Well, the “chump was stumped!” I had an interesting conversation with a client who is using some advanced tax planning for his annuities. Now, I’m always the first to admit that I know a lot about certain subjects, such as taxes, but I am by no means an expert on the subject, and you should always consult with an expert in that given area.
However, when it comes to annuities, I like to think I know more than the average advisor. But this one term caught me off guard because I had never heard it- “annuity aggregation.”
This is one of those obscure tax rules that the majority of people, and I’m comfortable saying the majority of advisors as well, do not know about.
So, a special thank you to DJ for pointing this out to me!
What is “Annuity Aggregation?”
Basically, if you fund multiple annuities with the same company, in the same year (and that is specific to each company, i.e., calendar, fiscal, etc.), you have “aggregated” your annuities.
Now, this only applies to Non-Qualified Annuities (annuities funded with after-tax money). I wrote a pretty extensive newsletter that talks about all the different types of tax implications concerning annuities several months ago, which you can read by clicking here.
What are the tax implications of “annuity aggregation?”
The IRS views this separate funding as single funding. Meaning, when you withdraw money from one of the annuities, they consider the growth of all the annuities or the “aggregate.”
What does that mean?
Here’s an example:
You fund 3 separate annuities with $100,000 each for a laddering technique, such as a 5, 6, and 7-year Multi-Year Guaranteed Annuity (MYGA), and you are planning on pulling the interest growth from different annuities in different years.
For the simplicity of this example, let’s say they all have a 5% interest yield.
After the 1st year, each annuity would have been credited with $5,000 in interest credit, for a total of $15,000.
You decide that you want to exercise a 10% withdrawal from one of the 3 separate annuities for a total of $10,500 ($100,000 + 5% = $105,000) ($105,000 x 10% = $10,500).
The aggregate interest credit of all 3 annuities is $15,000. Therefore, you would pay tax on the full $10,500 because it is less than the aggregate return of $15,000.
What would happen if you exercised a 10% withdrawal on all 3 of them at the same time?
That would be a total withdrawal of $31,500 ($10,500 x 3). So, you would pay tax on the $15,000 of total interest credit, and the remaining $16,500 would be seen as a Return of Premium and therefore, not taxed.
Again, this is a totally obscure IRS rule, but it is important to know for intricate tax planning.
What is the solution?
- Either use separate companies for each annuity, or
- If you are married, set up one annuity for each spouse as the individual owner (not joint), and make your spouse the beneficiary. Or, if you have a trust, the trust could be a separate owner as well.
One more clarification from my last annuity tax newsletter:
I made the mistake of using the term “Income Annuity” to represent both SPIAs and FIAs with Income Riders.
There is a difference…
If you are receiving income from a SPIA, there is an exclusion ratio that is used to calculate your taxes. Even if you are using a SPIA that has a Return of Premium (Death Benefit), there is no “account value” recognized by the IRS.
However, if you are receiving income from a Fixed Indexed Annuity that has an Income Rider, there is a growth component to your account value/death benefit, and your taxes become a little bit of a moving target each year.
You have a $100,000 FIA that pays you $10,000 per year.
If you receive a 5% interest growth credit ($5,000) from the index you are tracking, then the first $5,000 paid to you that year would be taxable, and the remaining $5,000 would be seen as a Return of Premium and would not be taxed at all.
If the following year you received 0% in interest credits, then all $10,000 would be seen as a Return of Premium and you would pay no taxes on that income.
Once the Account Value/Death Benefit has been depleted, you would still receive all the income until your death, and the death of your spouse if it is set up for joint income, and you would pay tax on the full $10,000 of income.
This rule only applies to the “Account Value” and not the “Income Value” which normally has a bonus and a guaranteed roll-up every year that income is deferred.
And, just as a reminder, this is in no way to be construed as tax advice. This is intended to be used for educational purposes only. Please always check with a tax professional for your personal situation.
I’m glad you stuck around. These are boring topics, but they are important if you are in a tax-sensitive situation. If you have any concerns about your retirement tax situation, I do have a CPA on staff that can assist in answering questions, but you would always want to involve your personal tax professional. And, if you want to learn how to use annuities most effectively for income, then I highly encourage you to watch my video series, “20% More Income in Retirement”. Then take the time to book a short phone call to get your questions answered by clicking the “Schedule a Call” button. I hope this finds you well!
All the best,