More Than an Annuity: The Unique Benefits of i4LIFE® Advantage with Natalia Keene

[00:00:24] Natalia Keene: Thank you, Doug, for having me. And thanks for inviting Lincoln Financial back. It's great to be here.

[00:00:30] Doug Heikkinen: So tax season is upon us. And with that comes an opportunity to review clients retirement portfolios for tax efficiencies and inefficiencies. How do non qualified deferred annuities come into this conversation?

And how can they help or hurt with regards to tax planning?

[00:00:50] Natalia Keene: Yeah, Doug, it is tax season. Everyone's favorite time of the year. And honestly a perfect time for all taxpayers to do a status check on where are we drawing income from and where are our taxes going? What are we paying in taxes?

And this of course includes analyzing income streams for those that are nearing or already in retirement. So tax season provides this opportunity for pre and post retirees to really review their retirement portfolios, determine which assets to draw income from, and really analyze the tax implications of each of them.

Because, as we know, each retirement asset has its own pros and cons regarding the benefits they provide, and the limitations they have. So when it comes specifically to non-qualified deferred annuities, they are really a fantastic retirement accumulation asset, primarily due to their tax deferred growth.

This is arguably the most appealing feature of these annuities as the earnings within the deferred annuity avoid income taxation until we actually take a distribution from them. In addition, clients can turn on a stream of lifetime income at a future date. So they have some really great benefits. In contrast, these annuities are not without their drawbacks.

The biggest one being that clients who want to draw income from non qualified deferred annuities have to pay taxes at ordinary income rates. Furthermore, any withdrawals that they make, if they need to, prior to age 59 and a half could be subject to that 10% early withdrawal penalty.

So as financial professionals, we really work with our clients to weigh the pros and cons of non qualified deferred annuities, against other potential retirement assets, to determine the appropriate retirement portfolio mix for our clients. So, for example, a client can place money in an investment portfolio instead of an annuity.

In that case, the client would be taxed annually on any growth versus it being deferred, but they would have access to that account value at any time, versus potentially getting a 10 percent early withdrawal penalty if you take it prior to age 59 and a half. And then the taxation of the investment portfolio allows for those long term capital gains versus ordinary income taxation. So, a lower potential tax. It's really important to discuss with our clients which retirement assets make sense in context of their, let's say, appetite for income taxes. And obviously there's a number of factors that go into this analysis beyond just the taxation, right?

Flexibility, access to liquidity, the different guarantees or death benefit options. But during tax season, when folks are filing and looking at their W2s and filing their 1040s and looking at their potential tax bill, we may, you know, rethink where we position assets and what products make the most sense for a given client situation.

[00:04:03] Doug Heikkinen: So that's a lot of great information. Non qualified deferred annuities are a fantastic way to defer current taxable income, but not tax efficient when clients want to draw income from these accounts. Is that the case for all annuities?

[00:04:19] Natalia Keene: Well, I think it's going to make sense, when we talk about annuities, to really step back a bit and review the history of annuities so we can understand really where we got to today from a taxation standpoint.

So for all you history buffs out there, one of the first known uses of annuities was during the Roman Empire. And what would happen is the empire would provide what was called an annua, or a stipend, which provided a stream of income to those soldiers and their families that were returning from war. Well fast forward to the 1920s and 30s when annuities became really prominent in the United States.

They functioned quite simply. The client would give an insurance company a sum of money in exchange for a promise of guaranteed income for life. From a taxation perspective, that stream of income was taxed using an exclusion ratio. So part of your income payment that you got included gains from the contracts, and that was taxed at ordinary income.

But part of your income was a return of your cost basis and you didn't pay any tax on that. So a really beneficial income stream that you were getting. These were called SPIAs or single premium immediate annuities and the U S tax code originally assumed that all annuities would operate this way.

You know, as immediately annuitized contracts. And so they granted that preferential tax treatment of the income with this exclusion ratio. Well, if we fast forward to the seventies and eighties, when the U S experience the phenomenon of high interest rates, that high interest rate environment had a significant impact on how people utilize annuities.

Clients were looking at their annuity accounts, getting say 10, 11, 12, 13 percent interest, and realizing they didn't want to take income now, but instead they wanted to let their account grow. They had discovered the eighth wonder of the world, Doug, in compounding interest. So this, at the time, worked out great for almost all parties.

Insurance companies kept assets on the books longer, financial professionals managed assets longer, clients' assets grew larger, and then when they eventually did take income, they got that tax exclusion ratio. Well, that's worked out great for all those folks, except for the IRS. They were late to the game on how these deferred annuities were being taxed.

So due to this high interest rate environment, Doug, people were not purchasing annuities as a retirement income vehicle, but rather as a tax deferred CD.

However, Congress's intent, and the resulting federal income tax treatment, that exclusion ratio that we talked about, was that annuities were truly meant to help individuals accumulate savings for retirement and provide income in retirement. So, Congress of course implemented legislation that more aligned with their intent.

What resulted was a change in how distributions from these contracts were taxed. After the enactment of TEFRA, the Tax Equity and Fiscal Responsibility Act of 1982, the law held that distributions from any non qualified deferred contracts issued after that enactment date no longer got the exclusion ratio.

Instead, they were going to be taxed on a LIFO, last in first out, tax basis. This meant that the gains came out first, and that's what people were going to be taxed on. Now it's good to know that TEFRA impacted the taxation of distributions from these deferred annuities, but not annuitized contracts.

I give this history, Doug, to reiterate the difference between these annuitized SPIA contracts, versus deferred contracts. Annuitized contracts have that tax preferred income, that exclusion ratio, but no access to the asset itself. Whereas deferred annuities allow that tax deferred growth and accumulation.

But when distributions are taken, they first must consist of gains, taxed as ordinary income.

[00:08:34] Doug Heikkinen: Love the history. Love going back to Rome, and the interest rates in the 80s, they had a significant impact on the taxation of annuities, particularly deferred annuities, which can obviously impact a client's taxable income in retirement.

So can you speak more to Lincoln's unique rider that can help bridge between the two tax provisions of annuitized and deferred annuities?

[00:08:56] Natalia Keene: Absolutely, Doug. Let's reiterate the purpose of annuities. They are meant to be spent. The IRS makes this clear with how they are taxed, and they really don't make it easy for us, with deferred non qualified annuities, because they require the spend down or, you know, when we take income from them to be LIFO based.

All the gains before we get any basis. So what we were seeing was clients that held non qualified annuities were putting off drawing that income because they didn't like the resulting tax associated with it. Well, enter a solution, Lincoln's i4LIFE Advantage. This is an optional benefit available only with Lincoln variable annuities for 0.4% per year above standard contracts expenses. Our unique i4LIFE rider allows the contract owner to receive that preferential exclusion ratio that we talked about, but still allows the client access to the account value. Which is really different compared to normal annuitized contracts or those SPIAs.

So if this sounds like a form of annuitization, it's because i4LIFE, in fact, is a form of annuitization. However, Lincoln does not require the client to relinquish control of the asset, as they would in a traditionally annuitized contract. Clients can reach in, take more money from the account, and those additional withdrawals would also have that tax preferential exclusion ratio. And an additional benefit of using i4LIFE as their spend down method,

so clients turn it on during their lives, they're taking income, is that when they die, they are then passing the benefits of an annuitized contract to their beneficiary, be that their children or even their trust. These beneficiaries now get to unlock FIFO, first in first out tax treatment, meaning the beneficiary can receive all that cost basis first, assuming they request it, which many times people do, and then they can stretch the gains and spend those down at least as rapidly.

So this unique product offering really allows additional options for clients based on their particular situation.

[00:11:13] Doug Heikkinen: This does sound very unique. How unique is this hybrid annuitization in the marketplace? And how did Lincoln come up with the idea?

[00:11:22] Natalia Keene: Well, I'm going to speak to the uniqueness first as it's an annuity feature exclusive to Lincoln.

We are the only carrier that offers the ability to take income with the tax exclusion ratio and access the account value. Now as background, i4LIFE was the result of a group of Lincoln actuaries getting together and brainstorming ways to enhance life insurance and annuity features. You can just imagine, you know, where they were and what they were doing. And they were really interested in analyzing ways that they could increase tax efficiency with these products. Well, as a result of these sessions, this group reviewed the number of contracts that we had that were annuitized. And they determined that less than 2 percent of our contracts were actually being turned on to that full annuitization, right?

So even though we know that annuitization is the most tax efficient way of liquidating a non qualified annuity, people were not annuitizing their contracts. Why? Well, they didn't want to give up their entire account value to the insurance company. So i4LIFE was created to help that annuity owner with tax efficiency and allowing them access to their investment. And we got the IRS's blessing for this. Lincoln, on behalf of Lincoln as a taxpayer, asked the IRS for several private letter rulings, or PLRs, that confirmed we were able to utilize i4LIFE Advantage in this way.

Let's remember, all variable annuities offer tax deferral, but only Lincoln variable annuities offer i4LIFE Advantage, a tax advantage distribution method that's been helping investors minimize the impact of their taxes on their income since 2001. So when clients are ready to transition from saving for retirement to taking retirement income payments, i4LIFE is an optional living benefit available through Lincoln's variable annuities for that additional charge we talked about above the standard contract expenses.

[00:13:26] Doug Heikkinen: So we've covered a lot here from the technicalities of annuity taxation, to Lincoln's proprietary tax efficient solution, i4LIFE advantage, what are some practical applications of i4LIFE advisors can bring to their clients?

[00:13:41] Natalia Keene: Great question, Doug. Thank you. The number one benefit of i4LIFE for clients is access to tax efficient lifetime income without giving up access or control of the asset.

Also, clients who die with i4LIFE running on their contracts, they pass the benefit of i4LIFE onto their beneficiaries. Additionally, Lincoln annuity contracts allow a beneficiary to add the i4LIFE rider to an annuity they inherited, even if the original owner didn't turn that feature on.

Furthermore, the benefits of i4LIFE really caught on and we found that beneficiaries of contracts with other carriers looked to 1035 exchange their contracts to Lincoln, and then utilize the features of i4LIFE. Currently we process between, I'd say two and three hundred contracts a month in this beneficiary 1035 space.

So, someone bringing in an inherited annuity from another company to Lincoln. And a majority of those provide that tax efficient income spend down to those beneficiaries by turning on i4LIFE. Another unique method of i4LIFE is tax efficient gifting of non qualified deferred contracts. Let's say a client has an annuity and they no longer need it, or they need to remove or want to remove an annuity from their estate for estate tax purposes, which has been, you know, a big talk with the Tax Cuts and Jobs Act and what's going on with the estate tax exemption.

Well, unfortunately, gifting of a deferred annuity triggers full recognition of the gain to the contract owner when they transfer it to a non spouse. If you want to gift it to your kid, you can, but you're going to have to recognize all the gain right then and there. However, i4LIFE, which is a form of annuitization remember, provides a way for us to gift that asset without triggering that gain.

Now they'd still have to file a gift tax return, but we're able to get the asset out of their estate and eliminate the recognition of that gain. i4LIFE can also provide solutions when planning with non-grantor irrevocable trusts. So think of your special needs trust or certain spend thrift trust that you might put in place for your children, where the trust is the beneficiary and/or the owner of an annuity running i4LIFE.

By doing this, we bypass some of the nuances associated with deferred annuities and trust ownership. And finally, i4LIFE can provide really a unique method of multi generational planning by allowing generation one, say grandma, to provide income to themselves, and then a legacy of income to their children and their grandchildren.

[00:16:38] Doug Heikkinen: Great real world applications for utilizing i4LIFE. Let's wrap up with a call to action or what financial professionals can do today to better prepare and support clients with their own annuity contracts, utilizing i4LIFE.

[00:16:53] Natalia Keene: Absolutely, Doug. Our advanced sales team always recommends reviewing all beneficiaries on all annuity contracts.

The key here is, let's make sure we understand how a client's annuity will distribute and what the implications will be of doing so. Second, we recommend reviewing all deferred non qualified annuities owned for several years, let's say 10 or more, and then determine what's the purpose of this annuity now.

Will they need to turn on income? And if so, when? Or do they want it to go to their kids either at death or perhaps a gift during life? Knowing what the purpose of the annuity is really helps us direct the client on what changes may need to be made structurally to right purpose it. So, we want to consider situations like, they have a special needs family member, they have an existing annuity they no longer need, they wish to leave a lasting legacy to their children and grandchildren.

They need to access retirement assets prior to 59 and a half, or for individuals that have inherited those non qualified annuity death benefits, and want more flexibility or options on what they can do with it. And finally, reviewing clients' estate plans and determining whether clients intend to utilize trusts to pass their annuity on.

There can be major complexities with annuities and trusts as owners or trusts as beneficiaries. And i4LIFE can be a really great solution for those situations. I mean, ultimately, Doug, what's key here are the options and flexibility financial professionals can provide to clients by implementing i4LIFE, where it makes sense for a client's particular planning objectives. And then really bringing new and different solutions to their clients.

You know, doing so we better ensure that assets are retained, right? And relationships through numerous generations, right? You helped mom, you helped grandma, I trust you, I want to do business with you. So really maintaining those relationships, which, not only benefits the planning outcomes for the clients, right,

we're giving them more options, but the success of an advisor's own business in increasing and maintaining assets under management. So remember i4LIFE Advantage takes advantage of the best aspects of deferred annuities and annuitized contracts. Lifetime income, control of the investment, access to cash value, growth potential, death benefits, and of course that tax efficiency.

 Knowing this and then targeting a list of your clients and prospects who might find value from the features and benefits i4LIFE has to offer can be a game changer for your clients deferred non qualified annuity options.

[00:19:51] Doug Heikkinen: Natalia, great information. Thanks so much for joining us.

[00:19:56] Natalia Keene: Thank you so much, Doug, for having me. It's been my pleasure.

[00:19:58] Doug Heikkinen: To learn more about Lincoln Financial and i4LIFE, please visit lincolnfinancial.com. Please follow us for timely updates on X, LinkedIn, and Facebook, all at Advisorpedia. For everybody at Advisorpedia, our producer Julia Smollen, our engineer Tory Miller, and the Power Your Advice podcast team, this is Doug Heikkinen.