By Paul Irving
March 24, 2011 -- Some things never go out of style, like a nice Rolex watch, wingtip shoes, or a classic sailing yacht. In the same spirit, a split annuity is a timeless strategy with enduring value.
Times are tough, especially for clients who own nonqualified CDs and use the interest earnings for living expenses. Our prolonged ultra-low interest rate environment really has CD owners concerned, as they are now systematically dipping into principal to make ends meet. At the time of this writing, the national average rate on a one-year CD is 1.08 percent, and a 5 year CD is 2.3 percent. For CD buyers used to earning 3 to 4 percent on their money, they’ve taken quite a pay cut. Not only are they earning much less than they had been accustomed to, but insult is added to injury as 100 percent of the income is taxable each year.
Is there a better way? You bet! We can help these clients by showing them how to maximize earnings and reduce current taxation using split annuities.
It seems that the simple split annuity concept has been around forever, maybe so much so that we’ve forgotten what a powerful tool it can be. If you’re new to the idea, here’s how it works:A lump sum is split into two parts. One part is a deferred annuity that will grow back to the original lump sum at the end of its contract length (five to ten years). The other part is a period certain only immediate annuity (SPIA) which generates tax advantaged payments for the same time frame. The tax advantages come into play as most of the income from the SPIA is excluded from taxation as return of principal.
Let’s look at a real live case. Harry Smith is a 75-year-old retiree in a combined 30 percent tax bracket who has been taking interest earnings from his CDs. He has a $100,000 CD coming due, and he’s looking for ways to increase his income without invading principal.
For Harry, let’s compare a five-year split annuity with a five-year CD under today’s environment. If he buys the five-year CD at 2.3 percent, he gets $191.67 per month for five years. However, since he pays income tax on 100 percent of these earnings, he nets $134.17 per month ($1,610 annual spendable income).
How about the split annuity? Because we work in the brokerage environment, we can find the most competitive guaranteed deferred annuity and match it with the most competitive SPIA. In most cases, we’ll be using two carriers to get the best results. For Harry’s case, we place $85,636 into the deferred annuity at 3.15 percent and it will grow back to $100,000 at the end of 5 years (guaranteed). We can then take the remaining $14,364 and place it into the five-year period certain only SPIA, which will generate $246.73 monthly for five years. Since most of these payments are the return of principal, only $7.40 per payment is taxable. So instead of netting $134.17 per month with his CD, Harry now nets $241.55 per month! You’ve just given him an 80 percent pay raise by using this simple, time tested strategy.
It is important to note that although the split annuity does provide immediate tax advantages, it creates a future tax liability on the deferred annuity. However, many clients these days would certainly opt to take more income now, and defer paying taxes until later. At the end of the 5 years, Harry can redeploy the same strategy and again defer taxation on the bulk of his payments if he’d like, or explore other income strategies.
For clients like Harry, and many others seeking more guaranteed income and preservation of principal, the split annuity concept remains a timeless classic.
Paul Irving is the Chief Marketing Officer for Annuity Department, a full-service national marketing organization serving select CPS Insurance Affiliates. He has over a decade of experience helping advisors design the best annuity solutions for their clients. Paul can be reached at 805-597-3616 or at firstname.lastname@example.org.
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