Annuities
Non-Qualified Plans: What They Have to Offer for Retirement Income and the Tax Implications
by Del Campbell and Jamie Branyan

A massive wave of Baby Boomers is reaching retirement, but the variable annuity industry is still strongly focused on accumulation. Times have changed and the industry needs to shift to a lifetime needs focus. The industry also needs to increase the number of tools in the advisorีs toolbox. Lifetime income security must be part of the planning process for retirement; risks of inflation, longevity, and uncertainty need to be addressed in a client-focused way.
The insurance industry can help create retirement income security with solutions for lifetime wealth accumulation, protection, and distribution. Guarantees help advisors offer their clients the protection they need to stay invested in the market. However, a vital part of the equation remains ะ the tax implications of annuity options, especially for non-qualified plans.
Combining elements of guaranteed minimum withdrawal benefits (GMWB) and lifetime withdrawals can offer substantial tax advantages over separate arrangements. This is especially true when using annuities in non-qualified retirement accounts. This unique method of annuitization combines the tax advantages of the traditional annuity with the control, access, and flexibility of GMWBs.

The numbers outline this most clearly. The following chart compares the combination annuitization model with a typical 5% GMWB model for a man with $100,000 to invest. The chart shows two ways of drawing money out of the contract and the amount each option offers for retirement income after taxes. The clientีs circumstances should be taken into consideration when determining the most appropriate choice.

The chart shows how systematic withdrawals can have negative effect on the spendable income from a non-qualified variable annuity ะ due to taxation on a gain-first basis. For instance, with most lifetime GMWBs, a 65-year-old man with $100,000 to invest could take out $5,000 for life guaranteed. But, he would lose a substantial portion to taxes because this is taxed gain first. He would only get $3,500 after tax with a 30% tax rate and even a modest 5% return.
The scenario would be slightly different if he used variable annuitization with a floor benefit. Their guarantee may be less at younger ages. The lifetime income guarantee for age 65 would be $4,439 versus the $5,000 for the GMWB.
However, the initial income is actually higher at $5,919 because the client receives a portion of the cost basis back. Also, $4,100 of the $5,919 income payment is considered tax-free due to the return of cost basis. This means the client is only taxed on $1,819, giving him a substantially higher spendable income of $5,373.
In fact, with a 30% tax rate and 5% return, the tax-free portion of the income exceeds the GMWBs after-tax total income in all four of the ages represented in the chart. The floor exceeds the GMWB at age 70 and above.
Even with a lower guarantee and modest market, the combination annuitization with access to account value provides more spendable income -- in this case, significantly more income. The client would continue getting this tax-free return of cost basis until he gets 100% of the original cost basis back. Keep in mind that taxes may be due upon distribution. Guarantees are backed by the financial strength of the insurer.

The combination annuitization approach allows the client to retain asset control; allows brokers to retain assets under management; and it guarantees income payments for life at a minimum income level; this is regardless of market activity even with substantial equity exposure. The rate of income is protected from market downturns and inflation. This approach also lends itself extremely well to าwrapำ or fee-based accounts. Most importantly for clients are the tax advantages, which keep more of their money where it belongs.
There has been a strong industry focus on guarantees, as well there should be; guarantees can help a client remain protected against a downturn and therefore, stay invested in the market. However, it is vital for clients to remember that taxes also need to be kept in check. Guarantees are a critical component, but the right guarantee maximizes their after-tax returns, which is the goal in any investment. This is particularly important in non-qualified accounts.

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Del Campbell is assistant VP, annuity product development with The Lincoln National Life Insurance Company. Heีs been with Lincoln for 13 years and has been dedicated to variable annuities for the past six years. Before that, he worked for Lincoln Financial Advisors developing and marketing investment advisor programs. Before that, he was a financial consultant with Merrill Lynch.
Jamie Branyan is variable annuity product analyst with Lincoln. Heีs been with Lincoln for six years, starting as strategic planning specialist in ิ01. Previously he completed his M.B.A. from Ball State Univ. in Indiana. For more information call 800-454-6265.