As part of ThinkAdvisor’s Special Report, 22 Days of Tax Planning Advice: 2015, throughout the month of March, we are partnering with our ALM Media sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.

This is part 1 of a two-part look at six important tax questions, covering questions 1-3, about Deferred Annuities. Please check out Part 2.

1. What is the difference between a longevity annuity and a deferred annuity?

A deferred annuity provides for an initial waiting period before the contract can be annuitized (usually between one and five years), and during that period the contract’s cash value generally remains liquid and available (albeit potentially subject to surrender charges). Beyond the initial waiting period the contract may be annuitized, though the choice remains in the hands of the annuity policyowner, at least until the contract’s maximum maturity age at which it must be annuitized.

———-

Planning Point: It is always the case that owners of deferred annuity contracts can annuitize after an initial waiting period (often one year, and rarely later than the fifth year). This is the case even when the contract’s maturity date is fixed at a date far into the future. – John L. Olsen, CLU, ChFC, AEP, Olsen Financial Group.

———-

By contrast, a longevity annuity generally has no access to the funds during the deferral period, does not allow the contract to be annuitized until the owner reaches a certain age (usually around 85).

In other words, many taxpayers purchase traditional deferred annuity products with a view toward waiting until old age to begin annuity payouts, but they always have the option of beginning payouts at an earlier date. With a longevity annuity, there is generally no choice, but this also allows for larger payments for those who do survive to the starting period; as a result, for those who survive, longevity annuities typically provide for a larger payout (often, much larger) than traditional deferred annuity products.

———-

Planning Point: The chief benefit of a longevity annuity is financial leverage. The benefit payment may be far larger than can be guaranteed, at the time of purchase, by any other instrument, including a deferred annuity. As one might expect, the leverage in a longevity annuity providing no benefit unless the annuitant lives to the annuity starting date is substantially greater than that provided by a contract with a death benefit. – John L. Olsen, CLU, ChFC, AEP.

———-

Most taxpayers who purchase longevity annuities do so in order to insure against the risk of outliving their traditional retirement assets. The longevity annuity, therefore, functions as a type of safety net for expenses incurred during advanced age. Where a deferred annuity contract may be more appropriately categorized as an investment product, the primary benefit of a longevity annuity is its insurance value.

2. Is the purchaser of a deferred variable annuity taxed on the annual growth of a deferred annuity during the accumulation period?

An annuity owner who is a “natural person” will pay no income tax until he or she receives distributions from the contract. If the contract is annuitized, taxation of payments will be calculated based on the rules that apply given the annuity starting date when payments begin.

The tax deferral enjoyed by a deferred annuity owned by a natural person is not derived from any specific IRC section granting such deferral. Rather, this tax treatment is granted by implication. All distributions from an annuity are either “amounts received as an annuity” or “amounts not received as an annuity.” As the annual growth of the annuity account balance, except to the extent of dividends, is not stated in the IRC to be either, it is not a “distribution,” and therefore is not subject to tax as earned.

3. Can a taxpayer combine a deferred income annuity with a traditional annuity product?

Yes. Insurance carriers have begun offering optional riders that can be attached to variable annuity products in order to include the benefits of a deferred income annuity within the variable annuity. These deferred income annuities allow the contract owner to withdraw portions of the variable annuity itself in order to fund annuity payouts late into retirement.

Taxpayers must purchase the rider at the time the variable annuity is purchased and can then begin transferring a portion of the variable annuity accumulation into the deferred income component as soon as two years after the contract is purchased. When the taxpayer begins making transfers into the deferred component, he or she must also choose the beginning date for the deferred payments.

The deferral period can be as brief as two years or, in some cases, as long as forty years, giving taxpayers substantial flexibility in designing the product to meet their individual financial needs. Further, taxpayers can choose to transfer as little as around $1,000 at a time or as much as $100,000 to build the deferred income portion more quickly.

The deferred income annuity rider can simplify taxpayers’ retirement income planning strategies in several important ways, not the least of which involves the ability to gain the benefits of both variable and deferred income annuities within one single annuity package.

This single-package treatment also allows taxpayers to avoid the situation where they wish to transition their planning strategies to eliminate the investment-type features common to variable annuity products into a product that allows for a definite income stream—a situation that commonly arises around the time when a taxpayer retires.

Without the combination product, the taxpayer would traditionally be required to execute a tax-free exchange of the variable annuity contract for a deferred income annuity. Instead, the deferred income annuity rider allows the taxpayer to systematically transfer funds from the variable portion of the contract into the deferred income portion over time (though lump sum transfers are also permissible).

See related content on ThinkAdvisor’s 22 Days of Tax Planning Advice: 2015 home page.