Under the Hood: What You Need to Know About Annuities With GMIB Riders

2) Annuitize the contract and begin receiving an income; or

3) Cash in the annuity, pay tax on the gain and invest the net proceeds in a taxable account. 

Cashing In the Annuity

Let’s focus on Choice #3. With this option, because the annuitant would cash in the annuity, he would be required to pay taxes in the amount of $18,867 on his $62,889 gain. Assuming this additional income of $62,889 puts him in the 33% marginal bracket, his net proceeds after cashing in his annuity and paying the tax due would be approximately $144,000. 

Note: I used a tax rate of 30% rather than 33% because of the progressive nature of the marginal tax brackets. Although this is not precise it is close enough for our purpose.

At this point we are left with $144,000, which is less than the annuity’s market value of $162,889 or the GMIB value of $196,715. Hence, the rate of return required on the $144,000 would be greater than the 5.14% mentioned earlier.

However, because the income received under the annuity in Choice #2 is subject to income tax, we must calculate its after-tax income and use this amount as the income we must generate under Choice #3 (taxable account). To calculate the tax due on the annuity’s income stream, we must determine the annuity exclusion percentage which is established when the contract is annuitized. This determines the percentage of each annuity payment that is subject to income tax. The formula for this is: 

Total Investment(s) minus Periodic Lump Sum Withdrawals (i.e.; Cost Basis)
GMIB Value When Annuitized 

Here is the calculation for our example: 

$100,000 / $196,715 = 51% 

Therefore, 51% of each payment would be a return of basis (not taxable) and 49% would be subject to income tax. If the payments continued to a point in time where the basis was fully recovered, then the entire annuity payment would be taxable. This actually occurs around year 16 in our example. Assuming the annuitant is in a marginal tax bracket of 25% (after year one which included the $62,889 gain), the net income of each year’s payment would be calculated as follows: 

1) Annual Gross Payment: $13,053

2) Amount of Gross Payment Subject to Tax: $6,396 (#1 x 49%)

3) Tax on #2 @ 25% Bracket: $1,599

4) Net Income (Years 1-15): $11,454 ($13,053 – $1,599)

5) Net Income (Years 16-20): $9,789 ($13,053 – $3,264)

Note how the net income declines after year 15 as the basis has been fully recovered and the entire payment is taxable.

Now that we have all the data, we can create an apples-to-apples comparison between choices two and three above. To be fair, it becomes necessary to provide the same annual income on an after-tax basis. Therefore, using a lump sum of $144,000 (i.e.; the amount of the annuity after cashing it out and paying tax on the gain), the rate of return required to generate an after-tax income equal to that from the annuity is about 4.80% per year. This also includes the following tax assumptions on the taxable account in Choice #3. 

Percentage of Total Annual Return Subject to Tax as:

1) Interest Income: 10%

2) Dividend Income: 5%

3) Capital Gains Income: 5% 

Conclusion

The analysis is fairly straightforward, but I suspect the results are not what most advisors would have anticipated. Paying tax on the gain in the annuity and reinvesting the net proceeds in a taxable account seems to be a better option than annuitizing the contract. Of course, if you accept this as true, then it may be better not to invest in the annuity in the first place.

In short, these products appear to be favorable on the surface, but when you consider the full picture, they lose some of their luster. Typically, clients who have invested in them would have received an illustration containing the GMIB account projection, a market value accumulation using a hypothetical return, and a future income stream of a certain dollar amount.

However, what the illustration lacks, and perhaps what the advisor failed to mention or understand, is the internal rate of return the insurance company would need to earn to deliver the promised income when the contract is annuitized. This is where the needle-in-the-haystack resides.

In other words, this rate is usually quite low and easy to achieve. This is not a knock on the insurance company. After all, they’re in business to earn a profit and must price their products accordingly. Otherwise, they wouldn’t be able to meet their obligations which would be a catastrophic event for their customers.

However, it should be noted that since the client is largely unaware of all of the nuances contained within an annuity contract, they rely on the agent/advisor who recommends it. Therefore, the advisor must tell the entire story, or perhaps more accurately, the advisor must have a full understanding of what they’re recommending.

One final item. The income from a non-qualified annuity is subject to the net investment income tax (NIIT).

I hope you’ve found this helpful.