Ready For Retirement
Ready For Retirement
Lump Sum vs. Annuitization: Tax Implications for Your Non-Qualified Annuity
Joe is planning for retirement and wants to minimize his tax burden, especially on the interest earned from his three annuities. James explains that non-qualified annuities are purchased with post-tax money and offer tax deferral on growth until withdrawal. When taking out funds, the principal is tax-free, but earnings are taxed at ordinary income rates.
He explores strategies for tax-efficient withdrawals. He also touches on annuities, options like a 1035 exchange to transfer an annuity into a different product for improved performance, the tax implications for heirs, and early withdrawal penalties before age 59 and a half.
Questions Answered:
How are non-qualified annuities taxed upon distribution, including both lump sum and annuity options?
What strategies can be implemented to keep the tax burden as low as possible when withdrawing from non-qualified annuities?
Timestamps:
0:00 - Joe’s question
1:52 - Non-qualified annuity overview
5:11 - Potential tax strategies
10:02 - Annuitization option
12:31 - Annuity regret
13:22 - 1035 Exchange
14:33 - Things to know
Create Your Custom Strategy ⬇️
On today's episode of Ready for Retirement, we're going to be diving into the world of non-qualified annuities and, specifically, we're going to be talking about how non-qualified annuities are taxed upon distribution. So whether you have one that you're looking to annuitize or you have one that you're looking to take a lump sum from, on today's episode we're going to help you understand how that's taxed, as well as talk about strategies you can implement to keep that tax as low as possible. This is another episode of Ready for Retirement. I'm your host, james Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. This episode is actually based upon a listener question. This question comes from Joe. Joe says the following Hi, james, my wife and I have three annuities. Two are at Jackson Life and one is at Delaware Life. The payment or the principal that we put into our Delaware Life annuity was $105,000 in 2004. It is now about $205,000. The Jackson annuities were $50,000, now worth $82,000, and a $75,000 contribution, now worth $118,000. All have since passed their surrender periods.
Speaker 1:My question is I plan on retiring next year at age 62. I would like to defer our social security payments for a while, so we won't have a lot of income. Should we take lump sum payments from these annuities so it keeps our tax burden down on the interest earnings? I know I don't want to annuitize them and we have enough in other parts of our nest egg to live off of that. We don't need to count on monthly income from them. I'm just trying to find a way to avoid taxes on the combined $174,000 of interest we've earned on these annuities. Can we cash out a little at a time to stay under the $85,000 earned income limit for married filing jointly, to keep within the 12% bracket? Please help me understand our options from Joe. Well, joe, thank you for that question, and we'll certainly help you understand the options as it pertains to these annuities. To start, though, I want to give a high level overview of how these annuities work, what your options are for taking income from them and, most importantly, how is that income taxed and what are the things you can think about doing to keep that tax as low as possible. So let's start.
Speaker 1:What we're talking about specifically here is an investment into an annuity made in a non-qualified account. Why do I say non-qualified account? Well, if you purchase an annuity in an IRA or in a Roth IRA number one, you lose out on one of the benefits of an annuity, which is tax deferral of any of the growth. So sometimes not a huge reason to do it there, although sometimes maybe you're doing it for different reasons. But if you purchase a non-qualified annuity, what it means is you're taking money that you've already paid taxes on to make that purchase. You are purchasing the annuity, which is essentially a contract between you and a life insurance company. When you make that contribution, if there's growth on that, or when there's growth on that or when there's growth on that, all that growth is tax deferred. So while that money is in the annuity the growth you're not paying taxes on it. You don't pay taxes until you take that money out as a withdrawal later on. There's a couple ways to take withdrawals We'll touch upon later. But you're not paying taxes on the growth. You do pay taxes when you take that growth out of the annuity. So what does that look like when you take money out of the annuities? Well, your principal comes back tax-free because, remember, you're using after-tax money If it's a non-qualified annuity to make the initial purchase. So when you pull money out of an annuity, that principal comes back tax-free. But any of the earnings, those are taxed at ordinary income rates.
Speaker 1:So for example, let's go back to Joe's question. He says the payment or principal for the Delaware life annuity was $105,000 in 2004. It is now about $205,000. Well, let's take a look at that. If Joe took a full distribution from this Delaware life annuity, the full amount is $205,000. $105,000 of it would not be subject to any taxes. That $105,000 is what he initially put in. That was money that had already been taxed. So that comes back out tax-free. But the $100,000 of growth since he purchases this annuity, that would be fully taxed at ordinary income rates if he took the withdrawal. But what if he doesn't take a full withdrawal? So that's simple enough. Joe takes money, he has $205,000 in his annuity. He takes it all out. Part comes back tax-free, part comes back it's taxed as ordinary income because that was growth. But what happens if Joe doesn't want the full $205,000? What if he only wants $50,000 or $100,000? Can he control where he takes money from, either from principal or from growth? No, unfortunately you can't.
Speaker 1:In a non-qualified annuity, withdrawals follow what's called a last in, first out taxation rule. In other words, any money you pull out is first going to be earnings. Now, you're not controlling this, but any distribution you take out the annuity company is tracking, is that earnings, is that principal, and you'll receive a tax form at the end of the year. But you're taking out the gains first. So if we go back to Joe's annuity, that has $205,000 in it, $100,000 of which is gains. If Joe just wanted to take $50,000 out, he could do so, but that full $50,000 is going to be taxed at ordinary income rates, but that full $50,000 is going to be taxed at ordinary income rates. If you wanted to take $100,000, he could do so, but that full $100,000 is going to be taxed at ordinary income rates. He can't go to Delaware Life and say, hey, I want $20,000 of my principal back and $80,000 of earnings. It's all going to be earnings until he's fully withdrawn those and then they'll start distributing the principal. So let's talk about some potential strategy around that.
Speaker 1:I'm going to go back to Joe's question. He said, quote I'm just trying to find a way to avoid taxes on the $174,000 of interest earned. Can we cash out a little at a time to stay under $85,000 of earned income? We'd file married, filing jointly, to keep within the 12% bracket. End quote so $174,000, when you hear him saying that that's the combined growth, combined earnings on all three of his annuities, he also says they're trying to stay under the $85,000 earned income limit. So this question, I believe, was submitted last year when the tax brackets were lower.
Speaker 1:But one important thing to note is for 2024, when I'm actually recording this episode, you can have taxable income of up to $94,300 before you move from the 12% bracket to the 22% federal bracket. So let's look at this. His goal is to stay under the 12% tax bracket and we need to acknowledge number one, that you do have less flexibility when withdrawing money from an annuity. It's not like a brokerage account where you can say, okay, we have a bunch of different investments, a bunch of different tax slots, maybe we take some principal, some growth. We can control what investment we're pulling from Annuities. You don't have that flexibility. You have earnings and you have principal and you have to take the earnings first. That being said, the annuity is not going to force you to take a certain amount of earnings or a certain amount of principle. You do have the ability to control how much you're taking each year.
Speaker 1:So, like I said for 2024, if you're married finally and jointly, like Joe and his wife are, you can have taxable income up to $94,300 and stay within the 12% bracket. Now taxable income is after you've taken your deduction. So the standard deduction for married filing jointly for 2024, if you're both under 65 is $29,200. In other words, you could have total adjusted gross income, so income before any deductions, of $123,500, because after applying a standard deduction you would then have $94,300 of taxable income which would fully fill the 10% bracket, fully fill the 12% bracket, without then spilling over into the 22% bracket.
Speaker 1:So in this specific example I don't know Joe and his wife's rest of their situation. I don't know what interest they have. If there's pensions, if there's dividends, there's probably other income sources, or almost certainly is. But if we assume for a second they had zero other income sources, what that means is Joe and his wife could take out $123,500 from the annuity so they could take that all amount and assuming all that was earnings, so they took a little bit from each of the three annuities. They would have some of that tax at 0%. The amount at 0% is essentially the amount that fills up the standard deduction, some of it tax at 10%, some of it tax at 12%, but they would not go into the 22% tax bracket. So that's part of the strategy they could look at. Now, obviously, anything that they did have any taxable income they did have from interest or dividends or other income sources they would want to reduce how much they're actually pulling from the annuity, because all those things would be combined to go into their adjusted gross income or their taxable income. But to look at it simply, that 123,500 is the threshold before which they cross over into the 22% bracket. So that's the strategy that I might look at.
Speaker 1:For someone like Joe is okay. We can't control how much we take out as earnings versus principal. We're just going to be taking the earnings out here because that's how annuities work. But we can control how much of those earnings we take out and we can control. Do we take that now? We'll say social security continues to grow and defer? Do we take that now? We'll say other investments to continue to grow and be deferred, to be used down the road, or vice versa, do we want these annuities to keep growing?
Speaker 1:For us, I don't know anything about how these annuities are invested or what the contract looks like. Us, I don't know anything about how these annuities are invested or what the contract looks like. But if 105,000 was put in in 2004 and now it's 205,000, maybe there's been some withdrawals since then. That's 20 years and the annuity hasn't even doubled. So you're probably not getting more than about 3% interest on that annuity. So you could probably use that annuity, maybe as like your conservative bucket, if you wanted to, as we start to tie this new investment strategy. Okay, maybe do we use that as the bucket we want to draw from if there's a downturn in the stock market, or maybe use that as a bucket we're going to draw from for the first couple of years, because my guess is these are annuities that are stable. They don't seem to be variable annuities. If they were, they just performed really poorly. But what we want to look at is both how do these tie in from both a tax strategy, a withdrawal strategy, an investment strategy and then try to see how do we use the right solution to check all those boxes, at least to the greatest extent possible. Now, that option that we just mentioned just taking a withdrawal up to a certain amount, that's just one option.
Speaker 1:There's also something called annuitization and Joe very clearly in his question said look, I don't think that we want to annuitize, but I'm going to discuss it anyways, just so that people understand how it works. An annuitization essentially means you're going to tell the annuity company hey, I have this lump sum, turn that into an income stream for the rest of my life. So an annuity is an insurance contract. An insurance contract, it essentially can allow you to say, turn this lump sum of capital into an income stream forever, depending on the type of annuity, whether there's writers or all these different things that can just become kind of like a pension. They'll say okay, joe, here's a specific dollar amount that you're going to get for the rest of your life.
Speaker 1:Each of those payments is divided into two parts. One part is a return of principal and one part is earnings. So of course, the return of principal is just the portion of your original contribution being paid back to you, and those earnings is the interest or growth that annuity generated and that's the portion, again, that's taxed at ordinary income rates. But how do you understand what portion of each payment is principal, what portion is earnings? Well, the annuity company is going to do that. They're going to calculate something called an exclusion ratio and the exclusion ratio is them understanding your total contributions as well as your expected payout period. To say, from a life expectancy standpoint, here's what we expect in terms of total payout period and, based upon that payout period, here's how much of each payment is a return of your own contributions. Here's how much is earnings. And once you have that, you can then see okay, here's my income amount each year, and of that income amount, here's the amount that's tax-free, because it's my money coming back to me, and how much of that is taxable. And I can then plan on that number to go into the rest of my tax strategy with withdrawals from other accounts that I have. So that itself is fairly straightforward.
Speaker 1:The question for most people just typically is should you annuitize? Should you take this as a lump sum, kind of like Joe's talking about, and try to spread that lump sum out over several years to keep it under certain tax thresholds? It's going to depend upon your needs, of course, and it's also going to depend upon what are your other assets and income sources. What does social security look like? What, if any, pension do you have? What retirement assets do you have? How do you tie all these together to maximize income, to reduce taxes and really to minimize risk to the greatest extent possible. So fairly straightforward there. Now here's some other things that you need to consider.
Speaker 1:It's not uncommon for people to have annuities that are very expensive, that they don't like, that they ultimately regret having purchased. But one thing I didn't mention is if you're under 59 and a half, you can't withdraw an annuity without incurring a 10% early distribution fee and that 10% penalty that's on top of whatever taxes you would pay on the gains. So sometimes people feel handcuffed by these things. So, yes, they can be great investments in a lot of scenarios, but other times unfortunately too many times these are sold as a bill of goods that people end up regretting purchasing. So what do you do if you say I don't really want to hold onto this, or maybe I've even been after 59 and a half, but I don't want to incur a huge tax bill. But I want to get out of this annuity that maybe it's really expensive or it's not doing what I need it to do?
Speaker 1:Well, you can do what's called a 1035 exchange. A 1035 exchange allows you to take the annuity that you have that maybe you don't like, maybe it's too expensive, maybe it's not the right type of an annuity for you. Whatever the case might be, you can do an exchange into another annuity or insurance product. That exchange is not taxable. So if you are like Joe and you bought an annuity for $105,000 and it's now worth $205,000, well, you could go purchase a different annuity.
Speaker 1:I'm not saying this is the case for Joe. In fact, joe maybe shouldn't do it because he's already out of surrender. This is money that he already has a general plan for, but, using that example, he could take that $205,000 and exchange it into another annuity or insurance product that better fit his specific situation. Now, when he does that, he's not paying taxes on that exchange. What he does have to be mindful of is he may be resetting. He probably is resetting his surrender period, so now the new annuity has another surrender period. He also, though, is taking whatever cost basis he had in the original product so 105,000 in this case and it becomes the same cost basis in the new product. So nothing changes about the total value or the cost basis. It's just transferred into something more appropriate, ideally.
Speaker 1:Another couple of things to know. Number one there's no required minimum distributions. So even though this money grows, tax deferred, kind of like an IRA does, in terms of at least the earnings on it. There's no required minimum distributions on non-qualified annuities, so you can choose to begin when you want to receive these payouts.
Speaker 1:Another thing on that note is if you have an annuity, let's go back to Joe's. He purchased it for $105,000. It's now worth $205,000. If Joe had a brokerage account that he had purchased for $105,000, so some stock he bought for $105,000, it's now worth $205,000. If Joe doesn't ever spend that and he passes away, that goes to his heirs with a full step-up in basis. So he bought it for $105,000. It's now worth $205,000. When his heirs inherit it, their new cost basis is $205,000.
Speaker 1:That's not how things work with an annuity. With an annuity, if your heirs inherit it, they're inheriting it at the same cost basis and with the same earnings. So when they ultimately inherit it, they will then be paying taxes at their ordinary income rates. So just one thing to keep in mind it's not like a typical brokerage account with a step up in basis. There is no step up in basis on annuities. And then finally and I already alluded to this but if you withdraw money from a non-qualified annuity before the age of 59 and a half, you're going to be subject to a 10% early withdrawal penalty in addition to the income taxes on the earnings portion of that annuity. So understand how that works there.
Speaker 1:But in general, this is an overview of just how do these annuities work in terms of when you're taking withdrawals, whether it's either in the form of a one-time lump sum withdrawal or an annuitization. What does that look like from a tax perspective? What does the tax look like to potential heirs if you don't fully spend down these accounts, and what are some strategies that you can use to distribute these accounts to try to stay under certain tax thresholds? So I hope that was helpful. Joe, thank you very much for your question. Thank you to all of you who are listening. That is it for today and I'll see you all next time.
Speaker 1:Hey everyone, it's me again for the disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment tax, legal or other financial advice. It is for informational purposes only. Thank you, it is for informational purposes only over the country, and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.
