In the latest “Till Death Do Us Part” feature at LifeHealth.com, Lili Vasileff describes some of the pitfalls that spouses may encounter when divorcing if annuities are involved, and how to avoid them.
When it comes to dividing marital property in divorce, it is important for you and your spouse to understand the nature of any asset you may have to divide. It would not be unusual if you or your spouse owned an annuity outright or owned an annuity as part of your retirement account.
Annuities play a key role in portfolio diversification and can anchor fixed income allocation for those nearing retirement. However, in divorce, annuities can also be the black sheep of the marital pie.
First let us define what is an annuity. Annuities were designed to be a reliable means of securing a steady cash flow for an individual during retirement years and to reduce fears of outliving one’s assets. An annuity is a legal contract that binds an insurance company to provide guaranteed periodic payments to the annuitant for a specific time period or for lifetime. In retirement, an annuity guarantees risk free retirement income.
Annuities come in all shapes and sizes. Each annuity contract varies among provider companies and each has its own set of rules. Each annuity contract specifies the structure (variable or fixed rate), any penalties for early withdrawal, surrender period, spousal provisions such as a survivor clause, death benefit, etc. Some are in retirement plans and some are not; some have living and death benefits, others do not. Some are deferred or immediate; some are non-qualified or qualified.
Non-Divisible
The complexity of the nature of annuities makes this asset very difficult to divide or value for purposes of equitable distribution.
Unfortunately, annuities are not like other marital assets which can be divided readily between both spouses. Divorce attorneys may not understand the impact of dividing annuities. There can be significant risks with changing an original annuity contract and there can be disastrous tax consequences if the annuity is not divided properly pursuant to divorce. You absolutely need to know all about the annuity, and along with the help of a financial expert, to determine if, and how, the annuity can be split. Otherwise, you could suffer lasting damage.
A non-qualified annuity is funded with after tax dollars which means there is no tax deduction for deposits into the contract. You have already paid taxes on the money you put in. When you take money out, each withdrawal will have two parts – some will be part of your original deposit (the principal) and the balance will be earnings (appreciation). Only the earnings will be taxed on withdrawal. Splitting a nonqualified annuity does not require a Qualified Domestic Relations Order (QDRO).
A qualified annuity is like an IRA. You deposit money into the contract and it is tax deductible; withdrawals are 100% taxable. Qualified annuities are used in connection with tax advantaged retirement plans, such as defined benefit pension plans and 403b plans (eg. tax sheltered annuities for teachers).
This type of annuity requires a QDRO if it is to be divided.
If you split an annuity, then any share of the annuity you receive will not be taxable at time of transfer in the context of divorce. However, if divided, you can receive at most the benefits of the existing contract, nothing more. You need to read the annuity contract to know if you are able to receive via QDRO a lump sum, cash-out, or rollover to an IRA. If the answer is no, you may not want this annuity as part of your share of the marital assets.
Unfortunately, annuities are not like other marital assets which can be divided readily between both spouses. Divorce attorneys may not understand this.
Four options in dividing annuities
There are four options for dividing an annuity. The first option is a withdrawal of all or part of the annuity with a direct distribution to you. The second choice is to transfer the amount awarded to you, whether a specific dollar amount or percentage of total contract value, via a direct transfer to your IRA. The third method, preferred by the vast majority of insurance companies, is to take a “withdrawal” from original contract and then issue two new contracts to you and your ex-spouse, that set forth pro rata benefits and new account values.
Processing new contracts is much easier and less of an administrative burden for the insurance companies. The last choice, that does not split the annuity but may be necessary in some divorce agreements, is to transfer ownership of the contract in whole to you, in which case, a new contract goes into effect.
With any of these options, the annuitant must authorize the insurance company to split or transfer the annuity and a QDRO may be required. You should always confirm with the annuity provider if they will allow an annuity to be split, transferred to a new owner, or allow for lump sum cash-outs. The insurance company should be contacted early in the divorce process to determine the options and what penalties; expenses or taxes will be incurred. Make sure you get everything in writing from the company.
Are you getting what you think you’re getting?
What happens in the process of issuing new contracts? You have risk – and, you may not be getting what you think you are as a new annuitant. Why? New contracts may not provide the same benefits as the original. Here are some of the adjustments that can be made by insurance companies.
Interest rate guarantees may be less than the original (in favor of the insurance companies).
Some companies may treat a withdrawal as a taxable event in the absence of proper and clear instructions in the divorce decree
If a living benefit is attached to the policy, a withdrawal will probably reduce both ex-spouses’ future guaranteed income. Living benefits generally guarantee some sort of defined payout while the annuitant is still alive; i.e., the guarantee of the annuitant’s principal, or, a specific amount of income per year, usually 4-6% of the income base.
A withdrawal exceeding that amount is called an excess withdrawal. A withdrawal of half of the annuity value will be considered an excess withdrawal and result in a reduction of future guaranteed income.
Some contracts also call for an excess withdrawal to reset the living benefit base to the new account value, thereby wiping out any additional benefits earned on the contract to date.
Many living benefit designs stop growing the income base at the guaranteed growth rate upon the first withdrawal.
The death benefit will likely be reduced pro rata by the amount of the “withdrawal.”
Surrender charges may apply to the withdrawal.
A new surrender period can be triggered with a new contract (you may have to wait up to 10 years before withdrawing).
Separate riders may not be renewed or available in new contracts.
Concepts to Consider
Do your homework and understand the nature of your annuity (call the company and get detailed policy information in writing)
Try to offset the annuity with other assets of equivalent value in the property division (you will need proper actuarial valuation)
Try not to split the annuity.
Explore sharing the income stream from the annuity in the future (if used for income).
Know when a QDRO is required to avoid tax disasters upon distribution
In conclusion, an annuity is a complex financial asset and one that can be irreparably harmed by uninformed parties seeking to divide, transfer or cash out in divorce.
Insurance and investment companies do not make it easy for you to execute terms of your divorce agreement if instructions are unspecific or unclear and contrary to their own policies. Act early and do your homework to better understand your annuity.
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Editor’s Note: Ms. Vasileff is a nationally recognized fee only financial planner and independent investment advisor. She is the founder & president of Divorce and Money Matters, LLC, and occasionally submits opinion and commentary to us focusing on the challenges of advising clients of financial challenges of divorce. Connect with her by e-mail at lili@divorcematters.com
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