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A N N U I T I E S
D ef initio n a nd Cha ra cteristics
An annuity is an insurance contract under which a regular series of payments (referred to as "distributions") is made in return for a set purchase price or premium. It is the only investment where an individual is guaranteed not to "outlive his or her money". Although an annuity is generally sold by an insurance company, it can also be purchased as an investment from banks and, sometimes, even individuals (known as a "private annuity"). Bec ause an annuity, particularly one that offers only a fixed payment, is a relatively low -risk investment, it may be an appropriate choice for clients who require longer-term financial security. Tax-deferred growth. The investment in an annuity accumulates cash value and grows tax-deferred; accordingly, the compounding effect of deferring taxes permits much faster growth. Unlimited contributions. There is no limit on the after-tax contributions to an annuity of any type. Higher effective yields. Since the interest is tax-deferred, an annuity returning the same interest rate as a taxable investment, suc h as a mutual fund, will result in a higher effective yield over the same period of time. Withdrawal options. Withdrawals may be taken as a lump-s um or annuitized, which m eans that the withdrawal is converted to periodic payments over tim e. It is important to note, however, that a penalty may be impos ed under the terms of the annuity contract for withdrawals before a certain specified date. A tax penalty m ay als o be impos ed in some instances (for exam ple, if the withdrawal is made before the individual reaches age 59.5). Disadvantages of annuities include: High costs. Compared to other investments, management and maintenance fees associated with an annuity can be higher. Fixed yield. An annuity that provides a long-term, fixed payout may not keep pace with inflation. Termination fees. Surrender costs may be expensive if the contract needs to be discontinued or terminated. Lack of flexibility. Onc e beginning distribution of an annuity in a periodic payment form (referred to as "annuitizing the annuity"), the annuitant c annot "commute" the value, that is, as k for his or her m oney back in a lump sum form.
Types of Annuities
Annuities are classified in several different ways, depending upon why they are purchased, the type of investment, the distribution terms, and the potential start date of the annuity. All, however, fall within one of two general categories for tax purposes: a qualified annuity or a nonqualified annuity. A qualified annuity is purchased as a part of, or in conjunction with, an employer-provided qualified retirement plan or within an individual IRA. If certain requirements are met, contributions to qualified annuities are made with before-tax dollars and interest is not taxed until distribution. However, upon distribution, payments from such an annuity are then fully taxable as ordinary income. In contrast, a nonqualified annuity, which is usually separately referred to as a commercial annuity, is not part of an employer provided retirem ent plan and is purchased by an individual or corporation. This is the type of annuity most individuals consider as a personal retirement savings vehicle. Contributions are made with after-tax dollars and are not deducted from gross income for income tax purposes. An "exclusion ratio" computation applies with this type of annuity (see subsequent discussion on the "Taxation of Annuities"). There are also additional forms of nonqualified annuities beyond the standard commercial form just menti oned. For example, a private annuity is a type of nonqualified annuity sometimes used in estate planning for a clos ely held business owner. This is the type of annuity referred to earlier as between individuals. Another means of classifying an annuity is by investment type. Afixed annuity disburses a fixed periodic payment and is typically invested only in safer investments such as Treasury bills and securities, guaranteed investment contracts (GICs), and certificates of deposit. A variable annuity may pay out a fixed or variable periodic payment based in the underlying value of the assets at the end of the accumulation period. The value of these assets m ay vary depending on market perform ance. Premiums for this type of annuity are invested in a wide variet y of investment options or sub-accounts similar to mutual funds. The options usually include diversified stock, bond, and money market mutual funds. Annuities are also classified by the manner in which the proceeds are returned to the investor. There are four categories: Single-life annuities Joint annuities Joint and survivor annuities Term-certain annuities
In a single-life annuity, the investor/purchaser buys a contract that provides for a periodic payment only over the life of the purchaser. These ar e a good investment if the purchaser should happen to outlive his or her projected life expectancy, but not-so-good a choice if the individual should die in a relatively short time period after purchasing the annuity. A variation of the single life annuity is refund annuity. With this feature, the annuity contract promises, on the death of the annuitant, to pay the annuitant's beneficiary a lump sum that is the difference between the purchase price of the annuity and the sum of the monthly payments received to date (or at date of death). A joint annuity is the same as a single-life annuity except payments are made to two persons as long as both are alive. When one of them dies, all payments terminate. In contrast, a joint and survivor annuity will pay while both of two covered individuals are alive (usually a husband and wife), but the payments continue after the death of either of the individuals, for the remainder of the survivor’s life. Joint and survivor annuities are often used as part of a qualified ann uity and are mandated by pension law in som e instances. Finally, a term-certain annuity makes payments to a beneficiary over a certain specified time frame, such as 10 or 20 years, even in the event of the death of the “annuitant” (the person receiving the annuity payments). A term-certain annuity is a way to ensure against the possibility of premature death without taking the reduction in lifetime payments that otherwise occurs with a joint and survivor annuity. The last means of classifying annuities is by start date. Benefits from an annuity may either begin immediately - defined as within a year of purchasing the contract - or be deferred until an agreed upon date. An immediate annuity, which may be either fixed or variable as well as single-life or joint, is commonly used when an individual wants to convert a large lump-sum amount (such as from a qualified retirement plan) into an immediate income stream. It is, therefore, not so much of a savings vehicle, but rather an investment that is used to provide retirement income. An immediate annuity is most appropriate for a retiree who wants to replace his or her regular paycheck after a formal date of retirement. A deferred annuity, on the other hand, postpones payments for a period of tim e after paym ents hav been m ade. Accordingly, it is best thought of as a retirementsavings vehicle that may be e used when an individual has cash to invest prior to retirement and wants to secure an income stream after retirement.
Taxation of Annuities
When using annuities within the context of the retirement planning process, it should be noted that a separate tax rule applies for annuity paym ents from a qualified plan. This is known as the Simplified Rule and is further discussed in IRS Publication 575, "Pension and Annuity Income" and Lesson 8 in this course. The simplified or safe harbor rule allows you to calculate the nontaxable percentage of each distribution from a qualified annuity using a single table. You merely divide the total amount of after-tax contributions to t he qualified plan by the number of expected monthly payments to determine a nontaxable percentage. Under the General Rule of taxation (also known as the exclusion ratio), the money invested in a nonqualified annuity contract is recovered tax free, over the life of the annuity. Every dollar paid out under the contract is made up of the investment and income on the investment (the “investment in the contract”), which is then divided by the contract’s expected return, or the total amount that the annuitant sho uld receive over the life of the annuity. This product, when multiplied times the actual annuity payment, results in the amount of payment that may be excluded from taxable income. When the annuity payment varies, rather than being fixed in amount, the taxable amount must be figured annually, once the annuitant knows how much she received during the year. The annuitant then divides her investment by the number of years over which she will receive payments. The result is the amount of tax-free annual payment. Example: The annuitant bought a policy for $10,000 that will pay her variable amounts at age 65, the annuity starting date. In the first year she received two payments of $400 and $500. The amount of excludible income from these payments is $500 computed as follows: $10,000 divided by 20, the actuarial life expectancy for a 65 year old individual, or $500. The amount of taxable payment in the first year is therefore $400 or $400 + $500 = $900 less $500 nontaxable portion. Finally, you should note that som e nonqualified annuities are not “annuitized”; therefore the general rule of taxation just described will not apply. Rather, if a nonqualified annuity accumulation amount is taken in a lump-sum distribution, the LIFO (“last in, first out”) rule of taxation is triggered, resulting in the taxability of interest portion first before any recovery of nontaxable basis or after-tax return of contribution is considered. Required Distributions on Death For payments to be taxed as an annuity, the contract must require the payout of any amounts undistributed at the annuitant's death to be distributed within a stipulated period of time. This stipulated period (just like in the case of a "qualified annuity" or retirement plan payment as discussed in the upcoming Lesson 8 of this course) depends on whether the annuitant died before or after the annuity starting date and whether there is a designated beneficiary. Death Before the Annuity Starting Date If the annuitant dies before the annuity starting date, all amounts to be distributed under the contract must generally be paid to the annuitant's beneficiary within five years of the death of the annuitant. However, if the distributions begin within one year of the annuitant's death, any part of the distribution that is to be made over a designated beneficiary's life expectancy is treated as having been distributed in full on the date the distributions began and the five year rule therefore does not apply. Death on or After the Annuity Starting Date If the annuitant dies on or after the annuity starting date, the remaining undistributed portion of the contract must be distributed at least as rapidly as the method of payment in effect on the date of death. However, as in the case of the annuitant's death before the annuity starting date, the exception for distributions to a named beneficiary over his or her life expectancy also applies in this situation.
The Surviving Spouse as Beneficiary If the annuitant's beneficiary is the surviving spouse, the contract need not apply the r equired post-death payout rules. In other words, the surviving spouse "steps into the shoes" of the deceased annuitant and the implementation of the payout rules is postponed until the spouse's subsequent death.
When to Use an Annuity in Retirement Planning
In the retirement planning process, generally an annuity should be considered when the client wants: A tax-deferred growth of invested funds Retirement income or an income stream for another person that cannot be outlived Freedom from investing and m anaging retirement assets A replacement or alternative to an IRA If safety of the underlying principal is paramount and/or the retiree is an extremely conservative investor, the fixed annuity type of investment should be considered. If the investor wants more control of the investment decision and is willing to bear a greater risk to purchase the potential of a greater annuity payout, a variable annuity is probably appropriate.