Take a balanced approach to retirement and estate planning using a split annuity

If you’re approaching retirement or have already retired, one of the biggest challenges is balancing the need to maintain your standard of living with your desire to preserve as much wealth as possible for your loved ones. This balance can be difficult to achieve, especially when retirement can last decades. One strategy to consider is the split annuity, which creates a current income stream while preserving wealth for the future.

ABCs of an annuity

An annuity is a tax-advantaged investment contract, usually with an insurance company or other financial services provider. You pay either a lump sum or annual premiums, and in exchange, the provider makes periodic payments to you for a term of years or for life.

For purposes of the split annuity strategy discussed below, we’ll focus on “fixed” annuities, which generally provide a guaranteed minimum rate of return. Other types of annuities include “variable” and “equity-indexed,” which may offer greater upside potential but also involve greater risk.

Annuities can be immediate or deferred. As the names suggest, with an immediate annuity, payouts begin right away, while a deferred annuity is designed to begin payouts at a specified date in the future.

From a tax perspective, annuity earnings are tax-deferred — that is, they grow tax-free until they’re paid out or withdrawn. A portion of each payment is subject to ordinary income tax, and a portion is treated as a tax-free return of principal (premiums). The ability to accumulate earnings on a tax-deferred basis allows deferred annuities to grow more quickly than comparable taxable accounts, which helps make up for their usually modest interest rates.

Annuities offer some flexibility to withdraw or reallocate the funds should your circumstances change. But keep in mind that — depending on how much you withdraw and when — you may be subject to surrender or early withdrawal charges.

Split annuity strategy

A split annuity may sound like a single product, but in fact, it simply refers to two (or more) annuities, usually funded with a single investment. In a typical split annuity strategy, you use a portion of the funds to purchase an immediate annuity that makes fixed payments to you for a specified term (10 years, for example). The remaining funds are applied to a deferred annuity that begins paying out at the end of the initial annuity period.

Ideally, at the end of the immediate annuity term, the deferred annuity will have accumulated enough earnings so that its value is equal to your original investment. In other words, if the split annuity is designed properly, you’ll enjoy a fixed income stream for a term of years while preserving your principal.

At the end of the term, you can reevaluate your options. For example, you might start receiving payments from the deferred annuity, withdraw some or all its cash value, or reinvest the funds in another split annuity or another investment vehicle.

If you’re interested in learning more about a split annuity, please contact us. We’d be pleased to help you determine if this strategy is right for your situation.