Partial annuitization: turning only part of a contract into income

Converting a deferred annuity into income does not have to be all or nothing. Many contracts, and the federal tax rules for non-qualified annuities, allow you to turn only a portion of the value into a stream of payments and leave the rest accumulating. The converted part becomes a guaranteed paycheck that cannot be reversed, and the part you leave keeps its flexibility and its cash value. The decision comes down to how large a gap there is between your guaranteed income and your essential spending, how healthy you are, how much you need to keep liquid, and how you feel about giving up control of a slice of your money.

This post sets out the criteria in the order most people meet them, works one example through with invented numbers and ends with a decision list. It is general information. The contract, the insurer's rules and a tax professional's reading of your situation decide the specifics.

What partial annuitization is

annuitization is the point at which a deferred annuity stops being a savings contract and becomes a stream of payments. You give up the account value in exchange for payments that last a lifetime or a stated number of years, and the insurer takes on the risk of how long you live. The payment depends on the amount converted, your age, the payout option you choose and the interest and mortality assumptions the insurer uses. A full annuitization applies to the entire contract. A partial annuitization applies to part of it.

A contract can handle this in two ways.

• Within the same contract. The owner asks the insurer to annuitize a stated dollar amount or percentage and keeps the rest as a deferred annuity. Not every contract offers this, and those that do may set a minimum amount for each portion.
• By exchanging part into a new income annuity. The owner moves a portion of the contract, through a partial 1035 exchanges: swapping policies without tax, into a separate immediate annuity. This depends on the insurers involved and on the IRS rules for partial exchanges, so it has to be done in a way that qualifies and with both companies' cooperation.

For a non-qualified contract, federal tax law has recognized partial annuitization since 2011, provided the payments last for the annuitant's life or for a period of at least ten years. Both the insurer and a tax professional should confirm that your arrangement meets the rule before you act.

Step 1: Find the income gap

The strongest reason to annuitize part of a contract is a gap between income you can count on and spending you cannot avoid. Social Security, a pension and any existing annuity payments are guaranteed income. Housing, food, utilities, health care premiums, insurance and taxes are the essentials. The difference is the gap.

Take an invented household. Their essential spending comes to $4,000 a month. Social Security pays $2,400 and a small pension pays $700, so guaranteed income is $3,100 and the gap is $900 a month, or $10,800 a year. They own a non-qualified deferred annuity worth $300,000 for which they paid $180,000, and they have separate savings for emergencies and travel.

If there is no gap, because guaranteed income already covers the essentials, the main reason to annuitize is gone. If the gap is large, it may be larger than one contract can fill without leaving the household with nothing liquid. The size of the gap is the first number to write down, and the annuity payout calculator can help estimate what a given amount might produce.

Step 2: Size the converted part

Payments depend on a quote. For this example, assume the insurer quotes $7 of annual income per $100 of premium for a life annuity with a ten-year period certain at the owners' ages. That figure is invented and will not match anyone's actual quote, which depends on age, sex, product and the interest rates of the day.

• Income needed: $10,800 a year.
• Amount required at 7 percent: $10,800 ÷ 0.07 ≈ $154,286.
• Round to $150,000: $150,000 × 0.07 = $10,500 a year, or $875 a month.

The household decides to convert $150,000, half of the $300,000. The $875 closes most of the $900 gap. A buyer might choose a slightly larger amount to cover it exactly, or accept a gap of $25 a month. Either choice is reasonable, and neither is a recommendation.

The $150,000 left in the deferred annuity remains an asset. It earns whatever the contract credits, it can be withdrawn subject to the contract's surrender charges, and it passes to the beneficiary at death. That second half is what makes the partial approach different from the full one.

Step 3: Understand how the tax basis splits

When a non-qualified contract is partly annuitized, the owner's cost basis is divided between the two parts in proportion to their share of the contract's value. The converted part carries its share of the basis, and the remainder keeps the rest.

In the example, the owner paid $180,000 into a contract worth $300,000, so the basis is 60 percent of the value.

• Basis in the converted $150,000: 60% × $150,000 = $90,000.
• Basis in the remaining $150,000: $90,000.
• Gain in each part: $150,000 − $90,000 = $60,000.

For the converted part, the exclusion ratio decides how each payment is taxed: the basis divided by the expected total of payments. Assume, for illustration, that the insurer's life expectancy table gives an expected return of $135,000, which is about 12.86 years of $10,500 payments. The ratio is $90,000 ÷ $135,000, or two thirds. Of each $875 payment, about $583 is a tax-free return of basis and about $292 is taxable at ordinary rates. After the basis is fully recovered, which would take roughly 12.86 years in this example, every further payment is fully taxable. The step-by-step version is in the exclusion ratio: how annuitized payments split into basis and gain.

The remaining $150,000 behaves like any non-qualified deferred annuity. Withdrawals come out gains first, so the first $60,000 taken is taxable. This matters for how you plan to draw on the liquid part, and the guide on how annuities are taxed lays out the rules and the 10 percent additional tax for withdrawals before 59½.

If the contract is held in an IRA or other plan, the picture is simpler and less favorable: there is typically no basis, so every payment is taxable, and required distribution rules apply. A qualified longevity annuity contract, covered in qualified longevity annuity contracts, is a related tool with its own limits.

Step 4: Think through what you give up

Converting is a trade, and each side of it should be written down.

• Control of the converted amount. In most income annuities, once payments begin the choice cannot be reversed. There is usually no cash value to withdraw and no way to change the payout option.
• The money for heirs, depending on the option. A life-only payout leaves nothing to a beneficiary when the annuitant dies. A period-certain, refund or joint-and-survivor option leaves something or continues to a spouse, at the cost of a smaller payment. The trade-offs are compared in period certain, cash refund and installment refund options compared and single life or joint-and-survivor: choosing how an income annuity pays.
• Inflation protection, in most cases. A level payment buys less each year. Some contracts offer increasing payments for a lower starting amount. See a flat annuity check and inflation: how purchasing power erodes.
• Flexibility for surprises. A major medical cost or a family need can be met from liquid savings but not from the converted part.

What you gain is a payment that does not depend on markets, on your skill as an investor or on how long you live. For people who worry about outliving their savings, that certainty is the point.

Step 5: Consider the alternatives to annuitizing

Annuitization is one way to turn a deferred annuity into income, and it is not always the best fit.

• Systematic withdrawals. Leave the contract alone and take regular withdrawals. This keeps liquidity and control but offers no guarantee that the money lasts for life.
• An income rider. Some contracts have a lifetime withdrawal benefit that pays an income without annuitizing, while keeping some access to the account. The rider has a cost and a benefit base that is not the same as the account value, as covered in guaranteed lifetime withdrawal benefit riders and an income rider on a deferred annuity versus a plain income annuity.
• A new immediate annuity bought with a 1035 exchange. The rates the old contract guarantees on annuitization are often more conservative than the rates a current immediate annuity offers. Ask for both quotes before deciding where to convert. A partial exchange has to follow the IRS procedure, so confirm that the insurers will handle it.
• A deferred income annuity or QLAC. If the need is for income starting later, such as at age 80 or 85, a deferred income annuity can buy a larger payment for the same premium because the payments start later and fewer people reach that age. See Deferred income annuities (DIAs): longevity insurance explained.
• Doing nothing yet. Waiting a year or two raises the payment for a given amount, since the buyer is older. It also carries the risk that health or rates change in the wrong direction.

Three variations on the same contract

The same $300,000 contract can lead to different answers for different households. These are invented sketches, not recommendations.

A single owner in poor health. She has a $900 monthly gap, but her doctors expect a shorter life than average. A life-only payment would pay out a smaller total in her case than the insurer assumed. She might convert a smaller amount with a refund option, rely on withdrawals, or rely on the retained contract's death benefit for her children. A 10-year period certain would protect heirs for ten years but lower the payment.

A married couple with long-lived families. The husband is 68 and the wife is 66, and both parents on each side lived into their nineties. The guaranteed paycheck matters most to the spouse who outlives the other. They compare a joint-and-survivor option, which pays less each month than a single-life option but continues after the first death. They convert half and keep the rest invested for growth, since a long retirement also means a long exposure to inflation.

An owner whose savings are all in the contract. He has the same gap but no other money. Converting half would leave $150,000 in the contract as his only reserve. He might convert a quarter first, keep the rest flexible, and revisit in a year, accepting that waiting changes the payment. The key fact is that he has no cushion if the annuity income turns out to be insufficient.

In each case, the contract and the payment quote are the same. What changes the answer is health, family, other assets and how the person weighs certainty against control.

A decision list

Use this as a set of conditions, not as advice. Every line should be checked against your own numbers.

1. If guaranteed income already covers essential spending with room to spare, then annuitizing for income adds little, and you may prefer to keep the whole contract flexible.
2. If there is a gap and you have enough liquid savings to cover emergencies and several years of irregular costs, then converting enough to close most of the gap is a reasonable option to price.
3. If there is a gap and nearly all your savings are in the contract, then converting a small part, or using an income rider or a phased approach, keeps more of your options open.
4. If your health is poor, or your family history suggests a shorter life than average, then a life-only payout is a weaker fit, and a refund or period-certain option, or no conversion, deserves a look. If your health is good and your family is long-lived, the lifetime guarantee is worth more.
5. If you are married and the spouse depends on the income, then compare joint-and-survivor options, since a single-life payout stops at your death.
6. If you worry about inflation over a long retirement, then compare a level payment with an increasing one and keep part of your money invested for growth.
7. If you cannot tolerate the idea of an irreversible decision, then convert a smaller amount first, if the contract allows later conversions, and see how it feels.
8. If the contract is qualified, then have a tax professional model the taxable income and the required distributions before you sign.
9. If the quoted payment from the contract is well below a quote you can get elsewhere, then ask whether a partial 1035 exchange to a separate income annuity is available, and what each insurer's rules and surrender charges would be.
10. If you are being pressured to decide quickly, then slow down. A legitimate income annuity quote stays available long enough for you to compare it.

Common questions to ask the insurer

• Does this contract allow partial annuitization, and what is the minimum amount per conversion?
• What payout options are available, and what is the quoted payment for each, using the same amount?
• How will the basis be allocated, and will the company report it on the tax form?
• Does the remaining contract keep its surrender schedule, riders and death benefit unchanged?
• Does conversion end any income rider or other benefit attached to the converted part?
• Is the converted payment fixed, or can it increase?

The answers should come in writing. The mistakes people make at this stage are covered in mistakes people make when they turn an annuity into income, and a fee-only planner or tax professional can run the household's real numbers against them.

Key takeaways

• Partial annuitization converts a chosen amount of a deferred annuity into guaranteed payments and leaves the rest liquid, though the converted portion is generally irreversible.
• Start with the gap between guaranteed income and essential spending. In the invented example, a $900 monthly gap led to converting $150,000 of a $300,000 contract.
• For a non-qualified contract, the cost basis splits in proportion to the amounts converted and retained, so the converted part gets an exclusion ratio of two thirds in the example, while the retained part is still taxed gains first.
• Weigh the loss of control, the effect of the payout option on heirs and the lack of inflation protection against the certainty of a lifetime check.
• Compare alternatives such as income riders, a separate immediate annuity or waiting, and get quotes in writing before deciding.