Changes to the income tax act that take effect in January will dial back the tax advantages of a key retirement tool for many clients: prescribed annuities. In spite of the changes, however, these products will continue to be an attractive option for generating income in retirement and, in certain cases, clients will benefit from the changes.

The changes reflect updates to the mortality tables to reflect the substantial increase in life expectancy since the current tables was published in 1971.

Although the changes will not affect the gross amount that clients receive from annuities, the updated mortality tables will affect the formula used to calculate the taxable portion of a prescribed annuity purchased on or after Jan. 1, 2017. “[The changes] affect how much is taxable and how much is not,” says Lea Koiv, president of Lea Koiv & Associates Inc. in Toronto.

Prescribed annuities use a formula to even out the portion of the payments that are taxable, so that taxes stay constant throughout the life of the annuitant. After this year, the portion of annuity income that’s deemed a return of capital – the non-taxable portion – will be spread over a longer period. As a result, the non-taxable portion will be lower for annuities purchased in 2017 and thereafter. The taxable component will, in many cases, be considerably higher. “Next year, [annuities are] not going to be as good a deal,” says Bruce Cumming, insurance advisor with Cumming & Cumming Wealth Management Inc. in Oakville, Ont., which operates under Toronto-based HollisWealth Insurance Agency Ltd.’s umbrella.

An illustration from Toronto-based Sun Life Financial Inc. shows that for a 65-year-old male with a $100,000 prescribed annuity with a 10-year guaranteed period, the taxable portion of the $5,906 in annual income would more than double to $980 when using the new mortality tables vs $412 when using the current tables.

The impact is even more significant for older clients: a 75-year-old male client receiving annual income of $7,680 and who doesn’t incur any taxes for that income when using the current morality tables would face a taxable portion of $687 if using the new tables.

Annuities purchased prior to Jan. 1 will be grandfathered under the existing mortality tables, so clients can avoid this higher tax bill by buying an annuity prior to the end of 2016. “In most situations, people who anticipate buying an annuity would not want to wait until 2017,” says Koiv. “I think we’ll see a bump in 2016, with people wanting to get into annuities in advance of the changes.”

In some cases, however, clients will be better off to wait to buy an annuity in 2017. Specifically, clients who have certain health conditions and who may qualify for an “impaired” annuity could benefit from more favourable tax treatment under the new rules. Impaired annuities provide a higher payout for individuals who have a shorter life expectancy, based on medical evidence provided at the client’s expense.

Under the current tax rules, the taxable portion of an impaired annuity is calculated based on the average life expectancy for that client’s age, not the shorter life expectancy unique to his or her circumstances. As a result, these annuitants currently face a higher portion of taxable income, compared to regular prescribed annuities. But, under the new rules, the taxable portion of income on an impaired annuity will be calculated based on the client’s individual life expectancy, often resulting in better tax treatment.

“People who would want to push out the acquisition of an annuity to 2017 would be those with significant health issues,” says Koiv. Examples include Parkinson’s disease, diabetes, cancer and paraplegia.

For the vast majority of clients who purchase a prescribed annuity after 2016, the result will be higher taxable income. The changes also may have negative consequences for clients in the form of clawbacks on old-age security and the guaranteed income supplement.

Even if clients aren’t prepared to begin receiving annuity income right away, they can lock in the current tax treatment by buying a deferred annuity before the end of the year. “I can buy an annuity today that will begin paying me in, let’s say, 2020,” Koiv says. “Then, today’s life expectancy tables will be used to calculate the taxable amount once the benefits commence.”

However, that approach may have near-term tax implications. Because payments must commence in order for the annuity to qualify for prescribed annuity status, clients may face taxes on a non-prescribed annuity basis in the years between purchasing the deferred annuity and receiving payments.

Once the changes take effect, prescribed annuities still will be an effective tool for retirees, even if the tax advantages are less generous, Cumming says: “Clients still should be buying annuities. Today, it’s an outstanding deal; in 2017, it will be just an excellent deal.”

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