SPIA post issue management concerns are not often considered. To most agents and individuals these contracts tend to be “fire and forget”. Post issue management concerns are typically associated with SPIAs issued via the new business application process and not associated with SPIAs that are created via “supplemental” annuity contracts when one annuitizes an existing deferred annuity contract or life insurance policy. Supplemental annuity contracts are altogether different animals when it comes to post issue Ownership privileges. While supplemental annuity contracts, in many cases, may sport better annuity income purchase rates/$000 of premium for any given variability because of higher imbedded guarantees vs current interest rates and mortality tables, typically; Owners have to surrender some rights they could otherwise obtain in the annuity/SPIA new issue market available with new purchase contracts.
A few SPIAs issued via the new business application process, may contain payment commutation rights AKA lump sum withdrawal privileges in their non-qualified contracts. Typically, these rights are accessible via a onetime request and sometime after the first contract year. But, depending on the carrier, they may support multiple requests over the life of the contract. Usually, the rights extend only to some or all of the period certain or cash refund portions of the SPIA. A common commutation is: a 10-year period certain and life contract with a $1,000 monthly payment becoming a $500 monthly payment for the reminder of the period certain term in exchange for a single lump sum then, reverting back to the $1,000 monthly benefit once the life contingent payments start. If the SPIA is exclusively a period certain contract, some carriers, in addition to the above treatment, reduce the number of payments vs. reducing the payment amount. For example: a 15-year period certain contact becomes a 10-year period certain contract, and the payment stays level from year to year.
A few carriers also permit a portion of life contingent payment to be commuted as well. However, for these contracts, typically a onetime request, Owners have to wait 2 years or more then, the lump sum is usually up to small percentage such as 10% of the contract value (calculated by the carrier). Due to adverse selection issues, these contracts are more restrictive when life contingent payments are commuted. When involving life contingent payments, a few carriers even ask the Annuitant for a health assessment prior to submitting a commutation request.
Although not a payment commutation, some carriers just advance payments and a six month advance is typical. However, annuity income becomes zero for a few months, but returns once the advance period concludes. In this case, nothing changes with the payment or the income tax reporting.
While carriers are quick to point out the payment commutation benefit as a market differentiation and how great they are by offering a liquidity feature, they are not so quick to disclose exactly how they intend to income tax report the commuted payments! The agent selling this feature should be aware of the income tax implications and will usually have to phone the home office to determine the carrier’s income tax reporting intentions. This is important because the IRS hasn’t been clear and consequently, carriers take different income tax reporting stances.
For example; carrier A feels this is a withdrawal event like any other annuity withdrawal and gains are taxed on a LIFO basis to the extent of the total contract gain. With carrier A; I purchase a non-qualified SPIA for a $100,000 purchase cost via the proceeds of a deferred annuity or life insurance policy transfer and my 1035 exchange gain is $20,000 and my cost basis is $80,000. If I commute all or a portion of the SPIA remaining period certain payments to a $20,000 lump sum then, this amount is attributable to my gain and fully taxable at ordinary income tax rates. In this case, the cost basis ($80,000) would not be re-calculated over the remaining payment duration.
On the other hand, you have carrier B that believes; any lump sum payment commutation should be prorated between interest and cost basis, under the tax theory; this is how the base contract income is taxed. In this case, some part of the $20,000 lump sum payment is non-taxable. For example, given the same contract, if the contract value is $100,000 at the request date and my lump sum payment calculated to $20,000 then about 20% ($20,000/$100,000) would be attributable to a cost basis withdrawal and $16,000 ($80,000 x 20%) would not be taxable. The remaining $4,000 ($20,000 – $16,000) is fully taxable at ordinary income tax rates. Given the remaining cost basis is $64,000 ($80,000 – $16,000), the future annual cost basis recover rate has to be recalculated to account for the $16,000 non-taxable distribution.
The agent needs a heightened awareness of how annuity taxation works with any particular carrier because, you don’t want the client to be income tax blindsided if and when they exercise a payment commutation feature.