Converting a Deferred Annuity to a SPIA 

Deferred annuities can be useful retirement savings tools for your clients. But have you considered that the best option for your clients may be to convert their deferred annuity into a single premium immediate annuity (SPIA)? By doing so, you may be able to help your clients:

• Reduce income tax on their retirement income.

• Minimize estate taxes for their beneficiaries.

• Prevent them from outliving the savings they worked so hard to accumulate.

Deferred annuities have become popular asset-accumulation products. Most often, deferred annuities are used to save money specifically for retirement because they provide tax-deferred growth on earned interest. Deferred annuities can be enticing to individuals who are seeking tax-deferred investment growth but don’t have a company-sponsored retirement plan or who have already contributed the maximum amount to an individual retirement account (IRA).

One advantage of nonqualified deferred annuities is that they are not subject to required minimum distribution rules. However, many annuity contracts may require cash surrender or settlement of the annuity by age 85 or 90, based on past IRS rulings. When your client is preparing to retire, they will have to decide how to receive the annuity’s cash value.

Benefits of a SPIA
The most tax-efficient method of distributing assets from a deferred annuity is to receive the payments as an immediate annuity. If the owner of a deferred annuity simply surrenders it for its cash accumulation value, ordinary income tax rates apply to the gain in the year in which it is surrendered. A SPIA, on the other hand, spreads out the gain from the deferred annuity over the term of the annuity payments.

A deferred annuity could become a liability if your client has accumulated a significant amount of other assets that are subject to estate taxes. If they die owning a deferred annuity that hasn’t matured, their gross estate will include the death benefit payable under the annuity contract. The death benefit will be considered income in respect of a decedent (IRD) to the extent the death benefit exceeds your client’s basis in the contract.

If your client’s estate is large enough to be subject to estate taxes (more than $2 million in 2006), the addition of the death benefit from the deferred annuity will ultimately increase the amount of estate taxes owed. Additionally, the beneficiary must pay income taxes on the death benefit. However, if your client’s estate pays estate taxes attributable to the IRD from the death benefit, the beneficiary will receive an income tax deduction for this. For these tax reasons, it makes sense to convert the deferred annuity to an immediate annuity if your client needs income during retirement.

The most important benefit of a SPIA is the ability to create a stream of income that your client cannot outlive. Life expectancies are rising, and many people at or near retirement fear they may not have enough retirement assets. While the deferred annuity is an excellent way to accumulate assets on a tax-deferred basis, many of your clients in this situation may need help creating a plan to distribute the wealth during retirement. An annuity that pays your client for their entire life can help them feel secure that they’ll always have the income they need.

Conversion of the annuity to a SPIA
One strategy to employ when converting a deferred annuity to an immediate annuity is to take only a portion of the deferred annuity’s value to create an income stream. The income payments can be paid over a specific period of time — five or 10 years, for example. Meanwhile, the assets remaining in the deferred annuity will continue to grow tax-deferred and will eventually replenish the fund. If your client needs more income later, they can tap the deferred annuity to create another income stream.

If your client wants to convert a deferred annuity to a SPIA, there are two options. First, deferred annuities often allow an individual to receive the annuity benefit under a settlement option. Therefore, before converting to a new immediate annuity contract, it’s important to investigate the payment options in the deferred annuity contract. If the contract offers favorable mortality and interest rate assumptions, your client may receive the highest income from a settlement option offered within that contract.

Alternatively, your client may benefit more from a 1035 exchange into an immediate annuity, especially if they want certain features of immediate annuity products. One such feature is a cost of living increase, which can help your client’s income payment keep pace with inflation. An age-rated annuity can be particularly helpful for your clients with health conditions. With an age-rated annuity, your client may be able to secure a greater income payment than would otherwise be possible. A few SPIAs also offer the ability to access the premium after the annuity payments have begun. This can provide added comfort for those who feel they may need to access their money for an emergency. One downside for the client with a 1035 exchange is that commission is paid on the transaction. However, even if the payment is ultimately higher or your client is attracted to other SPIA features, it may still be the best option all around.

Is a SPIA for everyone?
Despite the many benefits of converting a deferred annuity to an immediate annuity, doing so may not always be the best idea. Generally, there is a declining surrender charge schedule designed to discourage withdrawals from the contract during the first five to 10 years of a deferred annuity. If a conversion results in a surrender charge, then your client should consider the extent to which the surrender charge reduces the income potential of the immediate annuity. If its effect is too great, then it may be best to wait until the surrender charge diminishes or the surrender period ends altogether. Additionally, if the conversion occurs before the owner is age 591/2, a withdrawal or surrender of the contract will incur a 10 percent penalty tax from the IRS.

Lastly, an owner of a deferred annuity should avoid a conversion unless they need the income. Immediate annuities are great for creating an income stream, but if income is not an objective, then a different product may be the better choice.

Thomas J. Fridrich, JD, ChFC, CLTC is an advanced markets specialist focusing on retirement planning and charitable giving at Mutual of Omaha. He can be reached at 402-351-5693 or tom.fridrich@mutualofomaha.com.