It is widely known that a very small proportion of nonqualified deferred annuity contract owners–variable and fixed–ever choose to “annuitize” in order to receive a stream of payments for the rest of their lives. Some insiders put the annuitization at less than 5%. (See box for reasons.)

In recent years, life insurers have taken steps to encourage people to reap the benefits of deferred annuity life annuitization guarantees. For example, the products are more flexible, and post-annuitization liquidity and guarantees are becoming common. Also, substantial resources have gone into educating the public, policymakers and financial advisors about life annuity benefits (e.g., the work of Americans for Secure Retirement). Even so, progress is slow. One reason is that current tax rules make it hard for people to annuitize only a portion of a deferred annuity.

Consider three friends–Joan, Jill and Ann–who all are retiring from the same company at age 65. Each has $250,000 in a 401(k), $100,000 in mutual funds and $100,000 in a nonqualified deferred variable annuity–but no defined benefit plan. If the 401(k) is typical, it will not offer a lifetime annuity option, so their only source of “annuity” income will be monthly Social Security checks–which are likely not enough to cover their monthly expenses.

Each new retiree could benefit from an additional source of lifetime income. Their deferred VAs are ideal for that. Based on current purchase rates, the annuitized VAs could pay each $623/month for the rest of her life (or $609/month lifetime, with payments guaranteed for at least 10 years).

Joan may be reluctant to spend any of her nonemployer plan retirement savings on a life annuity, let alone half ($100,000), even with the 10-year guarantee. Assume, however, that Ann, who knows the benefits of a life annuity and is familiar with Joan’s finances, persuades Joan to obtain at least some additional lifetime income. Joan concludes she could spend 25% ($50,000) of her personal savings on a life annuity that pays about $300/month.

Jill, like Ann, appreciates the benefits of a life annuity and decides she only needs an additional $200/month (annuitizing one-third of her VA cash value).

Ann, meanwhile, needs an additional $300/month now and $300/month more starting in five years when she moves to a retirement community (annuitizing half her VA now and half in five years). This will likely result in over $600/month in income since Ann will be five years older at the second annuitization.

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.