Considering Surrendering Annuity As a Net Gain

[Drifting]

I am considering surrendering part or all of a variable annuity that I've held for a long time in favor of low cost ETF's. I wanted your opinions as to whether it might be worth it.

I'm paying 1.4% for a "mortality an expense charge" which I have no need for. History says that ETF's do .8% better than actively managed funds. So I figure that I'm losing 2.2% per year with this annuity. Another negative with annuities is that a Wealth Manger article called "Photo Finish" says that ordinary income taxation will more than defeat the so called "benefits" of deferred taxation that I get with this annuity. ETF's are only taxed at that lower capital gains rate.

I won't turn 59 1/2 for another 11 years. I live in California, which has its taxes too. About a third of this non-qualified annuity is "tax deferred earnings" according to my statement. What exactly does that mean? My yearly income is small. About 10K. So I'm in a low tax braket now.

One of the downsides to surrendering this annuity if I choose to do so is that whatever tax penalties that I pay will represent money that will never get a change to work for me to appreciate over time. So that might not even make it worth surrendering. What do you think? The upside is that with the surrendered money I would enjoy the lower capital gains tax rate and lower fees.

Also couple of years ago I started annuitizing this contract. I am thinking about stopping that and just paying the taxes on those 3 years of payments that I got. I read that once you annuitize you lose the deferred taxation. Correct?

I tested entering some numbers with my 2012 Turbo Tax software.
25,000 surrender - Total state and fed taxes = $2,930 (or 11.72%)
50,000 surrender - Total state and fed taxes = $7,940 (or 15.88%)
75,000 surrender - Total state and fed taxes = $17,176 (or 22.90%)
100,000 surrender - Total state and fed taxes = $25,874 (or 25.87%)

 

[Tahoe Ray]

I am considering surrendering part or all of a variable annuity that I've held for a long time in favor of low cost ETF's. I wanted your opinions as to whether it might be worth it.

I'm paying 1.4% for a "mortality an expense charge" which I have no need for. History says that ETF's do .8% better than actively managed funds. So I figure that I'm losing 2.2% per year with this annuity. Another negative with annuities is that a Wealth Manger article called "Photo Finish" says that ordinary income taxation will more than defeat the so called "benefits" of deferred taxation that I get with this annuity. ETF's are only taxed at that lower capital gains rate.

I won't turn 59 1/2 for another 11 years. I live in California, which has its taxes too. About a third of this non-qualified annuity is "tax deferred earnings" according to my statement. What exactly does that mean? My yearly income is small. About 10K. So I'm in a low tax braket now.

One of the downsides to surrendering this annuity if I choose to do so is that whatever tax penalties that I pay will represent money that will never get a change to work for me to appreciate over time. So that might not even make it worth surrendering. What do you think? The upside is that with the surrendered money I would enjoy the lower capital gains tax rate and lower fees.

Also couple of years ago I started annuitizing this contract. I am thinking about stopping that and just paying the taxes on those 3 years of payments that I got. I read that once you annuitize you lose the deferred taxation. Correct?

I tested entering some numbers with my 2012 Turbo Tax software.
25,000 surrender - Total state and fed taxes = $2,930 (or 11.72%)
50,000 surrender - Total state and fed taxes = $7,940 (or 15.88%)
75,000 surrender - Total state and fed taxes = $17,176 (or 22.90%)
100,000 surrender - Total state and fed taxes = $25,874 (or 25.87%)

Very few people on this forum are going to be able to give you advice about selling or buying securities (which your VA and ETFs are...).

From a tax perspective (I'm not an accountant and this is not advice), if 1/3 of your annuity is tax deferred gain, then that is what you would owe tax on (ordinary income) if you surrendered it.

I am confused when you mention that you annuitized and yet have surrender value. Some contracts have a liquidity option but normally when you pull the annuitization trigger, you can't put the bullet back into the gun.

That being said, you should have an exclusion ratio, which is the % of your annuity payments that are free from any tax whatsoever so you don't technically lose your deferral. Some of your payments should be a tax-free return of principal.

The bottom line is that you (or your beneficiaries) will eventually have to pay taxes on your annuity gains.

Depending on where you are in CA, I might be able to refer you to someone who can help provide a more personalized solution.
Let me know if you need help.

 

[Drifting]

Very few people on this forum are going to be able to give you advice about selling or buying securities (which your VA and ETFs are...).

From a tax perspective (I'm not an accountant and this is not advice), if 1/3 of your annuity is tax deferred gain, then that is what you would owe tax on (ordinary income) if you surrendered it.

I am confused when you mention that you annuitized and yet have surrender value. Some contracts have a liquidity option but normally when you pull the annuitization trigger, you can't put the bullet back into the gun.

That being said, you should have an exclusion ratio, which is the % of your annuity payments that are free from any tax whatsoever so you don't technically lose your deferral. Some of your payments should be a tax-free return of principal.

The bottom line is that you (or your beneficiaries) will eventually have to pay taxes on your annuity gains.

Depending on where you are in CA, I might be able to refer you to someone who can help provide a more personalized solution.
Let me know if you need help.

I understand that there is no adviser / client relationship established in a forum. I spoke to the insurance company today and they confirmed exactly what you said, that the 1/3 is "gains" that are subject to both ordinary income and the federal (10%) and state tax penalties. The rest is principal that is only subject to the state and federal tax penalties.

This annuity is under a 72t program if that helps to know. They told me that I could undo the systemic partial withdrawal program, but I would just have to pay taxes on what I've taken out.

I'm a bit on the fence as to whether I will pull money out of this annuity in 2 or 3 years. I figure I will save 1.4% per year by eliminating the separate account fees as well as management fees and turnover which are typically .8% more than ETF's. Then I will also enjoy capital gains taxation. I think that within less than 10 years it will be a net gain to surrender the annuity in 2 or 3 parts.

No need for any specific referrals, but would I want a financial planner or a tax accountant?

 

[Tahoe Ray]

I understand that there is no adviser / client relationship established in a forum. I spoke to the insurance company today and they confirmed exactly what you said, that the 1/3 is "gains" that are subject to both ordinary income and the federal (10%) and state tax penalties. The rest is principal that is only subject to the state and federal tax penalties.

This annuity is under a 72t program if that helps to know. They told me that I could undo the systemic partial withdrawal program, but I would just have to pay taxes on what I've taken out.

I'm a bit on the fence as to whether I will pull money out of this annuity in 2 or 3 years. I figure I will save 1.4% per year by eliminating the separate account fees as well as management fees and turnover which are typically .8% more than ETF's. Then I will also enjoy capital gains taxation. I think that within less than 10 years it will be a net gain to surrender the annuity in 2 or 3 parts.

No need for any specific referrals, but would I want a financial planner or a tax accountant?

Talk to either an accountant who understands investments (very few) or a planner when knows taxes (more than a few but not by much).

Getting both would be a waste of money. If you go with a planner, find one who charges hourly...they have few incentives (besides procrastinating) to steer you wrong.

It sounds like you haven't truly annuitized. Does your VA have a lifetime income rider?

If you're under 72t, this is a qualified account. That being said, you may want to ride out your distributions until you turn 59 1/2. Why pay the 10% penalty?

Does your VA offer a fixed option? You won't have the M&E charges assessed against it and if you bought it a while ago, the rate might not be terrible.

Another option is to just do a custodian to custodian transfer where you maintain your SEPP and can participate in less expensive options. Your current and new custodian will make you sign several forms stating they have no tax liability if it gets screwed up but if you're motivated and detail oriented, it might be a good option.

Bottom line, you can certainly do this yourself but like any DYI project, if you don't have any experience, it might not end up as planned.

Talk to an expert (not just the service center) and get it done the right.

Good luck.

 

[Drifting]

If you're under 72t, this is a qualified account. That being said, you may want to ride out your distributions until you turn 59 1/2. Why pay the 10% penalty?

Does your VA offer a fixed option? You won't have the M&E charges assessed against it and if you bought it a while ago, the rate might not be terrible.

Why pay the 10% penalty? Because I have no need for the 1.4% separate account fee which includes the M&E charge. Actively managed funds (like those offered within variable annuities) on average have about a 1% shortfall in returns compared to equivalent ETF's. The other reason to get out of the annuity is ordinary income taxation which from what I can tell is typically about 11% more than the capital gains rate.
The fixed account which pays 4% is too conservative for me. I would rather diversify with short / medium term bond ETF's and again the capital gains tax rate.

 

[Tahoe Ray]

Why pay the 10% penalty? Because I have no need for the 1.4% separate account fee which includes the M&E charge. Actively managed funds (like those offered within variable annuities) on average have about a 1% shortfall in returns compared to equivalent ETF's. The other reason to get out of the annuity is ordinary income taxation which from what I can tell is typically about 11% more than the capital gains rate.
The fixed account which pays 4% is too conservative for me. I would rather diversify with short / medium term bond ETF's and again the capital gains tax rate.

Again, since this is a qualified account, you should be able to move it almost anywhere and as long as the SEPP stays consistent, you won't have a penalty.

If you break your 72t, you'll owe ordinary income on all distributions plus the penalty. You have no opportunity to take advantage of capital gains rates if this is a qualified account. All distributions will be subject to ordinary income, regardless of the investment vehicle. Are you maybe taking 72q distributions?

If this account is non-qualified, we're having a different conversation.

 

[Drifting]

Again, since this is a qualified account, you should be able to move it almost anywhere and as long as the SEPP stays consistent, you won't have a penalty.

If you break your 72t, you'll owe ordinary income on all distributions plus the penalty. You have no opportunity to take advantage of capital gains rates if this is a qualified account. All distributions will be subject to ordinary income, regardless of the investment vehicle. Are you maybe taking 72q distributions?

If this account is non-qualified, we're having a different conversation.

Indeed a different conversation. This is a non-qualified account. The money that I originally invested had already been taxed. Currently about 1/3 of this annuity is earnings. 2/3 is original investment principal.

Yes. 10% federal plus possible 1% California penalty (is that right?) plus ordinary income on the 1/3. 10% federal plus 1% California penalty (?) on the 2/3.

 

[Tahoe Ray]

Indeed a different conversation. This is a non-qualified account. The money that I originally invested had already been taxed. About 1/3 of this annuity is earnings. 2/3 is original investment principal.

OK...so you're taking 72q distributions, not 72t. Now your options are limited. Do the math on your penalty vs your assumed saving on the expenses and your expected return. You'll have a break even point at sometime in the future. That will help with your decision.

Another option is a 1035 exchange to a low cost annuity like Vanguard. Keep your SEPP and lower your overall costs.

I applaud your knowledge on your investments and your proactive thought process.

Hopefully this will work out to your benefit.

----------

Indeed a different conversation. This is a non-qualified account. The money that I originally invested had already been taxed. Currently about 1/3 of this annuity is earnings. 2/3 is original investment principal.

Yes. 10% federal plus possible 1% California penalty (is that right?) plus ordinary income on the 1/3. 10% federal plus 1% California penalty (?) on the 2/3.

You won't have penalties (from a taxation standpoint) on your basis (the 2/3rds)

 

[Drifting]

OK...so you're taking 72q distributions, not 72t. Now your options are limited. Do the math on your penalty vs your assumed saving on the expenses and your expected return. You'll have a break even point at sometime in the future. That will help with your decision.

Another option is a 1035 exchange to a low cost annuity like Vanguard. Keep your SEPP and lower your overall costs.

I applaud your knowledge on your investments and your proactive thought process.

Hopefully this will work out to your benefit.

Actually I thought the woman at the insurance company told me that I was under a 72t. I may have not heard her right. I have been under a "systemic partial withdrawal" for 3 years now.

I trust Vanguard and didn't know that they offer annuities so I will definitely check them out! Thanks for bringing that to my attention. That just might be the ticket. I own a few Vanguard ETF's. VOO is the S & P 500 ETF that I wish my annuity money was in now!

I know the investment side well but I'm rather "tax illiterate". I have been crunching numbers in TurboTax. Trying to fill in some blanks through this forum before I meet with a professional.

 

[Tahoe Ray]

Actually I though the woman at the insurance company told me that I was under a 72t. I have been under a "systemic partial withdrawal" for 3 years now.

I trust Vanguard and didn't know that they offer annuities so I will definitely check them out! Thanks for bringing that to my attention. I own a few Vanguard ETF's. VOO is the S & P 500 ETF that I wish my annuity money was in now!

I know the investment side well but I'm rather "tax illiterate". I have been crunching numbers in TurboTax. Trying to fill in some blanks through this forum before I meet with a professional.

72t is the code for SEPP distributions of qualified accounts, 72q is for non qualified annuities. I wouldn't be surprised to hear that you were told differently...call a service center three times about a question like this and you're likely to get three different answers.

A systematic w/d is not the same thing as annuitization. You may have taken an an annuitization (vs amortization or life expectancy) option for your SEPP but that does not mean that you annuitized your contract.

Good luck in your search.