Withdrawal Advice with Variable Annuity

[Trooper]

DW and I are 64 and 65, respectively, and have been retired for about 7 years. During this time we have been doing Roth conversions from our traditional IRAs, but we still have a ways to go to limit RMDs.

We have spending from taxable funds since retirement, but will run out of taxable funds in roughly the middle of this year. DW also has a non-qualified variable annuity that was 1035-d into Vanguard (now Transamerica). The annuity is worth $480K, is invested in a 60/40 allocation, has an expense ratio of 0.41%, and a cost basis of $315K. My wife will begin collecting a pension next year, and we have decided to collect SS at age 70, giving us three “annuities” at that point. Note: we have not annuitized the VA to this point.

My question is from where should we draw our living expenses, once the taxable monies are used up?

The annuity’s expense ratio isn’t great, but compared to many annuities it is not horrible. We could draw the gains ($480-$315 = $165K) for living expenses, then surrender the annuity and invest the basis in taxable funds. Or we could let the annuity sit and withdraw from our tIRAs, which would have the effect of a Roth conversion (reduces RMDs) while providing money for living expenses. Lastly we could draw from our Roth accounts, but I really do not want to do that.

Any advice is appreciated, thanks.

 

[Dtail]

Are the gains regular income or capital gains?

 

[pb4uski]

I'm pretty sure that withdrawals are all ordinary income, and to make it worse withdrawals are income first and then basis... so the first $165k of withdrawals are ordinary income and the next $315k is tax-free basis.

Sorry for the bad news.

 

[pjm-7]

How much are your expenses that you need? Also, what is your tax bracket? For simplicity's sake if you take the $165,000 gain from the annuity (it is all ordinary income under post August 1982 rules of Last in First Out) over five years, that is approximately $33,000 of income per year. This will get both of you to about age 70, so before RMD's start. Once you have removed the gain, then close the account and transfer the funds to a taxable account.

 

[MarieIG]

I would take it out of the traditional IRA. That's marching towards RMDs. You have much longer to fiddle with the annuity.

P.S. I have that annuity. I bought it from Vanguard. Initially I was going to trigger it with the rider, 100 percent joint and survivor lifetime starting at age 65. Instead, it appears I'm going to kick the can down the road a bit, delay SS to age 70, and use the income space to do Roth conversions. I'll revisit the Transamerica annuity later, but I may use it as longevity insurance for DH and myself if I'm around (i.e. nursing care if necessary). There is also the possibility of a 1035 conversion, but I'm not there yet.

 

[SevenUp]

If you are past the surrender fee time on the annuity, consider withdrawing from it (the account with the higher expense ratio) instead of from the IRA (the account with with lower expense ratio).

 

[DektolMan]

We are in the exact same position as our Vanguard annuities were merged into TransAmerica. What we are doing is taking systematic monthly withdrawals. This way we can increase or decrease the monthly amount or stop payments all together which gives us full control of our money without surrendering it to an insurance company.

 

[pb4uski]

I'm pretty sure that withdrawals are all ordinary income, and to make it worse withdrawals are income first and then basis... so the first $165k of withdrawals are ordinary income and the next $315k is tax-free basis.

Sorry for the bad news.

From Pub 575:

Variable Annuities
The tax rules in this publication apply both to annuities that provide fixed payments and to annuities that provide payments that vary in amount based on investment results or other factors. For example, they apply to commercial variable annuity contracts, whether bought by an employee retirement plan for its participants or bought directly from the issuer by an individual investor. Under these contracts, the owner can generally allocate the purchase payments among several types of investment portfolios or mutual funds and the contract value is determined by the performance of those investments. The earnings aren't taxed until distributed either in a withdrawal or in annuity payments. The taxable part of a distribution is treated as ordinary income.. ..

Withdrawals. If you withdraw funds before your annuity starting date and your annuity is under a qualified retirement plan, a ratable part of the amount withdrawn is tax free. The tax-free part is based on the ratio of your cost (investment in the contract) to your account balance under the plan.

If your annuity is under a nonqualified plan (including a contract you bought directly from the issuer), the amount withdrawn is allocated first to earnings (the taxable part) and then to your cost (the tax-free part). However, if you bought your annuity contract before August 14, 1982, a different allocation applies to the investment before that date and the earnings on that investment. To the extent the amount withdrawn doesn't exceed that investment and earnings, it is allocated first to your cost (the tax-free part) and then to earnings (the taxable part). ...

Source:https://www.irs.gov/publications/p575#en_US_2021_publink1000226702

 

[MarieIG]

Hmmm. What a mess. I am going to revisit the possibility of doing a 1035 into a 100 percent joint and survivor SPIA (with a 3% inflation rider built in) down the road. The initial payments would be tiny. It certainly is not the most efficient way to handle money.

This would give DH more income when he is older (passes the 1/2 way point on the life expectancy chart). IIRC, it is currently set to "annuitize" at age 85, so (hopefully), there is no rush for me to deal with it.

 

[pb4uski]

What is the mess?

 

[MarieIG]

What is the mess?

I had thought the taxes were prorated for each payment; not first out. It would "mess" with my Roth window - so down the road it goes.

 

[pb4uski]

Ah, I see.... the income is prorated for each payment only if you take periodic annuity payments, but not for withdrawals.

... Variable annuities. For variable annuity payments, figure the amount of each payment that is tax free by dividing your investment in the contract (adjusted for any refund feature) by the total number of periodic payments you expect to get under the contract. If the annuity is for a definite period, you determine the total number of payments by multiplying the number of payments to be made each year by the number of years you will receive payments. If the annuity is for life, you determine the total number of payments by using a multiple from the appropriate actuarial table. ...

Source:https://www.irs.gov/publications/p939#en_US_201812_publink100094814

BIL's mom had an annuity that I helped her get out of many years ago, and even though it was gain first as ordinary income, her income was only SS so we were able to split the withdrawals between December one year and January the next year and have it work out that she didn't pay any tax on the withdrawals.

 

[Trooper]

Thanks everyone for your responses.

@pb4uski - you've summarized exactly what I understand to be the taxation rules for an NQ variable annuity.
Pre-annuitization: gains come out first and are taxed at ordinary income. Basis comes out tax-free.
Post-annuitization: each periodic payment is considered a mix of gain and basis, and is partly taxable based on the pro-ration of basis and gain.

There is also the possibility of a 1035 conversion, but I'm not there yet.

Are you saying that I could, later on, purchase a SPIA with the balance on variable annuity? How then would the SPIA payments be taxed - the same way as if I annuitized the VA?

We are in the exact same position as our Vanguard annuities were merged into TransAmerica. What we are doing is taking systematic monthly withdrawals. This way we can increase or decrease the monthly amount or stop payments all together which gives us full control of our money without surrendering it to an insurance company.

I am assuming that by "systematic monthly withdrawals...that can be increased or decreased" you have not annuitized the contract but instead are simply withdrawing funds as you need them. How did you set that up with Transamerica?

 

[DektolMan]

I am assuming that by "systematic monthly withdrawals...that can be increased or decreased" you have not annuitized the contract but instead are simply withdrawing funds as you need them. How did you set that up with Transamerica?

I set it up with Vanguard before the transfer. 100% would be taxable until a certain point then I could take out the balance tax free. I'm sure TransAmerica will do the same as I have changed the amount we get monthly twice.

 

[friar1610]

Would it make any sense to annuitize for a period certain (e.g.. 5 years, 7 years, whatever) to see you through until SS starts? That way (1) the income would all be pro-rata (2) you would dispose of the annuity within a relatively short period. Not really sure what that would do to your taxes.

 

[Trooper]

I set it up with Vanguard before the transfer. 100% would be taxable until a certain point then I could take out the balance tax free. I'm sure TransAmerica will do the same as I have changed the amount we get monthly twice.

Thanks. I will look into that.

Would it make any sense to annuitize for a period certain (e.g.. 5 years, 7 years, whatever) to see you through until SS starts? That way (1) the income would all be pro-rata (2) you would dispose of the annuity within a relatively short period. Not really sure what that would do to your taxes.

A interesting idea. Since my gains are roughly 1/3 of the total balance, I am speculating that each payment would be 1/3 taxable and 2/3 tax-free. This might be a way to smooth out the tax hit. I would need to confirm the tax treatment with the annuity company (Transamerica or potentially a 1035 transfer insurance company).

Of course, I would give up control of the asset at the time of annuitization.

 

[friar1610]

Thanks. I will look into that.


A interesting idea. Since my gains are roughly 1/3 of the total balance, I am speculating that each payment would be 1/3 taxable and 2/3 tax-free. This might be a way to smooth out the tax hit. I would need to confirm the tax treatment with the annuity company (Transamerica or potentially a 1035 transfer insurance company).

Of course, I would give up control of the asset at the time of annuitization.

I suggested that because I have an annuity (not yet annuitized) that I sorta wish I didn’t have. I have several ideas on how to use it to greatest effect. One of them is that if (God forbid) my wife ends up in a nursing home while I’m still alive, I would annuitize it for perhaps 5 years, use the proceeds to pay for the nursing home and also get a tax deduction for much of the taxable annuity income since it would be used for medical expenses. That idea has me looking for other ways that a period certain annuitization might make more sense than a lifetime one.

And yes, you would give up control of the assets in the scenario I suggested.

Best of luck in your planning!

 

[MarieIG]

Hi Trooper, I saw your message just now. I'm getting sleepy, so will check back in tomorrow.

 

[MarieIG]

Thanks everyone for your responses.

@pb4uski - you've summarized exactly what I understand to be the taxation rules for an NQ variable annuity.
Pre-annuitization: gains come out first and are taxed at ordinary income. Basis comes out tax-free.
Post-annuitization: each periodic payment is considered a mix of gain and basis, and is partly taxable based on the pro-ration of basis and gain.



Are you saying that I could, later on, purchase a SPIA with the balance on variable annuity? How then would the SPIA payments be taxed - the same way as if I annuitized the VA?

That is my understanding.

 

[Trooper]

How to Evaluate Annuity Quotes

I am still contemplating annuitizing over 5 years as friar1610 suggested in post #15.

I am receiving quotes for a 5year period certain annuity from immediateannuities.com. How would I calculate the IRR for ~$8900/month on a $494K principal amount? I am pretty good with Excel but can't seem to find the right function.

Would I need to do a 1035 exchange from Transamerica to the new insurance company?

How can I be assured that the taxable income (per the future 1099s) will be in line with what I expect?

 

[pb4uski]

=((1+RATE(5*12,8900,-494000))^12)-1 = 3.15%

Not very attractive to me for a 5 year term.

 

[OldShooter]

... The annuity’s expense ratio isn’t great, but compared to many annuities it is not horrible. ...

From my very limited exposure to these, the growth I have seen is limited to the nominal value of an index. IOW, the difference between price quotes over some period of time; annual, quarterly, etc. What this means is that you do not get the benefit of the dividends that are paid over that period. The insurance company keeps those. The ones I have seen also cap the growth amount.

I'd suggest that you check your annuity. Capped growth and missing out on dividends will totally swamp the expense ratio they are quoting.

 

[Trooper]

=((1+RATE(5*12,8900,-494000))^12)-1 = 3.15%

Not very attractive to me for a 5 year term.

Thanks pb4uski.

From my very limited exposure to these, the growth I have seen is limited to the nominal value of an index. IOW, the difference between price quotes over some period of time; annual, quarterly, etc. What this means is that you do not get the benefit of the dividends that are paid over that period. The insurance company keeps those. The ones I have seen also cap the growth amount.

I'd suggest that you check your annuity. Capped growth and missing out on dividends will totally swamp the expense ratio they are quoting.

I totally agree. I'm not trying to decide whether to purchase one, I'm evaluating two options: drawing down the gains for living expenses while controlling taxable income, or annuitizing over a 5-year period to spread out the tax hit.

 

[rmorris50]

How much are your expenses that you need? Also, what is your tax bracket? For simplicity's sake if you take the $165,000 gain from the annuity (it is all ordinary income under post August 1982 rules of Last in First Out) over five years, that is approximately $33,000 of income per year. This will get both of you to about age 70, so before RMD's start. Once you have removed the gain, then close the account and transfer the funds to a taxable account.

This is what I would prob do.

 

[alwayslearningmore]

We are in the exact same position as our Vanguard annuities were merged into TransAmerica. What we are doing is taking systematic monthly withdrawals. This way we can increase or decrease the monthly amount or stop payments all together which gives us full control of our money without surrendering it to an insurance company.

This is a good approach. But it doesn't provide longevity insurance.