Should an annuity be annuitized?

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Some financial planners are upbeat about variable annuities while others avoid them. However you feel about variable annuities, there’s no doubt that they’re ubiquitous: Morningstar reports that VA net assets reached a record $1.87 trillion at year-end 2013. Chances are that some of your clients hold VAs, including contracts acquired during a prior advisory engagement.

Deferred annuities such as VAs are designed to be retirement income vehicles—that’s why taxes on investment earnings are deferred. Given their nature, does it make sense for retired clients to annuitize their VAs for spending money?

“We haven’t had clients annuitize their variable annuities,” says Joe Heider, regional managing principal at the Westlake, Ohio, office of Rehmann Financial, a wealth management, CPA, and business consulting firm. “Today’s interest rates are too low to lock in for the rest of your life with an annuity.”

According to Heider, annuity payouts tend to be comparable to yields on 10-year Treasuries. “They’re paying around 2.5% now,” he says, “and that’s around the internal rate of return on the annuities we see.”


Instead of annuitizing, clients who need income from VAs can take withdrawals. “Most variable annuities that clients own will have some type of guaranteed income rider,” says Heider. “They might allow clients to take out 5% of the initial investment each year, with some provision for increased income if the investment value goes up.”

Heider adds that these VA provisions tend to be complex and they vary from issuer to issuer, but there typically is some way to pull guaranteed cash flow from the contract. With a promise of a 5% withdrawal and a $100,000 outlay, for instance, a buyer may be able to pull out $5,000 annually even if the investments inside the VA lose value. “With these guarantees, you’re buying insurance against worst case investment results,” he says. “That’s one reason variable annuities can be expensive.”


There can be situations when annuitization makes sense, Heider notes. “If someone needs every possible dollar in retirement, and there are no heirs, that could be the best choice,” he says. “Even with today’s low returns, an individual might get the highest predictable level of income by annuitizing. That would be especially true for older people, who’d get more cash flow from annuitizing. In addition, annuitization gets better tax treatment.”

Except for annuities purchased before August 14, 1982, withdrawals from deferred annuities are taxed on a LIFO (last-in, first-out) basis, so withdrawn earnings are fully taxed and possibly subject to a 10% penalty before age 59-1/2. Once a deferred annuity contract is annuitized, payments are partially taxed and partially a tax-free return of principal until the invested amount has been fully paid out. (The return of principal generates the possibly higher level of cash flow.)

“If a client decides to annuitize,” says Heider, “it might be best to wait until the variable annuity is out of the surrender charge period, which usually takes five to 10 years. Then the client could shop the market and do a tax-free exchange to an annuity with a higher payout, under Section 1035 of the tax code.”

Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

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