Many people look for ways to not only create the retirement income they need but also to preserve their principal. Relying on bank savings often falls short, and having your retirement savings exposed to the ups and downs of the market can be nerve-racking. Fortunately, there is a solution that does provide guaranteed tax-advantaged income, tax-deferral, and principal preservation. If you are currently living off of interest from your brokerage account or other investments, then a split annuity could be a strategy for you to consider.
A split annuity is a funding combination of two annuities: an immediate annuity and a tax-deferred annuity. The immediate annuity will give you monthly income, which means the amount deposited in the immediate annuity will experience minimal growth due to the immediate or almost immediate payout, but the remaining funds can grow deferred in a tax-deferred annuity at a minimum rate of at least 3% and as high as 7%. The two-annuities-in-one strategy allows you to receive a reliable income from one account while saving and growing tax-deferred funds in a separate account with principal protection. So, you can receive the income you need and reinvest the tax-deferred funds, all while preserving your initial principal balance.
As it relates to taxes, split annuities follow what’s called the “annuity exclusion ratio.” This simply means that the income received from the immediate annuity will be tax-exempt if it is a return of principal. Any interest earned will be taxed as ordinary income, not capital gains. The split annuity is designed to return your investment in equal, tax-free payments over the payment period, then tax any interest earned. Any interest on the remaining tax-deferred funds would be taxed at ordinary income levels when withdrawn. However, since a split annuity solution works best with non-qualified funds, if non-qualified funds are used, you won’t have to take money out of the tax-deferred account.
As a hypothetical example, let’s say a 60-year-old male has an immediate need for income but also wants the remaining funds to grow tax-deferred, and he is looking for principal preservation. Additionally, he has $400,000 in a brokerage account, which receives 4% in dividend income that equals about $16,000. If he were to deposit $150,000 into an immediate annuity, he would receive about $1,350 per month, or $16,200 per year, which is equal to his dividend income. However, the tax situation would be different. His dividend income of $16,000 is taxed at 15% capital gains, which is $2,400 per year, but his immediate annuity income occurs over a period of 10 years and acts as a return of principal, except for the $12,000 in interest he will earn over the 10 years. Spreading the $12,000 in interest out over 10 years equals $1,200 a year without experiencing double taxation.
A split annuity strategy is structured in such a way to produce immediate tax-advantaged income for a promised period of time so it can restore your original principal at the end of that time period. Is a split annuity right for you? That depends on your retirement objectives. If you are looking for a dependable source of income, tax-deferral, and principal preservation, then the split annuity concept may be worth exploring, especially if you are currently living off of interest from a brokerage account or similar investment account. It is a strategy that may help alleviate the concerns of daily market volatility and allow you to enjoy the finer things in life.
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