Small Annuity Decisions, Big Tax Consequences

Let me walk you through a real example from a client I just helped last month.

The Situation

My client was a 65-year-old man who had several million dollars invested in the market.

He's in great shape financially and plans to leave most of his money invested for long-term growth.

But he wanted something else, too: a reliable income stream he could count on no matter what the market did.

We looked at two options.

One was a traditional immediate annuity, or SPIA. The other was a fixed indexed annuity with an income rider.

The indexed annuity ended up paying about $200 more per month. It also gave him more flexibility.

If he ever wanted to access the money, he could, even though he likely never will.

That mattered to him, so he chose that option.

He put in $750,000 of non-qualified money and started income right away.

His income came out to about $5,000 per month for life.

The Big Concern Was Taxes

The client's first reaction wasn't about the income. It was about what that income would do to his taxes.

He's already in the 32% tax bracket.

Adding another $60,000 of income could push him into a much higher bracket not only for his regular income, but also for his bonus and other extras he was getting during his last year of retirement.

That was something he wanted to avoid.

This is where the strategy gets interesting.

Why the Non-Qualified Annuity Income Isn't Taxed Right Away

The money the client used came from non-qualified sources.

That means it was already taxed before going into the annuity.

With annuities, the IRS uses what's called the last-in, first-out method, or LIFO.

In simple terms, earnings come out first and are taxed. After that, the principal comes out tax-free.

But here's the key: This is an indexed annuity, and the client started getting income immediately.

There are no earnings yet in the first year because interest isn't credited until the end of the contract year.

So… what's he receiving right now?

His own principal.

That means the income he takes in year one isn't taxable.

In his case, he'll receive $40,000 this year and pay zero income tax on it (since he started income in April).

Turning a Problem into an Opportunity

Originally, the client planned to pull about $30,000 from his savings to live on during the first year while waiting till next year to start his annuity income.

He was trying to avoid creating more taxable income.

Instead, we put that money to work right away, which resulted in him receiving $40,000 in income from the annuity immediately, which isn't taxable.

That's about $10,000 more than he planned, and it's still not increasing his tax bill!

At the same time, he locked in lifetime income.

Same dollars, better outcome.

Where This Fits for Advisors

This works really well for clients in high-income years.

Think about someone who is retiring soon and has bonuses, deferred compensation, or large payouts coming in.

The client's tax bracket is already elevated. The last thing the client wants is more taxable income.

Using non-qualified annuity income in that first year can give the client cash flow without adding to the problem.

It also pairs well with clients who want to keep most of their assets in the market but still want a dependable income floor.

The Bottom Line

Income planning isn't just about how much you can generate.

It's about how that income shows up on a tax return.

When you use non-qualified annuities the right way, you can create income right away and keep it from increasing taxes in the first year.

For the right client, that's a simple strategy that can make a meaningful difference.

John Stevenson is a retirement and wealth strategist based in Las Vegas.

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