Partial Annuitization: Benefits And Barriers

All three friends would benefit from the same solution to their somewhat different problems: Joan is reluctant to annuitize at all but will try it with a small portion of savings; Jill only needs part of the income coming from annuitizing her VA; and Ann needs only half the income from annuitizing the VA now but will need the rest starting five years from now.

The solution? Partially annuitize the deferred VAs–i.e., use part of the VA cash values to generate a lifetime income and leave the rest invested in the contract.

However, all three face a substantial tax barrier to obtaining the benefits of a life annuity. This is the Internal Revenue Service. The IRS appears to interpret the income tax rules governing deferred annuities in a manner that effectively precludes partial annuitization. Specifically, rather than allowing the three retirees to allocate a portion of their VAs’ basis to the annuitized portion of the cash value and computing an exclusion ratio for the annuitized income stream, the IRS apparently believes the lifetime income streams that would result should be treated as nonperiodic withdrawals–and thus be taxed on an income-first basis.

Although the IRS view is not without some technical basis, in my view the IRS could readily read the current rules to allow Jill, Joan and Ann to reap the life annuity’s benefits without adverse tax consequences.

Not only would such an interpretation yield clear societal benefits, i.e., more life annuitizations, but it would benefit the government from a revenue perspective. Why? Because absent the ability to annuitize partially, Joan, Jill and Ann are likely to do what many annuity owners do–i.e., defer taking withdrawals for as long as possible to avoid taxation of annuity earnings. (The three will almost certainly pay less in taxes if they sell their mutual fund shares and pay tax at capital gains rates than if they take withdrawals from their deferred VAs and pay tax at higher ordinary income rates.)

Last fall, Sen. Chuck Grassley, R-Iowa, chairman of the Senate Finance Committee and a strong advocate of better retirement policies, wrote Secretary of the Treasury John Snow about the tax barriers to partial annuitizations, urging such annuitizations be encouraged. Secretary Snow, a leader in the administration’s efforts to place Social Security on sounder footing, understands (as do other administration officials) the benefits of guaranteed lifetime income. Hopefully, this will help achieve removal of needless partial annuitization barriers.