Effectively managing the income taxes in your investment portfolio can make a significant difference in your retirement.  The question is, How well are you doing?

Since the 07-08 financial crisis, investors concerned about their retirement have benefited from using some types of annuities. These programs can not only provide life-time income guarantees, they can also be a potent way to accumulate earnings on a tax-deferred basis.   However at some point you will want to withdraw those earnings.  Understanding the tax nuances associated with those withdrawals can help assure you are doing all you can to optimize how much is available for spending.

But let’s back up a minute. An annuity is a contract between you and an insurance company where funds can be invested and earnings typically accumulate tax-deferred.  When withdrawals begin, those accumulated earnings are subject to income taxes.  For annuities outside of a retirement plan, the deposits (called premiums or cost basis) can be withdrawn from the contract tax-free since you already paid taxes on those contributions.

All said, there are several important principles and techniques to help preserve as much of your withdrawals as possible.

Last In-First Out (LIFO): When it comes to annuity withdrawals, the IRS generally requires that earnings be distributed first and be taxed in that year. In addition, earnings withdrawn prior to age 59.5 will incur a 10 percent tax penalty.  Once the accumulated earnings have been distributed, subsequent withdrawals will be mostly principal (cost basis) which was presumably taxed when originally earned (and therefore cannot be taxed again).

Annuity Laddering:  One strategy that could potentially work around some of the LIFO requirement is “laddering.” Herein, multiple annuities are established with different companies then depleted one at a time.  This allows tax-free principal to be accessed sooner.  We effectively postpone taxes on earnings in the other annuities while still benefiting from the cash flow withdrawals. Sometimes clients raise concern because this strategy includes principal invasion.  However, they may be consoled to realize what is being depleted in one contract may in part be replaced by postponing distributions from another. When applying laddering it is important to use different insurers so to avoid the “serial annuity (aggregation)rule.”  [1]

1035 Tax Free Exchange:  The IRS allows you to transfer an annuity from one insurer to another without incurring taxes. So if a contract that is outdated, has inferior benefits compared to current offerings, has higher fees or simply no longer meets your needs, you can replace that existing annuity with a new one without incurring any tax liability. With all 1035 exchanges, the contract must be like-for-like (same owner and annuitant) so please consult your CPA or financial advisor for specifics.

Partial 1035 Exchange:  A subset of the 1035, this allows you to do a partial 1035 exchange and carry over the proration of the cost basis. There is a two-step process:

First, do a partial exchange from an existing annuity contract to another company. Second, do not take withdrawals from either annuity for at least 180 days. If you take a withdrawal from either annuity prior to 180 days of transaction, the withdrawal could be considered all earnings and fully taxable.

For example, suppose you have an existing annuity contract with total premiums (cost basis) of $500,000 and total value of $1MM (e.g., $500,000 in taxable gain). Since typically the earnings are taxed first, you would pay taxes on the first $500,000 of distributions. If you were to apply the rules of IRS 2011-38 you could transfer a portion of the annuity, say half, to a new contract with a different insurer. Since the cost basis is split pro rata, the new contract would have a value of $500,000 with $250,000 cost basis. After 180 days, you could generate cash flow from one contract, only have taxable earnings of $250,000 and postpone taxes on the second until needed.[2]

Annuitization:  All annuities provide the ability to convert the investment’s value into a cash flow stream for a specific term or for life. Since the stream includes principal plus the accumulated earnings a portion is not taxable until the entire principal is returned.  Thereafter the stream is 100 percent taxable.  Particularly for clients who have legacy goals, they may want to consider an annuity that offers a “cash refund” death benefit so beneficiaries can receive any remaining principal in case of premature passing.

Spousal Continuation:  As a general rule, when a death occurs, if the spouse is listed as the sole primary beneficiary on the contract, he/she may be able to assume the contract for his/her own benefit. Mechanically, the contract is credited with the death benefit then is retitled in the survivor’s name as owner and annuitant.  This allows the contract to be stretched and taxes deferred. Older contracts may not credit the death benefit if it is continued, as may be true of newer contracts.

Bottom line, annuities can be an effective tool for building your wealth on a tax-deferred basis. It is important to strategically plan withdrawals to help assure there is not unnecessary erosion from income taxes.  Any annuity withdrawal should be done with an eye toward surrender charges, fees, rider terms, and tax implications.  It is a good idea to consult your CPA and financial planner before any transactions.

Uncertainty over the economy and financial markets has many people concerned about their financial futures. For friends, relatives and colleagues who may find this information helpful, please feel free to share with them.  Remember, for those who could benefit we offer a complimentary “Second Opinion” that can offer an objective financial review. Keep us in mind for those who may be seeking a wealth advisory firm like ours—one that delivers services according to the needs and perspectives of its clients.

Annuities are generally considered long-term investments. Withdrawals made prior to age 59 ½ may incur a 10% federal penalty. Withdrawals from annuities will affect both the account value and the death benefit. The hypothetical example presented is for illustrative purposes only and is not indicative of any specific annuity’s performance. Individual results may vary. Guarantees are subject to the claims paying ability of the insurance company. WFAFN does not offer tax or legal advice or services.

 This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Wells Fargo Advisors Financial Network LLC (WFAFN) does not provide tax or legal advice. We strongly recommend an advanced tax and estate planning expert be contacted for further information. Any opinions are those of Mitchell Kauffman and not necessarily those of WFAFN. The information has been obtained from sources considered to be reliable, but Wells Fargo Advisors Financial Network does not guarantee that the foregoing material is accurate or complete. Prior to making a financial decision, please consult with your financial advisor about your individual situation.

Mitchell Kauffman provides wealth management services to corporate executives, business owners, professionals, independent women, and the affluent.  He is one of only five financial advisors from across the U.S. named the industry’s most qualified Financial Advisor through Research magazine’s Hall of Fame in 2010.

Inductees into the Advisor Hall of Fame have passed a rigorous screening, served a minimum of 15 years in the industry, acquired substantial assets under management, demonstrate superior client service, and have earned recognition from their peers and the broader community.

Kauffman’s articles have appeared in national publications, and he is often quoted in the media. He is an Instructor of Financial Planning and Investment Management at the University of California at Santa Barbara.

For more information, visit www.kwmwealthadvisory.com or call (866) 467-8981.  Investment products and services are offered through Wells Fargo Advisors Financial Network LLC (WFAFN), Member SIPC.  KWM Wealth Advisory is a separate entity from WFAFN.


1 Serial annuity (aggregation) rule states that if you own different annuity contracts with the same insurer purchased the same year and used the same Social Security number, then withdrawals taxed as if they came from the same annuity contract. See “Annuity ladders to tax-smart client’s cash flow” by Bruce Beaty, Legacy Marketing Group.

Partial 1035 Exchange: Also called “IRS Revenue Procedure 2011-38,”  please see Administrative, Procedural & Miscellaneous.

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