The Top 4 Advanced Annuity Designs for Near Retirees

Annuities have long stood out as a popular financial instrument because of the reliable income streams they create.

Annuities are contracts between you and an insurance company where you make a lump sum payment or series of payments in exchange for regular disbursements.

There are five main types of annuities.

1. Fixed Annuities: Payment amount is guaranteed, based on a fixed interest rate.

2. Variable Annuities: Payment amount is based on the performance of an investment portfolio you select.

3. Indexed Annuities: Returns are tied to a specific market index, usually with a floor and a cap.

4. Immediate Annuities: Payments begin after a lump sum investment.

5. Deferred Annuities: Payments start after a set amount of time, allowing your investment to grow.

What most people don’t realize is that annuities can be strategically designed to achieve outcomes beyond guaranteed income.

Beyond the Basics: Advanced Annuity Design Strategies

Strategy 1: The Annuity Ladder

One advanced annuity design is creating an annuity ladder with annuities that have staggered maturity dates.

For example, rather than putting $500K into a single annuity, you might divide it into five $100K contracts spread over five years. This creates a gradual transition into annuitized income while also maintaining flexibility and potentially taking advantage of changing interest rates.

This strategy allows for progressive income increases to combat inflation, diversification across multiple carriers to reduce risk, and effectively spreading your tax liability by controlling distribution timing.

Strategy 2: Hybrid Long-Term Care and Annuity Integration

Another advanced design integrates long-term care benefits with your annuity. This addresses two retirement concerns:

1. Income security through guaranteed annuity payments

2. Protection against high long-term care expenses

These usually offer a multiplier effect where your death benefit or income stream can be multiplied by 2-3 times when used for qualified long-term care expenses.

If you expect to purchase LTC insurance and an annuity, this can be a more cost effective option.

Strategy 3: Charitable Remainder Trusts (CRTs) and Annuity Integration

If you have significant assets and philanthropic goals, combining a CRT with an annuity might be worth exploring.

In this strategy, you donate assets to a CRT which are then removed from your taxable estate, and which gives you an immediate charitable deduction. The CRT can then purchase an annuity to provide guaranteed income to you, the donor, for life. Any remaining assets eventually transfer to the designated charity.

This design turns appreciated assets that would otherwise face capital gains taxes into a tax-advantaged income stream.

Strategy 4: Split Annuities for Tax-Optimized Income

The split annuity approach divides capital between immediate and deferred annuities to create two income sources – one for the present and one for the future.

Portion A gets placed in an immediate annuity to provide your current income, while Portion B is positioned in a deferred annuity and grows tax-deferred.

When Portion A is depleted, Portion B has ideally grown to replace or exceed the original principal.

This creates predictable income while managing tax exposure through the strategic timing of taxable events.

The above strategies should be integrated with your overall financial plan to ensure optimal outcomes.

For example, you should review your estate planning to make sure your annuity’s beneficiary designations align with provisions in your will/trust. It would also be beneficial to review your income tax projections so that you time your annuity income with all other income sources to manage your tax bracket. Lastly, keep liquidity in mind so that you have enough cash for any emergency needs.

Annuities have strategic design opportunities, and they also have specific tax implications which can be taken advantage of.

What tax implications do annuities have?

1. Tax-Deferred Growth

   All non-qualified annuities grow tax-deferred, meaning you pay no taxes on earnings until withdrawal.

2. Exclusion Ratio Benefits

   With non-qualified immediate annuities, each payment received is partially a return of principal and partially taxable interest. The non-taxable portion is determined by an "exclusion ratio" based on your life expectancy, spreading your tax liability over your projected lifetime.

3. Stepped-Up Cost Basis Opportunities

   Some annuities allow for stepped-up cost basis strategies, which are especially useful when integrated with estate planning. If structured properly beneficiaries can receive enhanced cost basis treatment, reducing their eventual tax burden.

4. 1035 Exchanges

   Section 1035 of the IRC allows the exchange of one annuity contract for another without triggering immediate taxation. This allows for the repositioning of annuity assets to take advantage of improved contract terms or enhanced benefit riders.

5. Purchasing an Annuity with Pre vs. Post Tax Dollars

   If you use pre-tax funds, distributions are generally taxable as ordinary income. If you use after-tax dollars, usually only the earnings portion of distributions is taxable.

While advanced annuity designs can be enticing, whether they are right for you depend on a number of factors. And the interaction between tax regulations, contract provisions, and other factors make ongoing management important.

As always, we recommend working with a tax professional who understands both tax strategies and wealth management.

Author: Rob Cucchiaro, CFP®, CRPC, AAMS

Questions answered in this article:

• What is an annuity?

• What are the four types of annuities?

• What are the top 4 advanced annuity designs?

• How is an annuity ladder an effective strategy?

• What is a cost effective way to purchase long-term care insurance and an annuity?

• How can I integrate my annuity with my CRT to improve my tax situation?

• Can I use optimal finance rates to take out a loan, then use that to buy an annuity?

• Can I take buy an immediate annuity and deferred annuity at the same time?

• How is a split annuity strategy different from annuity laddering?

• What tax implications do annuities have?

• Are annuity distributions taxable if I bought it using qualified funds?

• Are annuity distributions taxable if I bought it using non-qualified funds?

• How does my annuity fit into my overall financial plan?