What happens to an annuity in a divorce?
You had planned on growing old together. But things don’t always work out as planned and now you and your spouse are divorcing. So what happens to that annuity you planned to use for retirement income?
Annuities are kind of like marriages in that they are fairly easy to enter into, but difficult to split up. There are a host of considerations when it comes to divvying the annuity assets, such as surrender charges, taxes, and the value of the contract. Depending on the circumstances, it can be difficult to divide annuity interests into lump sum payouts, especially if the annuity income stream has already commenced. In fact, in some cases it would be better to leave the annuity intact and allow one party to keep it while the other gets something of equivalent value.
Financial expertise should be strongly considered during the process as most divorce attorneys will not understand these issues and may put the divorcing parties in a difficult situation. You should also involve the insurance company that issued the contract during the proceedings.
Whether the annuity can be split is determined by whether or not it is considered marital property. This will depend on the state in which you live, but in general, if one partner owned the annuity prior to the marriage and did not pay any premiums into it during the marriage, the original owner maintains full rights. If it was purchased during the marriage or if the couple paid premiums into a pre-existing contract, then both spouses may have a claim.
What does the contract say?
What happens to the annuity will also depend on the terms of the contract. For example, some insurance companies will not allow a single annuity to be split, even in the event of a divorce, and other contracts don’t allow lump-sum payments. If a lump sum option isn’t available, then the court would have to split the income that the annuity generates.
One of the items that also must be determined is how the contract should be valued. It could be valued based on its current account value. But if it provides living benefits, the annuity may have a greater value long-term than what would be available if it were cashed out. Again, the insurance company and/or your agent or financial advisor should be involved with this decision.
If some or all of the annuity is transferred to a spouse because of a divorce decree, there is no taxable income or tax penalty incurred in the transaction. But don’t make the mistake of splitting the contract without a divorce decree, or else it could result in a 10 percent tax penalty if you are not at least 59 1/2.
Non-qualified annuity income — meaning the contract is not inside a 401(k), IRA, or other tax-qualified retirement plan — is taxable to the extent there is gain in the contract. This means you are not taxed on the portion of the income this is considered a return of the premium you paid into the contract since you did not receive tax deductions for those contributions.
When a person receives all or part of an annuity from an ex-spouse, he or she also inherits the contract’s tax-basis. The spouse will receive credit for all the premiums paid into the annuity when income is withdrawn.
If the annuity is contained inside a qualified retirement plan, then it must be transferred using a Qualified Domestic Relations Order (QDRO). This is a court order that directs the insurance company to transfer the annuity assets.
Surrender periods, income payments and riders
If the contract is still in its surrender period, both parties may owe a surrender charge for canceling the original contract, depending on its provisions. In addition, the new annuity(s) purchased will likely begin a new surrender period.
If the contract has been annuitized and was providing income to the couple, then the divorce decree will largely determine how the contract is split. It could be divided as an asset based on its value at the time the divorce is finalized, and a portion of the value would be transferred to a new annuity owned individually by the recipient spouse. It could also be decreed that the annuity owner forward a portion of the regular income stream to the ex-spouse.
If the annuity has any riders attached, then be aware that they often contain separate contractual provisions governing how they are treated in a divorce.