Non-Qualified Variable Annuities Distribution Options

[bpgdeg1234]

Thanks once again in advance for any advice you can provide.

Variable annuities are clearly not one of our strong points but FIL apparently had a keen interest in them as he had several that DW received upon his passing in November. Of particular note are 3 variable and 1 fixed non-qualified annuities with values as follows:

Fixed Annuity 1 @3.5%: $54,000 ($30,000 earnings and principal of $24,000)
Variable Annuity 2: $52,000 ($36,000 earnings and principal of $16,000)
Variable Annuity 3: $134,000 ($116,000 earnings and principal of $18,000)
Variable Annuity 4: $105,000 ($91,000 earnings and principal of $14,000)

All four non-qualified, variable annuities allow for the following beneficiary distribution options:
- Lump Sum Payout
- 5 year deferral with partial/full withdrawals requiring complete drain/closure of account required by end of 5th year
- Payments over Single-life expectancy (DW would be 27 years) with required annual withdrawals & partial/full withdrawals at any time
- Annuity Income with typical life only, life income for specified period, etc. choices

We are presently in the 22% fed and 4% state marginal tax brackets and have been in the process of doing Roth conversions and planned to continue for the next couple years up into the 24% bracket to $250K (just to NIIT level so roughly $125,000-$150,000 conversion per year) and then planned to only do Roth conversions up to IRMAA Tier 1 level starting in 2024 so approximatley somewhere between $50,000-$60,000 at that point.

Now though with DW's inheritance we're trying to consider what to do with the non-qualified annuities in general and in light of our plan for the Roth conversions. We initially have considered the following distribution options below to allow us to continue with the vast majority of our Roth Conversion plan but not sure this makes sense or is there a more optimum approach we should consider:

Annuity 1 (fixed 3.5%) - go with 5 year deferral as 3.5% looks pretty good with closure at end of year 5 (note 3.5% fixed only applies to this term)
Annuity 2 (variable) - cash out this annuity in 2022, reduce 2022 Roth conversion by same amount and invest proceeds in brokerage account
Annuity 3 (variable) - choose DW payments over single-life expectancy, non-qualified stretch (27 years life expectancy at this point)
Annuity 4 (variable) - choose DW payments over single-life expectancy, non-qualified stretch (27 years life expectancy at this point)

One concern we had with Annuity 3 and 4 payment over single-life stretch distribution is the high insurance company fees (2+%). As such, if this approach was pursued we likely may have to consider a 1035 exchange into a new, lower cost provider account such as Fidelity.

Appreciate any thoughts in advance. Thanks.

 

[kgtest]

Thanks once again in advance for any advice you can provide.

Variable annuities are clearly not one of our strong points but FIL apparently had a keen interest in them as he had several that DW received upon his passing in November. Of particular note are 3 variable and 1 fixed non-qualified annuities with values as follows:

Fixed Annuity 1 @3.5%: $54,000 ($30,000 earnings and principal of $24,000)
Variable Annuity 2: $52,000 ($36,000 earnings and principal of $16,000)
Variable Annuity 3: $134,000 ($116,000 earnings and principal of $18,000)
Variable Annuity 4: $105,000 ($91,000 earnings and principal of $14,000)

All four non-qualified, variable annuities allow for the following beneficiary distribution options:
- Lump Sum Payout
- 5 year deferral with partial/full withdrawals requiring complete drain/closure of account required by end of 5th year
- Payments over Single-life expectancy (DW would be 27 years) with required annual withdrawals & partial/full withdrawals at any time
- Annuity Income with typical life only, life income for specified period, etc. choices

We are presently in the 22% fed and 4% state marginal tax brackets and have been in the process of doing Roth conversions and planned to continue for the next couple years up into the 24% bracket to $250K (just to NIIT level so roughly $125,000-$150,000 conversion per year) and then planned to only do Roth conversions up to IRMAA Tier 1 level starting in 2024 so approximatley somewhere between $50,000-$60,000 at that point.

Now though with DW's inheritance we're trying to consider what to do with the non-qualified annuities in general and in light of our plan for the Roth conversions. We initially have considered the following distribution options below to allow us to continue with the vast majority of our Roth Conversion plan but not sure this makes sense or is there a more optimum approach we should consider:

Annuity 1 (fixed 3.5%) - go with 5 year deferral as 3.5% looks pretty good with closure at end of year 5 (note 3.5% fixed only applies to this term)
Annuity 2 (variable) - cash out this annuity in 2022, reduce 2022 Roth conversion by same amount and invest proceeds in brokerage account
Annuity 3 (variable) - choose DW payments over single-life expectancy, non-qualified stretch (27 years life expectancy at this point)
Annuity 4 (variable) - choose DW payments over single-life expectancy, non-qualified stretch (27 years life expectancy at this point)

One concern we had with Annuity 3 and 4 payment over single-life stretch distribution is the high insurance company fees (2+%). As such, if this approach was pursued we likely may have to consider a 1035 exchange into a new, lower cost provider account such as Fidelity.

Appreciate any thoughts in advance. Thanks.

I would cash them out as fast as possible. Fee's will eat that principle alive. I've worked in IT for the 2nd and 3rd largest Life Insurance companies and the returns you can get in the stock market are far greater than what an annuity gain less insurance fees would be.

I understand you are looking to do mega backdoor conversions. Still doesn't change my answer. In the long run you will have more freedom and control breaking free form the insurance contract and self-managing in the markets. IF you were terrible with money (gambling/other addict) or unable to perform basic care duties (special needs) there is a case for an annuity, but I would still rather pay a third party to manage as executor of estate in individual equities/ETFs then being locked into a binding insurance policy.

I would make it a priority in my independent investment plan to withdraw the annuity and forego the attached contract ASAP. Not sure what your life expectancy is or how healthy you are, but if you have a long runway its an even greater case to get away from the annuity.

 

[bpgdeg1234]

I would cash them out as fast as possible. Fee's will eat that principle alive. I've worked in IT for the 2nd and 3rd largest Life Insurance companies and the returns you can get in the stock market are far greater than what an annuity gain less insurance fees would be.

I understand you are looking to do mega backdoor conversions. Still doesn't change my answer. In the long run you will have more freedom and control breaking free form the insurance contract and self-managing in the markets. IF you were terrible with money (gambling/other addict) or unable to perform basic care duties (special needs) there is a case for an annuity, but I would still rather pay a third party to manage as executor of estate in individual equities/ETFs then being locked into a binding insurance policy.

I would make it a priority in my independent investment plan to withdraw the annuity and forego the attached contract ASAP. Not sure what your life expectancy is or how healthy you are, but if you have a long runway its an even greater case to get away from the annuity.

Very interesting perspective as we have indeed considered that perhaps this may be a good approach with a future gains taxed at preferential rather than ordinary tax rates, as well as the step up in basis if DW never needed the money.

If we were to keep the two variable annuities (3 and 4) we would look to do a 1035 Exchange to Fidelity with index funds so total fees would be only .35% (.25% annuity and .10% index fund fee) so that would negate a lot of the high fee (2.25%+) concerns associated with the insurance carrier. It also allows us to continue with our ongoing Roth conversion strategy while allowing us to still consider cashing them out at some point down the road.

 

[pb4uski]

... We initially have considered the following distribution options below to allow us to continue with the vast majority of our Roth Conversion plan but not sure this makes sense or is there a more optimum approach we should consider:

Annuity 1 (fixed 3.5%) - go with 5 year deferral as 3.5% looks pretty good with closure at end of year 5 (note 3.5% fixed only applies to this term)
Annuity 2 (variable) - cash out this annuity in 2022, reduce 2022 Roth conversion by same amount and invest proceeds in brokerage account
Annuity 3 (variable) - choose DW payments over single-life expectancy, non-qualified stretch (27 years life expectancy at this point)
Annuity 4 (variable) - choose DW payments over single-life expectancy, non-qualified stretch (27 years life expectancy at this point)

One concern we had with Annuity 3 and 4 payment over single-life stretch distribution is the high insurance company fees (2+%). As such, if this approach was pursued we likely may have to consider a 1035 exchange into a new, lower cost provider account such as Fidelity.

Appreciate any thoughts in advance. Thanks.

That is one additional thing about annuities that stink compared to taxable account investments... no stepped up basis upon death so your heirs inherit a tax liability along with the asset.

It might be too late, but who would the annuities go to if she disclaimed them? If it would be one of your heirs who has a lower tax bracket then that might be worth considering.

Otherwise, I think your plan makes sense since you're pretty much between a rock and a hard place anyway. I'd definitely keep the 3.5% fixed annuity.

For the last two, I'd look at fees and returns after fees compared to what you would invest the proceeds in but I think your plan makes sense. Another option might be to covert the VAs to fixed payout annuities, especially if DW is in good health. Or just cash them out and forgo a couple years of Roth conversions which pushes the deferred income out and possibly to your heirs.

You might also see if you can 1035 exchange 2, 3 or 4 into 1 and get more of that juicy 3.5% rate... I suspect not but it doesn't hurt to ask.

Another option to consider is to use some of the money to establish a scholarship in your DFIL's name at an educational institution that he cherished (assuming that there is one).

 

[Chuckanut]

That is one additional thing about annuities that stink compared to taxable account investments... no stepped up basis upon death so your heirs inherit a tax liability along with the asset.

Thanks for the above well timed remark. It's another reminder that I truly don't know what I don't know.

A friend who is rapidly approaching retirement asked me the other day about annuities so as to lock in an income for life with little risk. While I don't tell people what to do, we discussed some of the pros and cons of annuities. We also discussed alternatives such as stock index funds, Wellesley, and iBonds. I'll add this to the list of reasons I think he should be very very careful about buying any annuity but a SPIA if he decides he must have an annuity.

 

[bpgdeg1234]

That is one additional thing about annuities that stink compared to taxable account investments... no stepped up basis upon death so your heirs inherit a tax liability along with the asset.

It might be too late, but who would the annuities go to if she disclaimed them? If it would be one of your heirs who has a lower tax bracket then that might be worth considering.

Otherwise, I think your plan makes sense since you're pretty much between a rock and a hard place anyway. I'd definitely keep the 3.5% fixed annuity.

For the last two, I'd look at fees and returns after fees compared to what you would invest the proceeds in but I think your plan makes sense. Another option might be to covert the VAs to fixed payout annuities, especially if DW is in good health. Or just cash them out and forgo a couple years of Roth conversions which pushes the deferred income out and possibly to your heirs.

You might also see if you can 1035 exchange 2, 3 or 4 into 1 and get more of that juicy 3.5% rate... I suspect not but it doesn't hurt to ask.

Another option to consider is to use some of the money to establish a scholarship in your DFIL's name at an educational institution that he cherished (assuming that there is one).

Thanks pb4uski for your usual great thoughts. Some things to surely consider and follow-up on.

Don't believe disclaiming would do much good as heirs are in similar tax bracket as DW.

As for keeping annuity versus cashing out, I did do a spreadsheet comparing the cash out option within two years (foregoing Roth Conversions) versus keeping annuity with with insurance carrier with single-life expectancy stretch option and 1035 exchanging same into Fidelity but using low cost index funds as investment option.

Needless to say insurance carrier was obviously the worst of the three with the Fidelity annuity and "cash out" close starting out, but then "cash out" moves ahead in Year 2/Year 3 and continues widening the gap moving forward. Additionally, the step up in basis of the cash-out invest in brokerage account is a biggie as well since we don't anticipate needing the money.

Current thinking (subject to change lol) is doing either Annuity 3 or 4 as a cash out now with 2022 tax hit (limited Roth conversion this year) with a 1035 exchange of the other annuity into Fidelity as don't want to do both this year due to tax reasons. In 2023 we'll have a year behind us and can then decide on the second one on whether to keep with Fidelity annuity or cash it out as well.

As for annuitization, DW not very interested in this option as afraid of leaving money on the table although have discussed 10/20 year certain guarantee potentials. From talking to insurance carrier we can't 1035 exchange into the fixed at that 3.5% rate as that was only for the 5 year payout of that existing contract. I do though have to investigate more of the fixed option rates that one could get in general. Thanks again for your perspectives.

 

[all4j]

I think you have a good handle on this, but will add a few thoughts just in case.

I'm assuming that you are keeping #1 with a 5 year plan & so really addressing the others. I would have all them as life expectancy initially because at any point later you can empty them.

As background, just pointing out that distributions always come from earning 1st before touching principal. The RMD factor on inherited will increase by 1 each year, a bit different.

I would definitely check out 1035 exchange, being sure as not to start any surrender fee clock etc. I would also check out a PARTIAL 1035 because I think these prorate earnings & principal. For example, if you 1035'd half of # 4. That would mean you would have 2 with earnings of $45.5k & principal of $7k. Then you could empty the original (remaining half) #4, which would "liberate" the principal without a tax hit to you.

You might also consider a 1035 into a myga(s).

IRMAA has a hard edge but tax brackets don't. By that I mean, the higher tax rate only affects what's in the bracket. I try not to let the tax tail wag the dog unnecessarily. Simplicity means more to some than others.

Good luck -- think you are well on the way

 

[Dash man]

I’m curious why you’re only going up to the $250k NIIT level with your conversions? Do you have a lot of dividends and capital gains to be concerned with? I assume going into the 24% bracket you’re looking at higher rates when RMDs kick in, so why not do more now?
If I were in your situation, I’d look into cashing out some of the annuities to pay the taxes on the Roth conversions. It doesn’t sound like you’re going to be in a lower tax bracket soon and tax rates go up in 2026 when the TCJA sunsets. There’s also the consideration of one of you paying single tax rates should one pass sooner than expected.

 

[Souschef]

My DW got sold an variable annuity which matures in 2025. She plans to cash it in then to avoid early withdrawal penalties.
Unfortunately, from what I have read, the appreciation will be taxed as ordinary income.
I would appreciate any thoughts. She plans to gift the proceeds to her 2 sons. I know she will have to file a 709, but that is not a big problem.

 

[kgtest]

bpgdeg1234 I do believe you have a pretty decent handle if you have run the tax consequence in your what-ifs with keeping vs cash-out with solid re-investment.

By keeping them all, you are essentially placing a bet with the insurance company betting you will die soon, vs you are betting you won't in the long run. Nobody knows when we will go.

As per dash man's suggestion, I am kinda in his boat, with the same assumption that your tax brackets will be higher later based on your comments this far. I believe a one year or two year large tax bill option is worth running the what-if against and if you feel you are in decent health, with lots of runway, and are looking to maximize the gains then that might be the better way knowing income tax brackets are rising in the future and knowing that the Roth IRA is the most attractive vessel for long term tax planning purposes. But a hybrid option might actually work better with long term tax planning. I would still advocate cashing as much out, as soon as that makes sense to your tax situation.

That lack of step-up basis and tax rate as ordinary income on all of the gains is a disappointment, but maybe its not soo bad?

 

[bpgdeg1234]

I’m curious why you’re only going up to the $250k NIIT level with your conversions? Do you have a lot of dividends and capital gains to be concerned with? I assume going into the 24% bracket you’re looking at higher rates when RMDs kick in, so why not do more now?
If I were in your situation, I’d look into cashing out some of the annuities to pay the taxes on the Roth conversions. It doesn’t sound like you’re going to be in a lower tax bracket soon and tax rates go up in 2026 when the TCJA sunsets. There’s also the consideration of one of you paying single tax rates should one pass sooner than expected.

Thanks good points. We have about $60K in interest/dividends this year but this will likely reduce to $40K in 2022. We also have the after tax funds to pay the taxes on the Roth conversions but just don't like paying that extra 3.8% NIIT on top of the marginal 24% federal tax and 4% state if we can avoid it so that's why we've been stopping at the $250K mark. Also, we had enough runway to get to the 50/50 level of traditional to Roth that we sought before getting anywhere near RMD age of 72.

 

[bpgdeg1234]

I think you have a good handle on this, but will add a few thoughts just in case.

I'm assuming that you are keeping #1 with a 5 year plan & so really addressing the others. I would have all them as life expectancy initially because at any point later you can empty them.

As background, just pointing out that distributions always come from earning 1st before touching principal. The RMD factor on inherited will increase by 1 each year, a bit different. Understood

I would definitely check out 1035 exchange, being sure as not to start any surrender fee clock etc. I would also check out a PARTIAL 1035 because I think these prorate earnings & principal. For example, if you 1035'd half of # 4. That would mean you would have 2 with earnings of $45.5k & principal of $7k. Then you could empty the original (remaining half) #4, which would "liberate" the principal without a tax hit to you. Interesting thought that we will need to investigate further.

You might also consider a 1035 into a myga(s). Plan on discussing this with blueprintincome this week.

IRMAA has a hard edge but tax brackets don't. By that I mean, the higher tax rate only affects what's in the bracket. I try not to let the tax tail wag the dog unnecessarily. Simplicity means more to some than others.

Good luck -- think you are well on the way

Thanks for all of your thoughts.

 

[bpgdeg1234]

bpgdeg1234 I do believe you have a pretty decent handle if you have run the tax consequence in your what-ifs with keeping vs cash-out with solid re-investment.

By keeping them all, you are essentially placing a bet with the insurance company betting you will die soon, vs you are betting you won't in the long run. Nobody knows when we will go. With single life expectancy distribution DW's beneficiary would get remaining payments or lump sum if she were to pass so not sure if this comes into play?

As per dash man's suggestion, I am kinda in his boat, with the same assumption that your tax brackets will be higher later based on your comments this far. I believe a one year or two year large tax bill option is worth running the what-if against and if you feel you are in decent health, with lots of runway, and are looking to maximize the gains then that might be the better way knowing income tax brackets are rising in the future and knowing that the Roth IRA is the most attractive vessel for long term tax planning purposes. But a hybrid option might actually work better with long term tax planning. I would still advocate cashing as much out, as soon as that makes sense to your tax situation. So just to be clear, you are still advocating as before to cash out, pay the taxes and skip Roth conversion for next two years?

That lack of step-up basis and tax rate as ordinary income on all of the gains is a disappointment, but maybe its not soo bad?

Thanks for your perspective once again.