How to build laddered, tax-deferred annuity contracts

In January, I wrote an article for Life Insurance Selling, describing how owners of billions of dollars worth of maturing U.S. Savings Bonds were caught in a not-so-tender tax trap. Many of you e-mailed me to learn more about the two financial planners who were able to place their clients' investments into laddered, tax-deferred annuity contracts.

By virtue of this arrangement, these planners were able to reduce their clients' Gross Taxable Income (GTI), which further enabled them to reduce their federal income taxes. Because their tax liabilities were substantially reduced, when the clients redeemed (cashed in) their maturing savings bonds, and they had to report the savings bond interest earnings as ordinary income on their federal income tax return, their new total GTI was still far less than what they were previously reporting before including the savings bond interest income.

The goal of reducing the tax bite on their savings bond interest income has been realized by making these clients more tax-efficient! Depending on the amount of money being realized by cashing in their savings bonds, these clients could have an appreciable amount of money to pay for current expenses.

Of equal importance, in a few years, once these clients have completely cashed in all their savings bonds, they will still be paying substantially less federal income tax than in the past. Yet another win for the client!

Staggering multiple annuities

The concept of laddering involves the allocation of an investor's assets into purchases of multiple annuity contracts that have different maturity dates, over an extended period of time -- say 20 years.

For the purposes of this discussion, we will call each contract a "bucket" of money. Depending upon the age of the investor (and their spouse), and the total amount of assets they invest at the onset, this could mean purchasing four or five -- or possibly more -- different annuity contracts with staggered maturity dates. These tax-deferred annuities will eventually provide monthly income at greatly reduced taxable amounts over the upcoming years.

For example, a 65-year-old investor with $400,000 might purchase five different annuity contracts. The first annuity could be an immediate annuity and provide monthly income for the initial five years. (If the investor doesn't need immediate cash flow, these monies could be invested into yet another deferred annuity contract.)

The remaining four annuities will be spread out over 20 years maturing on the 5th, 10th, 15th and 20th anniversaries. By purchasing annuities with maturity dates spread over progressively longer periods of time, each annuity will receive higher rates of interest. These various "buckets" of money will grow -- tax-deferred -- during their respective lifetimes until needed by the client for their monthly expenses.

By spacing these annuities out with five-year maturity periods, as each "bucket" of annuity money is depleted, the next "bucket" of annuity money becomes available. Because the IRS allows annuity contracts to grow in value without having to report the income until the money is withdrawn, the investor will earn substantial returns without having to pay income taxes each year.
Another benefit of having these annuity payments spread out over at least a five-year period of time is that the government will tax the annuity disbursements at a reduced level by virtue of an IRS-approved formula called the "Exclusion Ratio." This process allows the client to not have to pay taxes on a specific portion of each year's payout, based on the original amount of money invested in an annuity vs. the total aggregate amount in the annuity at the time of the distribution.

For example, assume that a person owns an annuity currently worth $100,000, and that the initial amount invested was $70,000, or 70% of the maturing investment. The balance of the amount attributable to growth is $30,000, or 30%. Because 70% of the amount of money that was paid out over the five years was the initial investment, only 30% of the monthly payouts would be taxable. This benefit reduces the GTI even more and will go a long way towards further reducing the net federal income taxes to be paid.

Additional benefits

It is actually possible to place the original investments into annuities with increasingly longer maturity periods so that at the maturation of the entire laddering program, (say 20 years), the initial investment used in year one to purchase all of the annuities will still be intact, despite drawing out a substantial monthly income over the 20-year period. In the end, once all of the annuity "buckets" -- except the oldest annuity -- have been depleted, the client will still have at least their original principal amount (their legacy).

Another key point not to be overlooked is that the number of successful recoveries made by the other brokers and planners when they realize that their (former) client is pulling out their investment(s), is practically non-existent. This is because the client has been actively involved with these other financial planners in creating the long-range plan and understands the inherent strategy, along with the greater returns and tax advantages built in to their new, long-term investment plan.

Jack Quinn is the founder/owner of SBPlanner.com in Spring Lake Heights, N.J. He has been teaching consumers and professionals about the intricacies of U.S. Savings Bonds for more than 18 years. Mr. Quinn is considered a consumer advocate and nongovernmental expert in the field of automated solutions for both the general public and financial professionals involving this uniquely American investment.