Splitting Annuities in a Divorce

May 8, 2023

It is not unusual, when splitting assets in a divorce, to divide each account right down the middle. That might be fine to do for most types of investment accounts, but when it comes to annuities you need to be very careful. Because of their unique structure, dividing an annuity can have unexpected tax consequences.

An annuity is financial product sold by insurance companies. Money invested in the account grows tax-deferred and can be withdrawn after age 59 1/2 without a penalty. Withdrawals can be lump-sum (partial or full withdrawals) or the contract can be “annuitized” which means the entire contract is turned over to the insurer in exchange for guaranteed lifetime income.

There are many variations of annuities – fixed-rate and variable-rate; deferred and immediate; non-qualified and qualified. Knowing the type of annuity is necessary to determine if, and how, the account can be split.

For instance, a non-qualified annuity is funded with after-tax money (which means there is no tax deduction for deposits into the account). As it grows, the account has two kinds of money in it: the owner’s original deposit and the subsequent earnings. Only the earnings are taxable. Splitting a non-qualified annuity does not require a QDRO and would not be taxable if it is pursuant to a divorce decree. However, some companies don’t allow an annuity to be split or don’t allow lump-sum cash-outs. In addition, if the owner splits the account without a divorce decree, he or she could incur a 10% penalty if under the age of 59 ½.

A qualified annuity is like an IRA – money deposited into the account is tax-deductible and withdrawals are 100% taxable. This type of annuity requires a QDRO if it is to be divided. A QDRO cannot award a party any income or annuity benefit that is not available under the terms of the original annuity contract, so if the contract says the annuity cannot be cashed out as a lump-sum, or transferred to an IRA, then a QDRO with those instructions will not be honored. Therefore, it’s important to read the contract before making any decisions on breaking up or transferring the annuity.

Even if you can transfer an annuity, it may start a new surrender period for the receiving spouse. That can mean the receiver may have to wait up to 10 years before being able to withdraw money from the account without a penalty (and don’t forget that if he or she is under age 59 ½ they would incur an additional penalty.)

All these possible penalties and charges mean that if the spouse receiving the annuity needs income, taking it from the annuity could be costly. For example, your client Judy is to receive 50% of her ex-husband Mike’s qualified annuity. Judy is age 45, and the annuity is worth $100,000. Mike bought it 11 years ago so he’s out of the 10-year surrender period. Judy and Mike submit a QDRO and $50,000 is transferred to a new annuity contract. Now Judy decides she needs $10,000 and makes a withdrawal. She will incur a 10% penalty for making an early withdrawal before age 59 ½ ($1,000), a 10% penalty for making a withdrawal in the first year of her new 10-year surrender period ($1,000) and income taxes ($150, assuming she is in the 15% tax bracket.) Her $10,000 withdrawal is whittled down to $7,850!

Some annuities have a living benefit rider, which is a popular feature. This type of rider provides a defined payout while the owner is alive; for example, it might guarantee withdrawals based on the highest account value over the past 5 years. The rider is a separate contractual provision with its own rules governing how it is treated in a divorce. In some cases, it might be lost if the account is transferred to a new owner.

In summary, when you see an annuity on the asset list know that you will need a lot more information about it before you make any decisions. The insurance company should be contacted early in the divorce process to determine what the options are for dividing or transferring the account, and what penalties, expenses or taxes will be incurred.

« Go back to Divorce Newsletters