Better defined as an annuity strategy, a split annuity provides an immediate tax advantaged income to retirees by using two different types of annuities in an ingenious way.
How It Works
Taking a portion of retirement funds and placing them into an immediate annuity for 5 to 10 years, monthly income is generated from the principal and interest. At the same time the immediate annuity is purchased, a deferred annuity is purchased for growth. This growth, in theory, replenishes the original principal taken out of the immediate annuity.
Therefore, when the immediate annuity is depleted, half of the deferred annuity is then invested into an immediate annuity and the cycle is repeated. This strategy only works with funds that are not in a tax-qualified retirement account or IRA. Those in the higher income tax brackets see the most benefits.
The split annuity strategy creates an ongoing income stream by combining monthly disbursements with an ongoing growth mechanism. In addition to the deferred annuity that continues to grow, an inflation rider can be added to hedge against inflation and the devaluation of the dollar. In comparison to bank certificates of deposit and bonds, the split annuity strategy is tax favorable because the growth from the deferred annuity is not treated or taxed as ordinary income.
When planning a retirement strategy for continued income, the split annuity strategy works well as part of a retirement income plan. As part of a retirement income planning conversion to a lifetime income, this strategy can also be “tweaked” for a longevity annuity strategy.
The two annuities, immediate and deferred, that are combined to make the split annuity strategy are composed of income from an immediate annuity and a fixed rate multi-year guaranteed annuity. Both annuities last for the same time period and structured so that when the immediate annuities assets are depleted, the fixed annuity’s principal has gained the original principal depleted from the immediate annuity. The most common time frame is 10 years.
Advantages of a Split Annuity
There are several advantages to a split annuity strategy.
- Dependable Income – By providing a safe, guaranteed, and predictable cash flow, monthly income is supplemented. This can provide a feeling of well-being and safety for retirees.
- Tax Savings – A significant part of the payments from the immediate annuity are tax-deferred. In some cases, almost 90 percent of income payments can be excluded from taxation.
- Tax-Deferred Growth – With a fixed rate multi-year guaranteed annuity, part of the strategy comes from the tax-deferred growth. In addition, interest is usually better than a certificate of deposit’s rate of return from a bank.
- Principal Preservation – While receiving a steady income stream and a tax-deferred growth savings, the original principal from the immediate annuity is restored at the end of the guarantee period. This provides retirees with many different options such as the ability to purchase another split annuity and repeat the process.
The Appeal of a Split Annuity Strategy
This type of annuity strategy appeals to conservative investors who want a guaranteed income stream and a fixed rate of return. Even though interest rates tend to be lower than stock market investment returns, the earnings are extremely protected and growth is tax-deferred. Swings in the stock market do not affect fixed deferred annuities or immediate annuities, therefore are appealing to many retirees who do not want to risk their future on a volatile market.
Since interest rates are historically low, many retirees are opting to purchase two annuities at once—a fixed annuity and an immediate annuity. The reason is simple: guaranteed income and an improved cash flow.
Even the most conservative investor cannot argue that using a split income annuity versus just a fixed rate annuity is the best route. For example, a $1 million immediate annuity will only provide around $34,000 per year income. However, if that same investor buys a $500,000 fixed deferred annuity and another $500,000 fixed immediate annuity, the income may be around $3,700 per month. In addition, the fixed deferred annuity is steadily building principal while a tax break on the earnings is given until they are withdrawn.
For many who want their assets liquid, an annuity might not be the best choice. Once an annuity is purchased, the rate is locked in and the owner cannot change their mind. Also, if an investor does not have a reasonable expectation of living a normal lifespan, they might not get their “money’s worth” from an annuity. However, a rider can be added to extend the income to a surviving spouse.
Withdrawals are based on a monthly payment blend of principal and interest. The tax savings comes in because the principal is exempt from taxation because it is considered after-tax money.
The key advantage of a fixed deferred annuity is the flexibility to surrender the annuity after the penalty period ends (whether 5, 7, or 10 years) and purchase a new annuity with preferably higher interest rates.
For example, the investor who purchased the two $500,000 annuities (one fixed and one immediate) will have another $500,000 to purchase a new annuity because no fees were paid on the fixed deferred annuity. If interest rates rise even a point or two, the investor can purchase another five-year fixed deferred annuity and increase the monthly income stream by more than $500 per month.
All in all, a mixture of an immediate annuity and a fixed deferred annuity make smart investment sense. Since the process can become complicated when adding riders or other types of changes, discussing investment and retirement options with a highly-qualified annuity expert is advisable.
In addition, purchasing an annuity should only be from an insurance company with financial strength and claims-paying ability. If an insurance company has a weak financial statement, the chances of that company lasting 5 or 10 years may not be viable and an investor could find themselves without any income. Choose an insurance company that has a stellar record of strength and longevity for peace of mind.