As annuity interest rates start to heat up coming out of their ice age thaw, it’s time to revisit what serial annuity contracts are and how to break serial contracts once they occur. Should general interest rates continue to rise and new declared rate deferred annuity business begins to pick up, there will be a fair amount of new 1035 exchange activity from older declared rate contracts with low current interest rates and equally low guaranteed rates moving to new deferred annuity contracts featuring higher interest rates. Let’s hope, for the carrier’s sake, what invariably will start as a trickle, doesn’t turn into a flood. But, I digress.
Serial deferred annuity contracts are so designated contracts by issue date that; are aggregated together to determine how contract withdrawals are going to be taxed by the IRS. To “get around’ the LIFO rules established by the IRS following TEFRA 1982, agents started dividing annuity premium into smaller more tax manageable contracts vs having one large contract. The IRS attempted to fix this loop hole in TAMRA 1988 and then with an adjustment in OBRA 1989. The fix basically said; deferred annuity contracts issued by the same carrier or affiliate carrier with in the last 12 months (TAMRA 1988) then, later changed to “last calendar year” (OBRA 1989) have to be aggregated to determine what portion of any contract withdrawal will be considered taxable.
A real case, in the near future, might be where; an agent submits a new deferred annuity contract application featuring a 4.00% crediting rate for a decades long languishing $100,000 bank deposit but then, discovers the Owner has an existing deferred annuity contract earning only 2.50% with a 1035 exchange transfer value of $131,409 reflecting an untaxed gain of $31,409. The existing contract is also exchanged to obtain the same 4.00% crediting rate. Following this transaction, this agent just inadvertently created two serial contracts, both contracts issued in the same calendar year. Not good.
If the original plan was to withdraw 10% (the free withdrawal amount based on premium cost of the new business contract) or $10,000 then, only $4,000 (interest portion) is taxed and $6,000 is a return of premium cost. However, because you now have to add both contracts together for income tax purposes, the same withdrawal results in a $10,000 taxable event! That’s because the $4,000 gain in the new business contract has to be added to the $36,665 gain ($131,409 @ 4.00%) of the 1035 exchanged from contract at the end of the first year and the time of withdrawal, for a total untaxed gain of $40,665 ($4,000 + $36,665). A $10,000 withdrawal at the end of the year, results in a remaining $30,665 untaxed gain balance between the two contracts. So, serial contracts can be problematic and in this case, the bigger the untaxed gain in the 1035 exchanged to contract relative to the new business contract premium the more years this withdrawal tax problem persists.
One way of correcting this problem is waiting to the end of surrender period and doing another 1035 exchange of one of these contracts to a new carrier or even the existing carrier and in the meantime, continuing to incur the tax problem for the needed income. The other option is not waiting, incur surrender penalties and do a deferred annuity 1035 exchange sometime before the end of the surrender period. Of course the client won’t be too happy to incur a surrender penalty just to fix the agent’s inspired tax mess.
Then of course, there is always the SPIA option. SPIAs are exempt from the serial contract rule! So, how to get out of this thing with the desired $10,000 annual income and also mitigating income taxes. Look to annuitize the smaller contract ($104,000) after the first year. The carrier issues a “supplemental” income (SPIA) contract for a 10 – year period certain on an annual payment mode stating in 30 days (“off mode”, annuity due, ten payments over nine years). At current rates, this should produce an annual payment of approximately $11,500 with $1,500 being taxable. While the client, for the most part, gets their income and tax issues restored to the original plan, the 10 – year supplemental contract will most likely earn less interest and an illiquidity requirement (absent a commutation provision) is imposed vs. just keeping the new business now as serial deferred contracts. Also, the agent needs to determine if the carrier will permit off modal payment supplemental contracts and not treat the request as a contract surrender with its associate surrender costs. Some fixed carriers treat contract annutization as a surrender.
Another option, if the carrier supports is; do a “partial” annuitization for half the value ($52,000) for 10 – year period certain on an off modal annual payment. The annual income is about $6,000 with $800 taxable. Of course, the carrier may not permit partial annuitization requests, but it could be worth asking.
If the current carrier for the new business contact is going to treat as a surrender then, the agent could be free to obtain the best 10 or 5 (for partial transfer) – year payment contract available in the market. You would probably have to explain to the annuity purchase suitability office at any new carrier what the issue is and why such an exchange cost needs to be incurred by the client. Regardless, it would be embarrassing to have the client “sit down” about how to fix the serial contract tax mess.
In any case, the old deferred annuity adage of having multiple smaller contracts utilizing various carriers’ vs having one large contract, usually is the best way to tax manage a premium for withdrawals and also contract settlements. It just that, it’s a lot more work for the agent to write and explained five $100,000 new business contracts vs. one $500,000 contract. But deferred annuity clients are usually better off. A single contract exception would be for one that permitted partial 1035 exchanges and partial annuitizations.