Insight on Estate Planning

The AP&S Trusts & Estates Blog

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Is a Split Annuity Strategy Right for You?

The average length of retirement is 18 years, according to the U.S. Census Bureau. And with today’s medical technology, it could last significantly longer. Thus, a major challenge is balancing the need to maintain your standard of living while preserving as much of your wealth as possible for your family to enjoy after your death. A split-annuity may be one strategy to consider. It creates a current income stream while preserving wealth for the future. Let’s take a closer look at how it works.

ABCs of annuities

An annuity is a tax-advantaged investment contract, usually with an insurance company or other financial services provider. You pay either a lump sum or annual premiums, and, in exchange, the provider makes periodic payments to you for a term of years or for life.

For purposes of the split-annuity strategy, we’ll focus on “fixed” annuities, which generally provide a guaranteed minimum rate of return. Other types of annuities include “variable” and “equity-indexed,” which may offer greater upside potential but also involve greater risk.

Annuities can be immediate or deferred. As the names suggest, with an immediate annuity, payouts begin right away, while a deferred annuity is designed to begin payouts at a specified future date.

From a tax perspective, annuity earnings are tax-deferred — that is, they grow tax-free until they’re paid out or withdrawn. With a “nonqualified” annuity, a portion of each payment is subject to ordinary income taxes, and a portion is treated as a tax-free return of principal (premiums). Note, however, that once the principal has been fully repaid, subsequent payments are taxable in full. (Qualified annuities are those that are purchased as part of a retirement account, and, with rare exception, the payments are fully taxable.) The ability to accumulate earnings on a tax-deferred basis allows deferred annuities to grow more quickly than comparable taxable accounts, which helps make up for their usually modest interest rates.

Annuities offer some flexibility to withdraw or reallocate the funds should your circumstances change. But keep in mind that — depending on how much you withdraw and when — you may be subject to surrender or early withdrawal charges. Most annuities provide some exceptions to these charges under certain circumstances, such as withdrawals attributable to disability, loss of employment or death of the annuity owner. Withdrawals before age 59½ may also be subject to 10% tax penalties.

Split annuity strategy in action

A split-annuity may sound like a single product, but in fact it simply refers to two (or more) annuities, usually funded with a single investment. In a typical split-annuity strategy, you use a portion of the funds to purchase an immediate annuity that makes fixed payments to you for a specified term (10 years, for example) and apply the remaining funds to a deferred annuity that begins paying out at the end of the initial annuity period.

Ideally, at the end of the immediate annuity term, the deferred annuity will have accumulated enough earnings so that its value is equal to your original investment. In other words, if the split annuity is designed properly you’ll enjoy a fixed income stream for a term of years while preserving your principal.

At the end of the term, you can reevaluate your options. For example, you might start receiving payments from the deferred annuity, withdraw some or all its cash value, or reinvest the funds in another split-annuity or another investment vehicle. Deferred annuities often allow you to withdraw some of their cash value penalty-free, but depending on how much you withdraw or reinvest, you may be subject to early withdrawal penalties or surrender charges.

Providing peace of mind

Here’s the bottom line regarding split annuities: while they don’t offer superior rates of return, they can offer the peace of mind of a fixed income stream while preserving as much wealth as possible for future generations. Contact us with questions regarding a split annuity.

About The Authors

A professional headshot of Kristin Matsko in front of windows.

Kristin N. Matsko

Kristin, Chair of the firm’s Trusts & Estates Group, counsels individuals and fiduciaries on a wide variety of trusts and estates… Read More

A professional headshot of David Riedel in front of windows.

David T. Riedel

An author and frequent lecturer on estate planning, administration and taxes, David provides responsive, sympathetic and personable counsel to his varied… Read More

A professional headshot of Kathryn Windsor in front of windows.

Kathryn S. Windsor

Kathryn is Chair of the firm’s Tax Group and represents clients in a variety of tax law matters. Her practice areas… Read More

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