ostensibly be free from taxation. Another $2,000 would be deducted from the initial principal amount of the annuity, and $1,000 would come from the “gains” portion of the account.

    Owners of existing non-qualified tax-deferred annuities with untapped appreciation may also be able to use the “1035” exchange provision to transfer the current account tax-free into a new hybrid annuity contract that contains a long-term care rider.

    Although future non-qualified withdrawals from the new contract will still be subject to taxation, the money that is taken out to cover qualified long-term care costs may avoid taxation.

  4. Partial Payments

    Before 2011, owners of nonqualified annuities looking to liquidate were faced with a choice between either cashing out (and paying taxes on any appreciation), or annuitizing the entire amount.

    As of Jan. 1, 2011, a provision in the 2010 Small Business Jobs Act allows owners of non-qualified annuities to annuitize just a portion of the account, leaving the remaining amount sheltered from taxes.

    As long as the annuitization period of the withdrawn portion is scheduled to last at least 10 years, or is based on at least one life, it effectively becomes a new, separate contract.

    Again, using the example above, the client could choose to annuitize, say, $60,000 of the $150,000. A third of the annuitized payments would be taxed as income, and two-thirds would be considered tax-free return of principal. The remaining $90,000 would stay in the previous annuity.

    True, this maneuver won't likely change the amount of taxable income the client eventually receives.

    However, spreading the tax hit over several years may prevent the distribution from artificially boosting the client up into a higher tax bracket, and still leave the client some control over the amount that isn't annuitized.

  5. Leave It (Alone)

    Retired clients who own non-qualified annuities with a large amount of appreciation may want to reconsider the wisdom of withdrawing the money while living, versus passing the untapped accounts on to the next generation(s).

    No, the beneficiaries don't receive a new step-up in basis, and the annuities are technically subject to estate taxation. But the recent changes to the estate tax laws make it unlikely that either of these issues will affect most families.

    Instead, the younger family members may be in a much lower tax bracket than the current annuity owners, and therefore would pay much less in taxes when the accounts are eventually liquidated.

    Besides, adding the names of the client's children or grandchildren to the annuity beneficiary designations could help ensure that your relationship with his family lasts at least as long as the client does.


Kevin McKinley CFP is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid A Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at

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