House lawmakers yesterday passed a bill that contains a provision giving Americans a little more control over their retirement fates. It is part of the Small Business Jobs Act, passed by the Senate earlier this month. President Barack Obama is expected to sign it into law on Monday.
The legislation provides Americans with "much needed flexibility to tailor the level of guaranteed income to fit their needs in retirement," says Thomas Bartell, chairman of Americans for Secure Retirement, a coalition of more than 70 organizations that works with policymakers to develop laws encouraging guaranteed sources of retirement income. (Yes, insurers are among their members, but so are a variety of other interests.)
The provision Bartell alludes to is a coup for his organization, and for investors who currently own or plan to buy deferred annuities. It comes at a time when stress levels about retirement planning run high.
Quick review of annuities
Deferred annuities are insurance products that enable you to invest unlimited amounts of after-tax money on a tax-deferred basis for a period of time, after which you can annuitize them when you're ready to retire. Annuitization converts a pile of money into a regular stream of income.
When you annuitize a deferred annuity, the payments are taxed on a pro rata basis, meaning that the earnings portion of the payment that grew tax-deferred is taxed as income, while the rest is considered a recovery of your capital. That is not taxed since you've already paid taxes on it. Follow me?
Lump-sum distributions from the annuity that are not annuitized, under current law, are taxed under an "income first" rule, meaning that "such distributions are fully taxable until all the gain in the contract has been withdrawn," says Bartell. Once the gain has been withdrawn, the owner can get his or her money back sans taxes.
What if a retiree only wants to annuitize a portion of the deferred annuity? "Under current law, there was some uncertainty whether the periodic annuity payments made pursuant to a partial annuitization were taxed under the income-first rule or the pro rata rule," Bartell says. "Obviously the pro rata rule is more favorable, so the possibility that the income-first rule would apply made partial annuitizations unattractive."
An example of the two scenarios
To help illustrate how this would affect retirees taking a distribution, Bartell provides this example:
"Assume that a 70-year-old male owns an individual deferred annuity with an account balance of $60,000. Assume further that his total after-tax premiums were $40,000. He wants to apply half of his account balance ($30,000) to produce a stream of fixed, periodic annuity payments that are guaranteed to continue for the longer of his life or 10 years. He wants to leave the remaining half of his account balance intact in case he has a cash emergency or to apply toward an income stream later. He takes these steps and begins receiving annuity payments of $200 per month.
"Under current law, it appears that the IRS position is that the income-first rule would apply. As a result, each $200 monthly payment he receives is fully taxable. Assuming he is in the 25 percent tax bracket, his net monthly payment would be $150. These monthly payments would continue to be fully taxable until all the gain in the contract was distributed. Although it is not entirely clear how this would be determined, it would take at least eight years of payments -- when the owner is age 78 -- before he would begin recovering any of his basis.
"Under the new law, the pro rata rule would apply to his annuity payments. As a result, only about $107 of each monthly payment would be taxable, and the rest would be tax-free as a return of basis. Assuming the same tax rate as above, his net monthly payment after taxes would be $173."
The new rules will apply to existing deferred annuities partially annuitized after Dec. 31 of this year, he says. And of course it will also apply to deferred annuities purchased and partially annuitized after that date.
As for whether annuities are the salve that will heal America's retirement income woes -- that's a whole 'nother topic for another time.
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