We frequently get people looking for ‘Lifetime Income’ who end up considering SMA’s. The lifetime products can be either an immediate annuity, or a hybrid annuity.
One common question is, “What are the taxes on SMA’s vs Immediate Annuities? How Do They Compare”
In regards to taxes, we need to state up front that this is not tax advice- your situation may be different. However in general, any lifetime annuity is by definition an indefinite period – your lifetime. So how much of it is taxed depends on your age, and the rate of return on it as an investment requires an end point to calculate.
Insurance companies and the IRS use an actuarial table to assume an end point on the income stream. This is your ‘Actuarial Life Expectancy” and you’re are taxed accordingly. You’ll see this Exclusion Ratio in the table .
Essentially, an Exclusion Ratio is the percentage of each payment that is return of principal, and the % that is interest income. Other rules apply for annuities held in 401K’s or annuity payment prior to 59.5, but those are details beyond the scope of this page.
Another common question is, “How do I compare the rate of return?”
An SMA is a period certain payment stream, therefore the rate of return can be calculated easily. In fact, it’s prominently displayed on every offer- it’s the ‘effective rate’.
With indefinite period (Lifetime) annuities, like Hybrid and Immediate annuities, you will often see an alternative measure, referred to as a “Payout Rate” or a “Cash Flow” percentage. This is more prominently displayed in hybrid annuity calculations, where an investor, for example, may have a 5% payout rate at 60 yrs of age, and a 5.5% at 65 yrs, and so on increasing with age.
The payout rate is simply your annual payments over the invested premium, as a %. So if you put in $100,000 and get $10,000 per year, this is a 10% payout rate. What rate of return the $100,000 investment is earning, however, is an entirely different, “Effective Rate” calculation described above, and which requires an end point.
Let’s be clear- the Effective Rate on an SMA is not the same as payout rate on an Immediate annuity, or an index annuity, which by definition are indefinitely long lifetime payments.
To help you understand I put the attached table together. Just Click the image to download the PDF. Though it’s labeled as ” Immediate annuity” the same principals would apply for Index and Hybrid annuities, however you would also need to include terminal account value to determine the Effective rate.
How Do They Compare:
You can see that in all three immediate annuity scenarios, (15 year, 20 year and 25 year payments) the SMA beats the IA in total income and rate of return.
With any lifetime income insurance product- immediate annuity, index with rider, or lifetime guarantee (LIG) you are buying INSURANCE first and foremost. This of course has a cost. You are insuring that if you live a very longtime you’ll have income. So remember that when comparing SMA to IA- it’s not all about the rate of return- it’s about insurance too.
For this reason, our strategy session conversations start by addressing what level of income you truly need to have insured, and focus on the best way to buy that base foundation of security. That really helps put this in perspective and focus the conversation on needs and solutions.