split annuity strategy

Understanding the split annuity strategy

One of the challenges of retirement income planning at the beginning of retirement is balancing current needs with having enough money for the future.

One way to address this dilemma is to employ a split annuity strategy. This involves taking funds from a CD, retirement account or other savings account and purchasing two annuities simultaneously; one a single premium immediate annuity and one a deferred annuity.

With an immediate annuity, you begin receiving income as soon as you enter into the contract with the insurer. With a deferred annuity, you are deferring income, which means you are choosing to receive income at a later date.

While the strategy can use any type of annuity, it most often uses traditional fixed annuities because of the guaranteed crediting rates and payout rates.

How a split strategy works

There are several ways to structure a split annuity strategy. The simplest is to set up both annuities to pay out lifetime income. The immediate annuity begins paying out as soon as you buy the contract and pays the same amount for life. When you begin receiving income from the deferred annuity, you basically give yourself a raise in pay, and both income sources will last for your lifetime.

Another way this strategy typically works is to divide your capital between the two annuities in a way that you receive immediate income for a set number of years, perhaps five or 10, rather than lifetime income like many immediate annuities are purchased for. During this initial period, the deferred annuity grows in value enough that it “restores” the original principal at the end of that time period.

For example, say you have $300,000 to invest. You buy an immediate annuity that pays income for 10 years. The amount you allocate to the deferred annuity should be such that its accumulated value equals $300,000 in 10 years. So you’ve received guaranteed income for a decade and you’ve essentially restored your original principal.

At the end of this 10-year period, you can take a period certain income payout, a guaranteed lifetime payout, or you can repeat the split annuity process by buying another immediate annuity and another deferred annuity with the $300,000, depending on your age at the time.

Because you will be older after the deferral period of the second annuity, you should receive a higher amount of income regardless of whether that income is from the deferred annuity or from an immediate annuity you use in a second split annuity strategy.

Keep in mind if you choose the third option, you will pay taxes on the full growth of the annuity contract unless you execute a 1035 exchange for a portion of the funds into one of the two new contracts. A 1035 exchange allows you to roll over funds from one tax-qualified account into another without owing taxes.

If you opt for one of the other two options, you will pay income tax on each withdrawal that is not considered a return of principal.

Advantages and disadvantages of the split annuity strategy

Advantages of this strategy include:

You have the ability to receive guaranteed income immediately and plan for guaranteed income in the future.

You will not pay tax on the portion of your payments that is considered a return of your original premium. The taxable portion is what your annuity pays above and beyond what you put into it. For example, if the value of your annuity doubles what you deposited, then half of your income withdrawals will be taxed as regular income. The other half will be considered a return of your principal. Furthermore, the money in the deferred annuity grows tax-deferred until you begin taking income.

You have the flexibility of choosing what to do with the deferred annuity once it matures based on your needs at that time. You can either annuitize it for lifetime income, take income for a set period, or take the lump sum and purchase two more annuities as part of a split strategy.

If you purchased a deferred annuity that offers free withdrawals, you can boost your income during the deferral period if the need arises.

One of the disadvantages is tying up your money for an extended period of time and reducing your liquidity. It’s important that you have access to additional funds if you employ this strategy in case a need arises.

If you opt for lifetime income from both annuities, then another disadvantage could come if you pass away before receiving the full benefit of the two contracts.