Income planning basics: Tax effects of annuitization versus withdrawals

By Scott Wheeler


As professionals that spend time helping advisors income strategize on behalf of their clients, we see all kinds of things. If we are not careful, we can easily get caught up in the industry jargon surrounding income planning -- decumulation, qualified versus nonqualified, laddering, income benefit riders, etc. Many times, if this jargon is used with clients, it can wreak havoc and ignite confusion.

A common area ripe for misunderstanding and miscommunication is the conversation the advisor has with his clients at the point of explaining the "dollars per month" the client will have to spend during retirement. Advisors tend to talk in terms of "income" planning, and they do this down to a monthly or annual amount. But, unbeknownst to many advisors, their clients tend to substitute the word "paycheck" for "income" in their own heads. Inevitably a chasm develops -- the client having grown accustomed to a paycheck (already reduced by taxes and benefit payments), throughout the last 50 years, assumes income means "spendable."

Let's talk about a couple of basic areas relating to annuities you can brush up on to minimize potential misunderstandings that could occur as you help your clients plan for the next stage of their lives.

Annuitization-based income

Historically, when income was derived from an annuity, it was accomplished through annuitizing the contract. This option entailed choosing a traditional annuitization option -- life only, period certain, or life with a period certain were all fairly common. Even today, as we team up with advisors to develop income maps for their clients, we sometimes use a five-year immediate annuity early in the retirement income strategy to allow other assets to grow, etc.

When you annuitize, you find yourself under the guise of Section 72 of the IRS code. This section details the mechanics and tax treatment of each annuitization payment -- known as the exclusion ratio. In essence, the exclusion ratio treats each annuity payment as a "slice" of the bigger pie. In other words, each annuity payment is deemed to have a proportionate amount of basis and interest growth -- thus spreading the taxes over time. In tax parlance, this is known as a tax preference.

The exclusion ratio described within the IRS code is best understood as a simple fraction applied to each monthly or annual annuity payment. The numerator is the amount of after tax money, or what's known as "basis," within the annuity. Since that money has already been taxed, it's excluded from taxation, as it is annuitized. The denominator is the "expected return" through annuitizing.



As an example, if $100,000 of after tax money was put into an annuity and subsequently annuitized using a 10-year certain annuitization option for $1,500 per month, the denominator would equal $180,000 ($1,500/month x 10 years).



Knowing this calculation can allow the advisor to communicate in the client's language and talk about an after-tax "paycheck." In other words, the $1,500 of income every month translates into $1,333 after taxes (assuming a 25 percent federal/state combined rate).

Based on the client's level of understanding, it's not uncommon for this conversation to lead to a decision to extend the payout period and reduce the amount taken out every month due to the tax preference that accrues to the client through the exclusion ratio. Or if the client actually needed the full $1,500 every month, they could make some adjustments to expenses or alternatively, take a shorter annuitization schedule. (Keep in mind, with other annuitization options, once basis is used up within Section 72, all the remaining income generated by the annuity is subject to tax.)

Withdrawal-based income

By structuring income payments using "free" withdrawals, the account value is left in place to continue to grow through additional interest credits. To the extent there is an account value available, (based on interest credits and the length of time withdrawals have been taken) that amount can be accessed at any time by the client (possibly subject to surrender charges and/or tax penalties).

Now here's where things can get a little dicey -- withdrawal payments are not treated the same compared to annuitization payments. Withdrawals are considered interest first, followed by basis. So, to the extent there are gains (interest/bonuses) affecting the account value, those dollars will be deemed to come out first, in the form of withdrawal payments before principal or basis. As a result, a larger portion of the income coming out of the annuity early on (when income begins) will be subject to tax compared to later payments.

As an example, assume $100,000 of after tax money was put into a 10 percent premium bonus annuity. The plan is to leave it alone for the first year and use the 10 percent free withdrawal provision to provide $10,000 of income during the second year. This will give the annuity time to accrue interest credits. Starting in the third year, scheduled income withdrawals will begin. Even if we assume no interest credits to the account, the account value starting day one of the second year is $110,000. Since withdrawals are deemed to be earnings first, basis later, the entire $10,000 free withdrawal is taxable. For someone needing a monthly paycheck of $833, but instead receives only $625, that could come as quite a shock ($10,000/12 compared to $7,500/12)

If this kind of tax treatment is not communicated and planned for, such an unforeseen event could cause much displeasure for the client, resulting in embarrassment for the advisor and possible loss of the client.

Moral of the story

Each client comes to the table with preconceived notions and personal understandings that could be different than the advisor. As you develop income strategies for your clients, try to cover the same information in more than one way. An effective way to do this is to repeat the information in a real life context. This can add clarity in the mind of your client.

As an example, since clients are prone to associating income planning with paycheck planning, go through each stage of the income flow and point out what is "spendable" for that year or period in question. By taking each stage and writing down the "net spendable amount" (the paycheck) available, this will help your client better understand. Of course, the next logical step is to relate the "net spendable" to their expected expenses for that period of time. By doing that, you'll find that your clients will see things more clearly. They will have a good opportunity to visualize what they can spend and if need be, make adjustments to the income or expense side of the ledger.

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