As if divorce were not complicated enough, owning annuities can make the mess bigger. As a refresher, these complicated financial products tend to have many twists and turns nestled inside a tax-deferred wrapper. When changes are made to the contract, this can trigger fees, taxes, loss of benefits, and have other nasty consequences.
Many investors believe that the contracts can simply be split in half like any other bank account. It’s generally not that straightforward. Some annuity companies will in fact split a contract in two equal pieces, but that is not always the case. Some annuity companies simply distribute half the value into a second contract. This can cause taxes to be due because distributions usually force earnings to come out first, exposing them to taxation. This can lead to nasty surprises when 1099’s are generated late in the year.
It’s often best to simply leave the contract intact and let one spouse keep the annuity entirely. Be sure to properly value accumulated taxable gain when negotiating for other assets which might be less encumbered. Remember, a stock with a $50,000 untaxed gain and an annuity with the same $50,000 increase are not treated the same for taxes. The annuity will always generate ordinary income taxes if it has gains when distributed, while the stock will likely generate capital gains taxation, which enjoy a tax rate roughly half that of ordinary income. The stocks will also likely get a tax free step up in basis at death, which could wipe out the tax liability entirely for all the increase in value. Annuities don’t ever enjoy such treatment. This could be huge when one spouse remarries and is widowed soon thereafter.
You should also be aware that annuities often carry income benefits that increase costs, but also change the risk profile of these investments. If you’re not careful, one spouse could get the risky assets and the other gets the safer stuff despite the values being the same and otherwise appearing equal on the surface; even with two nearly identical annuity contracts.
Some of the benefits that can get wiped out by improper treatment:
- Loss of tax deferral
- Penalties for early withdrawal
- Loss of “benefit base” where income is guaranteed on a higher value than the contract cash value
- Loss of increased death benefit over cash value
- Loss of income benefits no longer offered in new contracts
- Loss of capped costs for increased benefits found in older policies
- Loss of minimum fixed returns (some older policies guarantee 4% per year increases in cash value; very valuable in a near-zero interest rate world)
- Loss of any death benefit on the portion deemed to be an “excess withdrawal”
These are just some of the things that could surprise investors who thought they were getting “half”. It gets even trickier when you consider that these issues must be addressed before a court ordered separation of the contract is received by the company. Once the judge’s stamp is on the decree it’s probably too late to negotiate with the other spouse or to force the insurance company into some special type of treatment. It simply goes into the “paperwork mill”. We also recommend you get the name of every person you speak with at the company and their phone number. Clerical employees work hard to avoid the uncomfortable follow-up phone call with anyone they know is taking notes. They sit up straighter when you ask their name. And you should demand they confirm any promises in an email for proof of what they committed to do. It is also wise to take a financial advisor to the negotiating table because curves get thrown and decisions made on the spot that someone with a quicker mind for the implications could have changed the conversation. Big decisions get made with little information at the time and there’s often no going back.
Hopefully these tips can help you or someone you know make the best lemonade possible out of the surely sour divorce experience.