Annuity Planning Strategies

Author: Andrew Lee 
About 5 minutes read.

DISCLAIMER: Author is not a tax professional nor financial advisor. All materials here are provided as-is and it is only used for general information. It does not guarantee the same future performance or outcome. Please consult with a qualified tax professionals and financial advisor for your individual situation and perform your own due-diligence.

If you are new to Annuity, you can read up on this article “Annuity, annua? A lifetime income?” which provides a general overview what an Annuity is. It is recommended to consult with a qualified and licensed life agent or financial advisor for such product if you are interested.

Here, we will mention 2 common strategies. Whether the strategy is suitable for you depends on individual conditions, goals, and your risk tolerance. One is called the split annuity, and the other is leveraging an equity-indexed annuity product.

1. Split Annuity

There are different ways to plan according to individual situations. One strategy you may heard of is the term split annuity that is used as a long-term investment and tax strategy to preserve capital. The idea is straight forward, it utilize 2 single premium non-qualified annuity contracts - SPIA and SPDA. Here is an example based on after-tax investment amount $100,000 and expected goal is to have take-home money $4,000 (after-tax) per year. 

Basic Straight forward Investment with CD

We assume we invest in a financial product (e.g. 52 weeks CD) with an annual interest rate that is 1% for every year. This interest earned is taxable income annually (1099-INT), so based on your annual marginal tax bracket (e.g. 24%), your take-home money for the 1st year is $760. Income tax is $240. However, because yours withdraw plus earnings should meet the $4,000 goal, you will in fact withdraw more and more every year as you deplete your initial $100,000 capital. The following table is a breakdown on each year for a 10-years schedule.

After 10 years, you will have a remaining balance of $69,933.

Split Annuity Strategy with 2 Annuity contracts - SPIA + SPDA

However, the following is an example how we plan to derive similar annual income $4,000 with the concept of split annuity to preserve capital.

You split the initial investment (e.g. $100,000 after-tax) based on the exclusion ratio according to an interest rate or a target rate of return (e.g. 4%). Calculate present value $100,000 for 10 years 4% rate => $67,556. 2 Annuity contracts A (SPIA) and B (SPDA) are setup.

(A) Setup a 10-years non-qualified SPIA with $32,444 ($100,000 - $67,556) with a rate you shop around and a settlement option for a 10-years fix-period income payment. Annual income payout could be $4236 (varies by SPIA issuer. The rate here I use is ~2.125%* minus applicable fees, etc.). The earnings $992 ($4236 - $3,244) is taxable and $3,244 is tax-free because it is from your after-tax initial investment (return of investment). This is known as the exclusion ratio**. The following 10-years schedule table rounds up the decimal to simplify the numbers for calculation purposes.

* The rate for contract (A) non-qualified SPIA plays a critical role. You can read more on how “Rate in Annuity” works.

** An exclusion ratio applied so part of it is taxable and the other part is tax-free because it came from your own after-tax premium. Withdrawal is a combination of your own premium plus earnings.

(B) Setup a 10-years non-qualified SPDA with after-tax dollars $67,556 with minimum 4% guarantee rate. This will end up with $100,000 after 10 years, and keep in mind, the gain of $32,444 is tax-deferred taxable interest. After applying the 24% tax, take-home premium + earnings is $92,214 (=$67,556 + $32,444 x 0.76).

In this split annuity strategy, both withdrawal ~$4,000 per year, however, split annuity ends up with $92,214 as oppose to $69,933 after 10 years. There are several reasons why this could be a better strategy, one is tax-deferral advantage so earnings are not taxed annually and you have the compound advantage, another one is based on the financial institution providing a better rate of return as they manage your assets for you.

Note: Be aware of the gotchas when planning Annuities. The example here is a long-term planning, and any early withdraw/termination could subject to charges and fees, and trigger taxable events. Consult with a qualified tax professional and life agent for your situation.

2. Equity-Indexed Annuity or Indexed Annuity

For those that know Options trading, this is no news. However, if you never thought about this, hopefully this inspires you today.The strategy is simple, you split your initial capital into 2 portion, one portion utilize a fix-income product like CD, bond, or again an Annuity (SPDA), and the 2nd portion is invested in option on an equity index (e.g. stock, ETF) or a market index (e.g. S&P 500). The example here will re-use the example above, we take the SPDA contract from B starting with $67,556 and a 4% rate of return, and we utilize the remaining $32,444 to invest in options trading. The option trading strategy depends on your knowledge and due-diligence. This brings up various choice how you could split up the investments such as the following but not limited to:

• SPDA fixed rate + options trading
• SPDA fixed rate + Index Annuity***
• CD/Bond + options trading
• CD/Bond + Index Annuity

In my opinion, if you can locate a fixed rate of return, you can perform the same strategy, but keep in mind, there are tax events involved here which will impact your annual earnings which you do need to take into account, and the market risk that you are involving on the 2nd portion of your investment.

***Index annuity actually does not participate in the real market. Insurance company uses index as a reference only to credit you your rate. The risk from the insurance company in this case is not the same as investment company where they put your money in the real market.

Conclusion

I hope this inspires you with more choices when you perform your due-diligence and planning on your investment. The key take away for long-term investment here is to make sure you:

• set a financial goal, recognize some strategies like this article and perform due-diligence
• consider the tax consequence on the products you are studying
• consider the market risk that the product is exposed to
• consider the liquidity of the products
• consider leveraging financial institutions instead of DIY (Do It Yourself)
• consider the charges and fees of the products versus time and knowledge if DIY

I have opened comments for this articles because I would love to hear from you and collect feed-backs on different strategies to improve my knowledge. I hope you enjoy this article and please do let me know if I can make it better. Thanks.