Managing Money : Split Annuities Popular, but Liquidity Is Drawback

QUESTION: I am 65 years old and recently widowed. I have about $35,000 in my stockbroker’s cash management account, and I cannot afford to lose it in risky investments. I am looking for a safe investment with as high a yield as possible. I have recently heard about “split funding” on a five-year annuity with a guaranteed return of 8.1% that is 87% tax-free. Is this too good to be true?--L. T. W.

ANSWER: Yes. You have not been told everything you need to know about split annuities, and in some cases the information you have is incorrect. First, let’s explain what split annuity investments are. We’ll assume you have $20,000 to invest.

With a split annuity, the total investment would be divided in half by the company handling your deal. Half, or $10,000, would be paid to you in monthly installments. The payment amounts would be determined by the maturity date of your annuity and prevailing interest rates. A typical plan might run five years, offer an 8% interest rate and pay $203 a month.

The vast majority of these monthly payments are considered a return of your capital--which theoretically has already been taxed once--and only a small portion is considered interest income. Of course, it would depend on the interest rate of your annuity plan, but it is entirely possible that 87% of the monthly payments from this half of the annuity would be tax-free to you. In the above example, about $167 would be the return of your principal and $36 would be taxable interest. But this is only half of the issue.

The remaining $10,000 in the annuity plan would be invested by the underwriter with the goal of doubling the amount--in your case to $20,000--by the time disbursement of the first half exhausts the principal. The result is that, after receiving monthly payments from the first $10,000, you still have a $20,000 nest egg. However, the interest earned on this portion of your investment--not the principal itself--is taxable when you withdraw it. So if the second portion of your investment is indeed doubled, half--or $10,000--would be taxable to you.

According to Thomas Gau, with the Torrance financial planning firm of Kavesh & Gau, split annuities have gained a measure of popularity among retirees in recent years because, if they are underwritten by a reputable company, the investment is among the safest and most reliable you can make. And several annuity plans--including some of the most conservative--offer interest rates that are quite competitive with certificates of deposit offered by banks and savings and loans.

However, the downside to these investments is that they are very illiquid. If you must withdraw your money before the maturity date, you will be assessed a substantial penalty. So if having quick access to your money is important, this is not for you.

Also, you may be able to earn as high a yield on your investment in a money market fund or a federally insured certificate of deposit, both of which can be substantially easier to withdraw your money from than annuities. Also, annuity plans offer little or no protection against an increase in the rate of inflation because you are locked into a specific rate of return for a minimum of several years.

Q: I participate in a 401(k) program at work and have about $400 withheld from federal taxes each month. Is this amount still subject to Social Security taxes?--M. L.

A: Yes. Social Security taxes are levied on your total gross pay, not the amount remaining after payroll deductions for tax-deferred savings plans, such as the 401(k). You are still liable for Social Security payroll taxes until the maximum annual contribution of $3,379 for 1988 has been withheld.

Q: I have some tax-deferred annuities that I contributed to when I was employed by a public school in the 1960s and 1970s. Some of the annuities require that I begin making withdrawals by age 75. Another annuity company said the age was 85. The Internal Revenue Service’s Publication 571 dealing with tax-deferred annuity plans by public school employees does not offer any age. Does that mean I should follow the requirements of the annuity plans I hold?--J. H. H.

A: Yes. According to our experts, when your annuity policies were written, the IRS did not impose any mandatory distribution rules for annuity plans such as yours. The minimum age of 70 1/2 that the IRS now imposes for individual retirement accounts does not apply to annuity contracts such as yours.

Q: I am 59 years old and have been retired for several years. However, I will have a total earned income of $400 this year, which I intend to invest in an individual retirement account. I am wondering if my non-working wife may also contribute $400 to an IRA, or is she limited to a $250 contribution?--R. C. V.

A: Actually, your wife is not permitted to make any contribution at all if you put the full $400 into an IRA. A couple’s total contributions to an IRA are limited to 100% of the total income of the working spouse, in your case $400.

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Please do not telephone. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.