6 Tips to Kickstart Succession Planning with Your Business Owner Clients
Here are 6 tips you can share with your business owner clients to help kickstart their succession planning.
A deferred annuity with a living benefit rider may be attractive to your clients because it can provide lifetime payments to them even if the contract value is zero1. Understanding the taxes on different types of annuities can be a pain point for clients when saving for retirement, so in the sections below we’ll look at the tax treatment of payments from a deferred annuity with a living benefit rider where the contract value has gone to zero. We’ll also highlight the differences for the three main types of annuity ownership: nonqualified, Roth Individual Retirement Annuity (IRA) and pre-tax IRA.
Living benefit riders vary in whether they require annuitization, so it’s important that your clients are made aware of this difference. Guaranteed Living Withdrawal Benefits (GLWB), Guaranteed Minimum Withdrawal Benefits (GMWB), and Guaranteed Minimum Accumulation Benefits (GMAB) do not require annuitization of the policy to generate lifetime guaranteed income, while other living benefit riders like Guaranteed Minimum Income Benefits (GMIB) typically require annuitization.
Another important point to discuss with clients is the difference in tax treatment between non-annuitization distributions and annuitization payments from nonqualified annuities, which doesn’t exist for pre-tax IRAs and Roth IRAs.
Please note that all guarantees and protections are subject to the claims paying ability of the issuing insurance company and that living benefits are optional riders that are available at an additional cost.
Explaining nonqualified, non-annuitized distributions to your clients can be difficult depending on your client’s prior knowledge on annuities. However, a simple way to characterize the taxation flow of nonqualified deferred annuity non-annuitization guaranteed living benefit payments would be gains first, then cost basis, then gains again once all the cost basis has been recaptured.
Normal nonqualified deferred annuity taxation rules apply to distributions from a nonqualified deferred annuity with a non-annuitization living benefit rider. Under the normal deferred annuity taxation rules, gain is distributed first and taxed as ordinary income, and a 10% additional tax applies to any gain distributed prior to age 59½ unless an exception applies. Once all gain is distributed then cost basis begins to come out.
Ultimately, in the context of non-annuitized deferred annuity living benefits where the contract value has gone to zero, these taxation rules mean that once all cost basis has been recaptured, then the living benefit payments will be treated as gain and are fully taxable. Let’s look at an example:
The owner of a nonqualified deferred annuity with a living benefit rider has an annual payment guarantee of $5,000. The contract has a cost basis of $50,000. At age 62, the owner began taking withdrawals under the living benefit rider of the annuity. When withdrawals began from the annuity, the contract value was $100,000, meaning there was $50,000 of gain in the contract.
After several decades of taking withdrawals from this deferred annuity the contract value has been reduced to $1,500 which is all cost basis. Over time $46,000 of cost basis has been recovered.
At this point the owner then receives his $5,000 annual payment from the nonqualified deferred annuity with the living benefit rider. The classification of these funds is $1,500 of the contract value and $3,500 of the insurance company’s money under the rider’s payment guarantee.
The taxable amount of this distribution is $1,000 and the cost basis recovered is $4,000. The recovered cost basis is composed of $1,500 of the remaining amount of the contract value and $2,500 of the guaranteed payment amount which constitutes the final amount of recaptured cost basis (even though it’s the insurance company’s money.) Finally, the last $1,000 of the guaranteed payment is taxable gain (more of the insurance company’s money) under the annuity‘s living benefit rider payment guarantee.
After this payment the contract value of the annuity is zero, and because all the cost basis has been recaptured, all future guaranteed payments will be fully taxable each year.
Again, annuitization payments can be a complex topic, so a simple way to distinguish the taxation differences between nonqualified non-annuitization distributions from a deferred annuity and nonqualified annuitization payments to your clients would be that non-annuitization distributions from a deferred annuity follow the gains first rule, while annuitization payments use exclusion ratio treatment.
When a nonqualified deferred annuity contract with or without a living benefit rider is annuitized, the payments contain an exclusion ratio. An exclusion ratio means that each payment contains a portion of cost basis and a portion of gain. This exclusion ratio applies until life expectancy is reached for life-based annuitizations, meaning payments received after reaching life expectancy from a life-based payout annuitization are fully taxable. The 10% additional tax on premature distributions will apply to any deferred gain received prior to age 59½ unless an exception, like life-based payments, applies.
Normal Roth IRA taxation rules apply to distributions from a Roth IRA living benefit rider:
Let’s look at an example:
The owner of a Roth IRA living benefit contract has an annual payment guarantee of $5,000 under the rider. The annuity was purchased with a $50,000 Roth IRA conversion from a traditional IRA at age 55. When payments from the annuity started, the contract value was $100,000, meaning there was $50,000 of gain in the Roth IRA. The owner was 62 when they started receiving payments from the annuity. This is the owner’s only Roth IRA.
When payments began from the Roth IRA living benefit annuity contract, they came first from the converted amounts and were received both income tax free (because income tax had already been paid at the time of conversion) and 10% additional tax free because the owner was over age 59½.
Then, once the converted amount was fully distributed, gain amounts began to come out and were also received income tax free because the owner was over age 59½ and the Roth IRA was over five years old.
Finally, the payments received under the Roth IRA’s living benefit rider once the annuity’s contract value went to zero are still income tax free because they are treated as gain and, as mentioned earlier, gain from this Roth IRA is distributed income tax free because the Roth IRA owner is over age 59½ and the Roth IRA is more than five years old.
Normal pre-tax IRA taxation rules apply, meaning that any payments received from the annuity whether the contract value is zero or not will generally be fully taxable.2
Annuity living benefit riders could be an attractive retirement investment for your clients looking for a consistent income stream in retirement. Because of the complexities and considerations of these types of investments, it’s best to have in-depth conversations with clients where you discuss their many considerations like time horizon, risk tolerance, and long-term needs. In addition, clients might want to discuss potential income tax consequences with their tax advisor before purchasing additional investment products.
For more information, you can use ACG’s Advanced Annuity Marketing Concept Guide to help you solve for any retirement planning needs your clients face. Comprised of JDs, accountants (CPAs) and other highly trained financial services professionals, the Advanced Consulting Group is a powerhouse of education, knowledge, passion, and industry experience to help you and your clients tackle the hard questions about annuity living benefit riders and taxation.
Non-annuitization living benefit riders can have additional features that make them attractive income generation products. These additional features include the ability to allow future income payments to potentially increase while receiving income, but never decrease due to investment performance, and access to the contract value if the owner need access to larger distributions than are guaranteed under the rider. Please note, taking distributions from an annuity’s living benefit rider that is greater than the guaranteed payment amount can reduce future guaranteed payments.
Please note that if the pre-tax IRA owner has any after-tax contributions in any pre-tax IRA they own, they are required to apply a pro-rata portion of these after-tax contributions to any distributions they take from any pre-tax IRA. This pro-rata rule applies whether or not they have an annuity with a living benefit as an IRA investment and is the responsibility of the owner to track and allocate their after-tax contributions using IRS Form 8606.
This material is not a recommendation to buy or sell a financial product or to adopt an investment strategy. Investors should discuss their specific situation with their financial professional.
Income tax laws are complex and subject to change. The information in this memorandum is based on current interpretations of the law and is not guaranteed. Neither Nationwide, nor its employees, its agents, brokers, or registered representatives gives legal or tax advice