Many people are familiar with the requirement to begin taking distributions from Individual Retirement Accounts (IRAs). The purpose of this IRS rule is to end a portion of the tax-deferred growth and begin taxing the monies.
Non-qualified annuities are similar to IRAs in that they defer taxes on investment growth. The difference is that you do not have to take taxable distributions from this type of account at age 72.
Non-qualified annuities mature at a contract-specified age or date, most typically at age 85. It is at this age or date that a policyholder must choose how to begin taking income from the account—and thus start paying tax on the deferred gain. The choices are varied and might include immediate annuitization, a period-certain payout, delaying payment, or distributing the annuity in full, paying all deferred taxes in the year of distribution.
Popular Payout Options
Immediate single life annuities have advantages and disadvantages and should be evaluated carefully. One disadvantage is that, as life expectancy shortens after age 85, the probability of getting the full value of the annuity returned to you during your lifetime diminishes. In this case, the insurance company will probably be compensated well for this choice.
To increase the return of monies during their lifetime, many people consider a period-certain annuitization. In this choice, the value of the contract, at a specified interest rate, is used to calculate a fixed payment for a fixed period of years. Period-certain annuities may be an overlooked option for many policyholders. The hidden treasure in older annuity contracts is that the interest rate may be much higher than today’s interest rates. In addition, contract owners can name a beneficiary to the fixed income stream should they die prior to the end of the fixed period.
In some cases, an income stream is more desirable than a lump sum of money. For example, a couple in a second marriage may want to provide for their current spouse but not want these monies to continue to the spouse’s heirs. The ability to name primary and contingent beneficiaries to the income stream gives the annuity owner the ability to direct these after-life income streams during their lifetime.
Indecision Can Be Costly
Upon the maturity of the annuity contract, you may be able to delay making a final decision on payout. Keep in mind delaying the payment may force full payment of the annuity if you outlive the term of the continued income delay of the contract. For instance, if you delay the payment for 10 years at age 85, and you live to age 95, you may then be forced to take the total annuity value in one lump sum, incurring a potentially large tax consequence.
The maturity of the annuity may be a gift to annuity owners to further contemplate their exit strategy of this tax-deferred investment.
Getting Ready to Make a Decision
To summarize, if you own an annuity, you should know the following: what is the maturity date of the annuity? What are the gains inside the annuity (the gain is the difference between what was paid for the annuity, including capital additions, and what is it worth today)? What is the strategy for paying taxes on the gain when surrendered or annuitized? Does it make sense for the current owner to pay the tax, or does it make sense for the heirs to pay their portion of the embedded gains upon inheritance? What is the current interest rate the fixed annuity is paying, and how does this compare to current interest rates? By having the answers to these questions, you should be better prepared to make decisions to maximize the value of your annuity.
Originally published September 2015