VA Income Options Going Next-Gen

Recently, however, a new concept has emerged that combines elements of both of these retirement income options. The feature is being called a "next generation lifetime income" method of annuitization.

The next-generation method can have substantial tax advantages over the other arrangements, especially when using annuities in nonqualified retirement plans.

Next-generation annuitization addresses the shortcomings of both GMWBs and traditional annuitization. What makes it advantageous is that it retains the tax advantages afforded to the traditional annuity (which GMWBs do not) while keeping the control, access and flexibility of the GMWBs.

Table 1 summarizes the features and benefits each option provides. Table 2 compares a sample next-generation annuitization model with a typical 5% GMWB model for a male client with $100,000 to invest. The chart shows the amount each product type affords the client for actual retirement income after taxes have taken their cut.

What Table 2 shows is the negative impact that systematic withdrawal can have on spendable income from a nonqualified VA due to being taxed on a gain-first basis. For instance, the 60-year-old client with $100,000 to invest could take out $5,000 for life with most lifetime GMWBs, guaranteed. However, because this is taxed gain-first, a substantial portion is lost to taxes. Assuming a 30% tax rate and even a modest 5% return, the client only receives $3,500 after tax.

A client using variable annuitization with a floor benefit has a slightly different scenario. His/her guarantee typically will be less (in this instance, the lifetime income guarantee is $4,246 vs. the $5,000 for the GMWB). However, the initial income is actually higher ($5,662) due to receiving a portion of cost basis back. Of the $5,662 income payment, $3,667 is considered tax-free due to return of cost basis. This means the client is only taxed on $1,985, providing him/her with a substantially higher spendable income of $5,066.

In all four of the ages above, the tax-free portion of the income exceeds the GMWBs after-tax total income, assuming a 30% tax rate and 5% return. Essentially, even with a lower guarantee and modest market, the annuitization with access to account value provides more spendable incomein this case significantly more income.

The client will continue to receive this tax-free return of cost basis until he or she gets 100% of the original cost basis back (for the 60-year-old above that would be about 27 years!). Keep in mind, taxes may be due upon distribution. Guarantees are backed by the insurers financial strength.

Under next-generation annuitization, asset control remains with the client; brokers continue to retain assets under management; and income payments for life can be guaranteed at a minimum income level, regardless of market activity even with substantial equity exposure. The rate of income is protected from not only market downturns but also against the bite of inflation. Most importantly for clients, there are tax advantages, meaning they can keep more of their money where it belongs.

Given the bear market of a few years ago, a lot of financial focus is now on guarantees. This is good, in that guarantees can allow VA clients to stay invested knowing they are protected against a downturn. However, with the market rebound of the last 2 years and the plethora of guarantees now available, clients need to have ways to keep taxes in check, too. Guarantees are a critical component, but it is important that the right guarantees be applied to capture clients goals and maximize after-tax returns, particularly in nonqualified accounts.

Del Campbell is assistant vice president-annuity product intelligence and Jamie Branyan is marketing intelligence consultant with Lincoln National Life Insurance Company, an affiliate of Lincoln Financial Group.

Reproduced from National Underwriter Edition, April 1, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.