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CHAPTER 20 Powered By Docstoc
					                A NNUITIES AND I NDIVIDUAL                                                                  CHAPTER                    20
                    R ETIREMENT A CCOUNTS
                                                                                                            LEARNING OBJECTIVES
                “Buy an annuity cheap, and make your life interesting to yourself
                              and everybody else that watches the speculation.”                             After studying this chapter,
                                                                                 Charles Dickens            you should be able to

                                                                                                            N   Show how an annuity
                                                                                                                differs from life insurance.
   INTERNET                           RESOURCES                                                             N   Describe the basic charac-
I provides annuity quotes online and timely information about fixed, equity indexed,                 teristics of a fixed annuity
  variable, and other tax-deferred annuities. Visit the site at                                                 and a variable annuity.
                                                                                                            N   Explain the major charac-
I provides consumers with the tools and information to compare and buy tax-deferred
  annuities. You can conduct a side-by-side comparison of the top tax-deferred annuities on the market          teristics of an equity-
  today. Visit the site at                                                                                      indexed annuity.
                                                                                                            N   Describe the basic charac-
I provides online annuity rates for immediate annuities from major insurers. The             teristics of a traditional
  site claims consumers can save thousands of dollars by shopping for immediate annuities through its           tax-deductible individual
  service. Visit the site at
                                                                                                                retirement account (IRA).

I Charles Schwab provides informative articles and information on retirement planning, annuities,           N   Explain the basic charac-
  and individual retirement accounts (IRAs). Visit the site at                                                  teristics of a Roth IRA.
                                                                                                            N   Explain the income tax
I Fidelity Investments offers timely information on retirement planning, annuities, and IRAs, including         treatment of a traditional
  interactive calculators for making IRA decisions. Visit the site at
                                                                                                                IRA and a Roth IRA.

I is a leading provider of retirement income annuities on the Web today. The           N   Access an Internet site
  site has an income calculator that provides instant annuity quotes for single life annuities. Visit the       and obtain consumer
  site at                                                                                                       information about IRAs.

I provides timely information on annuities, IRAs, and other insurance products. The site
  provides a list of companies that have weak financial ratings. Visit the site at

I The Motley Fool provides individual investors with a considerable amount of practical advice on
  personal finance, including annuities, IRAs, and 40l(k) plans. Visit the site at

I The Roth IRA Web site is devoted to Roth IRAs and provides a considerable amount of consumer
  information on this type of IRA. The site provides links to articles, books, tapes, calculators, IRS
  documents, and a message board on Roth IRAs. Visit the site at

                                I TIAA-CREF is an excellent source of accurate information on retirement planning, annuities, and IRAs.
                                  Visit the site at

                                I The Vanguard Group provides timely information on variable annuities, IRAs, and retirement planning.
                                  Visit the site at

                 orri, age 25, graduated from college and accepted a job as a marketing analyst for
           L     an international oil company with an annual salary of $35,000. She wants to save
           money to provide for a comfortable retirement. Unfortunately, Lorri is ineligible to par-
           ticipate in the company’s Section 401(k) retirement plan for one year. A financial planner
           recommended an individual retirement account (Roth IRA). Lorri could start saving
           immediately for retirement; the investment income would accumulate income-tax free;
           and the retirement fund would grow to a sizable amount. The planner pointed out that if
           Lorri saved $3000 annually for 40 years, and the IRA account earned an average annual
           return of 8 percent, she would have more than $839,000 in her account at age 65. If her
           contributions were invested in a Roth IRA, she could withdraw the funds free of current
           income taxes.
               Like Lorri, millions of workers dream of achieving financial independence and a com-
           fortable retirement. Planning for a comfortable retirement should receive high priority in
           a personal risk management program. Retirement planning is especially important today
           because the proportion of older people in the population is increasing; the period of
           retirement for many workers is growing longer because of increased life expectancy and
           early retirement; and studies show that many workers are not saving enough for a com-
           fortable retirement.
               This chapter discusses the timely topic of retirement planning and shows how annu-
           ities and IRAs can ensure a comfortable retirement. Two major areas are emphasized.
           The first part discusses the annuity concept and the different types of annuities sold
           today. The second part discusses the characteristics of IRAs, including the traditional
           tax-deductible IRA and the Roth IRA.

                                                                   plans. Individual annuities can also be purchased to
INDIVIDUAL ANNUITIES                                               provide additional retirement income. An annuity is
The vast majority of workers who retire today receive              a tax-deferred product. Although the premiums are
Social Security retirement benefits. Some workers                   paid with after-tax dollars, the investment income
also receive benefits from their employers’ retirement              accumulates income-tax free and is not taxed

                                                                                                               TYPES OF ANNUITIES         397

until actually paid out. The investment returns of tax-                              will be sufficient during retirement. Some will die
deferred compounding over long periods can be im-                                    early before exhausting their savings, whereas others
pressive (see Exhibit 20.1).                                                         will still be alive after exhausting their principal.
                                                                                     Although the insurance company cannot predict
                                                                                     how long any particular member of the group will
Annuity Principle
                                                                                     live, it can determine the approximate number of
An annuity can be defined as a periodic payment                                       annuitants who will be alive at the end of each suc-
that continues for a fixed period or for the duration                                 cessive year. Thus, the company can calculate the
of a designated life or lives. The person who receives                               amount that each person must contribute to the
the periodic payments or whose life governs the                                      pool. Interest can be earned on the funds before they
duration of payment is known as the annuitant.                                       are paid out to the annuitants. Also, some annuitants
     An annuity is the opposite of life insurance. Life                              will die early, and their unliquidated principal can
insurance creates an immediate estate and provides                                   be used to provide additional payments to annui-
protection against dying too soon before financial                                    tants who survive beyond their life expectancy. Thus,
assets can be accumulated. In contrast, an annuity                                   annuity payments consist of three sources: (1) pre-
provides protection against living too long and ex-                                  mium payments, (2) interest earnings, and (3) the
hausting one’s savings while the individual is still                                 unliquidated principal of annuitants who die early.
alive. Thus, the fundamental purpose of an annuity                                   By pooling the risk of excessive longevity, insurers
is to provide a lifetime income that cannot be out-                                  can pay a lifetime income to annuitants that cannot
lived. It protects against the loss of income because                                be outlived.
of excessive longevity and the exhaustion of savings.                                     Annuitants tend to be healthy individuals who
     Annuities are possible because the risk of exces-                               generally live longer than most persons. Because of
sive longevity is pooled by the group. Individuals                                   the higher life expectancy of annuitants, actuaries use
acting alone cannot be certain that their savings                                    special annuity tables to calculate annuity premiums.

EXHIBIT 20.1                                                                         TYPES OF ANNUITIES
Tax-Deferred Compounding Builds Wealth Faster
                                                                                     Insurers sell a wide variety of individual annuities. For
    Value of $50,000 invested for 25 years earning an 8%                             sake of convenience and understanding, the major
    average annual return
                                                                                     annuities sold today can be classified as follows:
       $342,424 Tax-Deferred Investment
       $202,771 Taxable Investment                                   $342,424
                                                                                       I   Fixed annuity
                                                                                       I   Variable annuity
    Initial Investment $50,000                                                         I   Equity-indexed annuity

                                                                                     Fixed Annuity
0               5              10              15              20              25    A fixed annuity pays periodic income payments that
                                                                                     are guaranteed and fixed in amount. During the
NOTE: This chart shows hypothetical $50,000 taxable and tax-deferred investments.
Both earn 8% a year for 25 years. Over that time, the taxable investment grows       accumulation period prior to retirement, premiums
from $50,000 to $202,771, but the tax-deferred investment grows to $342,424—         are credited with a fixed rate of interest. There are
a difference of $139,653. The taxable investment is assumed to pay a combined
federal and state tax rate of 28% each year on investment returns. Taxes are even-   typically two interest rates: a guaranteed rate and a
tually due on the tax-deferred investment when you begin to withdraw income,         current rate. The guaranteed rate is the minimum
but even then, the tax-deferred investment still comes out ahead. This example
does not include fees or expenses, which would lower the performance shown.          interest rate that will be credited to the funds in
Also, if you withdraw funds from an annuity before age 591⁄2, a 10% federal income   the fixed annuity contract, such as 3 or 4 percent.
tax penalty may apply.
SOURCE: Adapted from Understanding Annuities, Prudential Financial (October
                                                                                     The current rate is higher and is based on market
2001).                                                                               conditions; current rates are not guaranteed or are

guaranteed only for a limited period. For example,        Annuity Settlement Options The annuity owner
the guaranteed rate may be 4 percent, but the cur-        has a choice of annuity settlement options. Cash can
rent rate may be 6 percent for only one year.             be withdrawn in a lump sum or in installments, or
     During the liquidation period, the accumulated       the funds can be annuitized or paid out as life in-
funds can be annuitized or paid to the annuitant in       come. As a practical matter, relatively few annuities
the form of guaranteed lifetime income; however,          are annuitized.
the periodic income payments are fixed in amount,              The following settlement options are typically
and generally do not change. As such, fixed annu-          available:
ities provide limited protection against inflation.          I   Cash option. The funds can be withdrawn in a
                                                                lump sum or in installments. The taxable por-
Payment of Benefits A fixed annuity can be pur-                   tion of the distribution (discussed later) is sub-
chased so that the income payments start immedi-                ject to federal and state income taxes. The cash
ately. This type of fixed annuity is called an imme-             option also leads to adverse selection against the
diate annuity. An immediate annuity is one where                insurer because those in poor health will take
the first payment is due one payment interval from               cash rather than annuitize the funds.
the date of purchase. For example, if the income is         I   Life income (no refund). A life income (no
paid monthly, the first payment starts one month                 refund) option provides a life income to the
from the purchase date, or one year from the pur-               annuitant only while the annuitant remains
chase date if the income is paid annually. Immediate            alive. No additional payments are made after the
annuities are typically purchased in a lump sum by              annuitant dies. This type of settlement option
people near retirement. Because of the wide varia-              pays the highest amount of periodic income pay-
tion in monthly payments, financial planners recom-              ments because it has no refund features. It is
mend generally that consumers shop around before                suitable for someone who needs maximum life-
purchasing an immediate annuity.                                time income and has no dependents or has pro-
     A fixed annuity can also be purchased that de-              vided for them through other means. However,
fers the income payments until some later date. A               because of the risk of forfeiting the unpaid prin-
deferred annuity provides income payments at some               cipal if death occurs early, relatively few annuity
future date. This type of annuity is essentially a plan         owners elect this option.
for accumulating a sum of money prior to retire-            I   Life income with guaranteed payments. A life
ment on a tax-deferred basis. If the annuitant dies             income with guaranteed payments (also called a
during the accumulation period prior to retirement,             life annuity certain) pays a life income to the
a death benefit is typically paid equal to the sum of            annuitant with a certain number of guaranteed
the gross premiums paid or the cash value if higher.            payments, such as for 5, 10, 15, or 20 years. If
At the maturity date of the contract, the annuitant             the annuitant dies before receiving the guaran-
can receive the funds in a lump sum or have them                teed number of payments, the remaining pay-
paid out under one of the settlement options (dis-              ments are paid to a designated beneficiary. This
cussed later).                                                  option can be used by someone who needs life-
     A fixed annuity that defers the income payments             time income but who also wishes to provide
until a future date can be purchased with a lump                income to the beneficiary in the event of an early
sum, or the contract may permit flexible premium                 death. Because of the guaranteed payments, the
payments. A deferred annuity purchased with a lump              periodic income payments are less than the
sum is called a single-premium deferred annuity.                income paid by a life annuity with no refund.
In contrast, a flexible-premium annuity allows the           I   Installment refund option. An installment re-
annuity owner to vary the premium payments;                     fund option pays a life income to the annuitant.
there is no requirement that the owner must deposit             If the annuitant dies before receiving total
a specified amount each year. Thus, the annuity                  income payments equal to the purchase price of
owner has considerable flexibility in the payment of             the annuity, the payments continue to the bene-
premiums.                                                       ficiary until they equal the purchase price. A
                                                                                                    TYPES OF ANNUITIES        399

        cash refund option is another version of this                      provide an inflation hedge by maintaining the real
        option. If the annuitant dies before receiving                     purchasing power of the periodic payments during
        total payments equal to the purchase price of                      retirement. It is based on the assumption of a positive
        the annuity, the balance is paid in a lump sum to                  correlation between the cost of living and common
        the beneficiary.                                                    stock prices over the long run.
   I    Joint-and-survivor annuity. A joint-and-survivor
        annuity option pays benefits based on the lives                     Basic Characteristics of a Variable Annuity Pre-
        of two or more annuitants, such as a husband                       miums are invested in a portfolio of common stocks
        and wife or a brother and sister. The annuity                      or other investments that presumably will increase in
        income is paid until the last annuitant dies.                      value during a period of inflation. The premiums are
        Some contracts pay the full amount of the orig-                    used to purchase accumulation units during the
        inal income payments until the last survivor                       period prior to retirement, and the value of each
        dies. Other plans pay only two-thirds or one-                      accumulation unit varies depending on common
        half of the original income after the first annui-                  stock prices. For example, assume that the accumula-
        tant dies.                                                         tion unit is initially valued at $1, and the annuitant
    Exhibit 20.2 provides examples of monthly                              makes a monthly premium payment of $100. During
income payments for a $100,000 immediate annuity                           the first month, 100 accumulation units are pur-
issued to a male age 65.                                                   chased.1 If common stock prices increase during the
                                                                           second month, and the accumulation unit rises to
                                                                           $1.10, about 91 accumulation units can be pur-
Variable Annuity                                                           chased. If the stock market declines during the third
A second type of annuity is a variable annuity. A vari-                    month, and the accumulation unit declines to $0.90,
able annuity pays a lifetime income, but the income                        111 accumulation units can be purchased. Thus,
payments vary depending on common stock prices.                            accumulation units are purchased over a long period
The fundamental purpose of a variable annuity is to                        of time in both rising and falling markets.
                                                                                At retirement, the accumulation units are con-
                                                                           verted into annuity units. The number of annuity
                                                                           units remains constant during the liquidation period,
EXHIBIT 20.2                                                               but the value of each unit will change each month or
Examples of Monthly Income Annuity Payments                                year depending on the level of common stock prices.
Immediate Annuity, $100,000, Male, Age 65                                  For example, at retirement, assume that the annu-
                                                                           itant has 10,000 accumulation units. Assume that
   Annuity Settlement Option                Estimated Monthly Income       the accumulation units are converted into 100 annu-
                                                                           ity units.2 As stated earlier, the number of annuity
   Life income with no refund                           $752               units remains constant, but the value of each unit
   Life income with 5 years                                                will change over time. Assume that the annuity unit
      guaranteed payments                                 745              is initially valued at $10 when the annuitant retires.
   Life income with 10 years                                               A monthly income of $1000 will be paid. During the
      guaranteed payments                                 727              second month, if the annuity unit increases in value
   Life income with 15 years                                               to $10.10, the monthly income also increases to
      guaranteed payments                                 700              $1010. During the third month, if the annuity units
   Life income with 20 years                                               decline in value to $9.90 because of a stock market
      guaranteed payments                                 668              decline, the monthly income is reduced to $990.
   Joint and survivor optiona                             645              Thus, the monthly income depends on the level of
   Joint and survivor option                                               common stock prices.
      with 20 years guaranteed                            633
aBoth annuitants are age 65.                                               Guaranteed Death Benefit Variable annuities typi-
SOURCE: Data shown are estimates as of April 2002.   cally provide a guaranteed death benefit that protects

the principal against loss due to market declines. The          centage of assets after the contract is issued; and
typical death benefit states that if the annuitant dies          (3) an allowance for profit.
before retirement, the amount paid to the beneficiary        I   Surrender charge. Most annuities have a sur-
will be the higher of two amounts: the amount                   render charge if the annuity is surrendered dur-
invested in the contract or the value of the account at         ing the early years of the contract. This charge
the time of death. Thus, if the annuitant dies during           helps to pay agents and brokers who sell vari-
a market decline, the beneficiary receives an amount             able annuities. It is usually a percentage of the
at least equal to the total amount invested in the              account value and declines over time. The sur-
contract.                                                       render charge is typically 7 percent of the ac-
     Some variable annuities go one step further                count value for the first year, declining one per-
and pay enhanced death benefits. Enhanced bene-                  centage point for each year until it reaches zero
fits either (1) guarantee the principal (contributions           for the eighth and later years. Most variable
made) plus interest or (2) periodically adjust the              annuities permit partial withdrawals each year
value of the account to lock in investment gains. For           of as much as 10 percent of the account value
example, the annuity may contain a rising-floor                  without imposition of a surrender charge.
death benefit by which the death benefit is periodi-
                                                               In addition to these charges, some annuities
cally reset. Thus, a 5 percent rising-floor benefit may
                                                          have a front-end load of 4 or 5 percent; the annuity
be periodically reset so that the beneficiary will
                                                          may have an annual contract fee, such as $25 or
receive the principal plus 5 percent interest.
                                                          $50; and there may be a charge if funds are trans-
     A second example is the stepped-up benefit by
                                                          ferred from one subaccount to another. In the aggre-
which the contract periodically locks in investment
                                                          gate, total fees and expenses in most variable annu-
gains, such as every five years. For example, assume
                                                          ities are high and can easily exceed 2 percent of
that $10,000 is invested in year 1, and the account is
                                                          assets. As a result, long-run total returns may be sig-
now worth $15,000 in year 5. The new death benefit
                                                          nificantly reduced in high-cost annuities.
is $15,000, even though the annuity owner has
                                                               Some annuities, however, have relatively low
invested only $10,000.
                                                          annual expenses, and a small number do not have a
                                                          surrender charge. Exhibit 20.3 shows the names and
Fees and Expenses Variable annuity owners pay a
                                                          telephone numbers for a selected group of low-cost
number of fees and expenses. Some fees consist of
                                                          variable annuities.
investment management and administrative fees;
other fees are insurance charges that pay for the
                                                          Investment Performance of Variable Annuities
guarantees and other services provided. In addition,
                                                          Variable annuities give the annuity owner several
most variable annuities have surrender charges.
                                                          investment choices, similar to mutual funds. The
     Specifically, variable annuities typically contain
                                                          premiums are invested in investment portfolios
the following fees and expenses:
                                                          called “subaccounts,” such as a growth stock fund,
  I   Investment management charge. This charge is a      corporate bond fund, international stock fund, or
      payment to the investment manager and asset-        money market fund. The funds can be transferred
      management company for the brokerage serv-          from one account to another without triggering
      ices and investment advice provided in the man-     unfavorable income-tax consequences.
      agement of the investment portfolio.                     The investment performance of variable annu-
  I   Administrative charge. This charge covers the       ities varies widely depending on the insurer, type of
      paperwork, record keeping, and periodic reports     investment, and total expense rate. Exhibit 20.4
      to the annuity owner.                               shows average annual total returns and average ex-
  I   Management and expense risk charge. This fee,       pense rates for various subaccounts for the five-year
      called the “M&E” fee, pays for (1) the mortality    period ending December 31, 2001. The five-year
      risk associated with the guaranteed death ben-      average annual total return ranged from 3.71 per-
      efit and excessive longevity; (2) a guarantee that   cent for money market accounts to 8.18 percent for
      annual expenses will not exceed a certain per-      growth accounts.
                                                                                                                   TYPES OF ANNUITIES          401

Five Low-Cost Variable Annuities

                                                        Annual                 Sales              Surrender    Minimum
   Name                                                Expenses                Load                Charge     Investment       Telephone Number

   Personal Annuity Select                              0.37%a                 None                 None        $ 250           800-223-1200
   Vanguard Variable Annuity Plan                       0.53%b                 None                 None         5000           800-522-5555
   USAA Variable Annuity                                0.91%c                 None                 None         1000           800-531-4440
   Fidelity Retirement Reserves                         1.08%d                 None                 None         2500           800-544-2442
   Schwab Select Annuity                                1.13%e                 None                 None         5000           800-838-0650
a Stock Index Account.
b Vanguard  Equity Index Fund. An annual fee of $25 applies to contracts less than $25,000.
c Premiums are invested in the Vanguard Equity Index Fund. An annual contract fee of $30 is also charged.
d Index 500 Portfolio.
e Schwab S&P 500 Fund.

                                                                                           ited to the contract. The insurer periodically deter-
Equity-Indexed Annuity
                                                                                           mines the participation rate, which is subject to
An equity-indexed annuity is a newer type of annu-                                         change. Participation rates generally range from 25
ity that offers the guarantees of a fixed annuity                                           percent to 90 percent of the gain in the stock index.
and limited participation in stock market gains. An                                        A few insurers have participation rates of 100 per-
equity-indexed annuity is a fixed, deferred annuity                                         cent. Investors usually receive only part of the in-
that allows the annuity owner to participate in the                                        crease in the stock index (excluding the reinvestment
growth of the stock market and also provides down-                                         of dividends). For example, if the participation rate
side protection against the loss of principal and                                          is 80 percent and the stock index rises 10 percent
prior interest earnings if the annuity is held to term.                                    during the measuring period, the annuity value in-
Term periods typically range from one to ten years.                                        creases by 8 percent.
The annuity value is linked to the performance of a
stock market index, typically Standard and Poor’s                                          Cap on the Maximum Percentage of Gain The cap
500 Composite Stock Index. If the stock market                                             is the maximum percentage of gain that is credited
rises, the annuity is credited with part of the gain                                       to the contract. For example, assume the annuity
in the index, which does not include the reinvest-                                         has a participation rate of 80 percent and a 10 per-
ment of dividends. If the stock market declines,                                           cent cap. If the index rises 10 percent, the annuity
the annuity earns at least a minimum return, which                                         has an 8 percent return. However, if the stock
typically is 3 percent on 90 percent of the principal                                      market soars and the index rises 20 percent, the
invested.                                                                                  maximum gain is capped at 10 percent (instead of
     The key elements of an equity-indexed annuity                                         16 percent). Thus, investors should seek annuities
are as follows: (1) the participation rate, (2) the cap                                    with no caps, which will allow larger gains to be
on the maximum percentage of gain credited to the                                          realized during periods when stock prices increase
contract, (3) the indexing method used, and (4) the                                        rapidly.
guaranteed minimum value.
                                                                                           Indexing Method The indexing method refers to
Participation Rate The participation rate is the                                           the method for crediting excess interest to the
percentage of growth in the stock index that is cred-                                      annuity. Insurers use several indexing methods for

Annuity Fund Performances and Fees
Averages and returns for periods ended Dec. 31

                                               Average             Average               4th-Qtr.             One-Year   Three-Year        Five-Year
                                                Fund                Total                  Total                Total    Annualized       Annualized
   Type of Fund                                Expense             Expense                Return               Return      Return           Return

   Aggressive growth                            0.93%               2.22%               +19.22%               –19.00%     +1.32%           +5.58%
   Balanced                                     0.79                2.08                + 6.48                – 5.74      +1.11            +6.84
   Corporate bond                               0.67                1.95                + 0.31                + 5.91      +3.75            +4.78
   Government bond general                      0.70                1.98                – 0.61                + 5.22      +4.11            +5.42
   Growth                                       0.90                2.20                +14.59                –14.57      +0.25            +8.18
   Growth and Income                            0.73                2.03                + 9.70                – 9.25      –0.19            +7.92
   High-yield bond                              0.81                2.12                + 4.48                – 2.01      –3.81            –0.64
   International bond                           1.36                2.65                + 0.14                + 1.28      +1.38            +1.15
   International stock                          1.12                2.41                +10.73                –19.84      –1.40            +1.78
   Money market                                 0.54                1.82                + 0.22                + 2.48      +3.58            +3.71
   Specialty fund                               1.05                2.34                +11.76                –14.44      +3.50            +4.02
   U.S. diversified equity avg.                  0.87                2.17                +14.34                –14.16      +0.35            +7.55
   Fixed-income average                         0.80                2.08                + 0.06                + 5.00      +3.43            +4.39

SOURCE: Adapted from Christopher Oster, “Annuity Money Funds Suffer,” Wall Street Journal, January 7, 2002, p. R23.

crediting interest, only one of which is discussed                                          tract during the first three or four policy years may
here. Under the annual reset method (also known as                                          experience a loss of principal. If it is held to term, the
the ratchet method), interest earnings are calculated                                       principal is guaranteed against loss.
based on the annual change in the stock index; the
index value starting point is also reset annually.
Thus, if the stock index decreases during any con-                                          TAXATION OF INDIVIDUAL ANNUITIES
tract year, the decrease does not have to be recov-                                         An individual annuity purchased from a commercial
ered before any additional growth in the index will                                         insurer is a nonqualified annuity. A nonqualified
be credited to the contract.                                                                annuity is an annuity that does not meet the Internal
                                                                                            Revenue Code requirements. As such, it does not
Guaranteed Minimum Value Equity-indexed annu-                                               qualify for most income-tax benefits that qualified
ities with terms longer than one year have a guaran-                                        employer retirement plans receive.
teed minimum value that provides downside protec-                                                Premiums for individual annuities are not
tion against the loss of principal if the annuity is held                                   income-tax deductible and are paid with after-tax
to term. This minimum value typically is 90 percent                                         dollars. However, the investment income is tax de-
of the single premium (less partial withdrawals)                                            ferred and accumulates free of current income taxes
accumulated at 3 percent interest. The result is a                                          until the funds are actually distributed.
guaranteed minimum value at the end of the term.                                                 The taxable portion of any distribution is tax-
For example, an annuity with a seven-year term                                              able as ordinary income. In addition, the taxable
would have a guaranteed minimum value of 110.69                                             portion of a premature distribution before age 591⁄2
percent of the single premium at the end of the term                                        is subject to a 10 percent penalty tax, with certain
(assuming no withdrawals). However, because the                                             exceptions.3
minimum guarantee applies to only 90 percent of the                                              The periodic annuity payments from an indi-
single premium, an investor who surrenders the con-                                         vidual annuity are taxed according to the General
                                                                              TAXATION OF INDIVIDUAL ANNUITIES                                  403

Insight 20.1
                                     When Do Variable Annuities Make Sense?
  Even if you have a long time horizon, variable annuities make        you had capital gains instead of ordinary income,” says
  sense only if you can answer yes to all of the following ques-       Dee Lee, a financial planner in Harvard, Massachusetts.
  tions:                                                             • Do you think you’ll need the money before you die?
                                                                       “Variable annuities are problematic in terms of estate
    • Are you contributing the maximum to your IRA,
                                                                       planning,” says Lambert. Your heirs will owe income tax
      401(k), or other retirement plans? These plans provide
                                                                       on earnings just as you would. Mutual funds, on the
      tax deferral without many of the fees. Some offer an
                                                                       other hand, pass to heirs income-tax free.
      employer match and let you invest pretax money. If you
                                                                     • Have you found a low-fee variable annuity? Annual
      use a Roth IRA, earnings are tax-free in retirement, not
                                                                       insurance fees range from less than $400 to nearly
      just tax-deferred.
                                                                       $2,000 on a $100,000 account. There’s little reason to
    • Can you live without the money until you reach age
                                                                       invest in higher-fee annuities. “The only difference I can
      591⁄2? If not, you’ll be hit with a 10 percent tax penalty
                                                                       see is the salesman comes to your kitchen,” says Lee.
      and may have to pay a surrender charge. Make sure you
      have enough money available for emergencies and pre-              The salesperson usually receives about 6 percent in com-
      retirement needs, such as paying for your children’s         mission, and the ongoing insurance costs eat into perform-
      education, buying a house, and supporting aging par-         ance. “What you spend on insurance expenses lowers your
      ents. “When you’re in your thirties and forties, age 591⁄2   return,” says Patrick Reinkemeyer, publisher of Morningstar
      is a long way away,” says Jeff Lambert, a financial           Variable Annuities/Life. The publication covers about 50
      planner in Sacramento, California.                           annuities that offer a version of Fidelity Equity Income Fund,
    • Are you in the 27 percent tax bracket or higher? If          he says.
      you’re in the 15 percent bracket, the benefits of tax              “Each has different expenses, but they’re the same
      deferral may never make up for the fees. You’ll do best if   fund,” he explains. “If I buy Fidelity Equity Income in a policy
      you defer taxes while in a high tax bracket and with-        that has 1.5 percent insurance expenses, I’m going to have a
      draw the money when you drop into a lower bracket in         lower return than with one with 0.75 percent insurance
      retirement.                                                  expenses.”
          “If you’re in the 35 percent to 38.6 percent tax
      bracket, tax deferral looks good now. But if your income-    SOURCE: Adapted from Kimberly Lankford, “Why Variable Annuities Are Just for a
      tax bracket doesn’t bump down, you’re going to wish          Few,”, 2002.

Rule. Under this rule, the net cost of the annuity                 that the annuitant can expect to receive under the
payments is recovered income-tax free over the pay-                contract. It is determined by multiplying the annual
ment period. The amount of each payment that                       payments the annuitant will receive by the life
exceeds the net cost is taxable as ordinary income.                expectancy of the annuitant, which is obtained from
    An exclusion ratio must be calculated to deter-                actuarial tables provided by the IRS.
mine the nontaxable and taxable portions of the                         As an example, assume that Ben, age 65, pur-
annuity payments. The exclusion ratio is determined                chased an immediate annuity for $108,000 that pays
by dividing the investment in the contract by the                  a lifetime monthly income of $1000. The annuity
expected return:                                                   has no refund features. Investment in the contract is
    Investment in the contract                                     $108,000. Based on the IRS actuarial table, Ben has
                                        Exclusion ratio            a life expectancy of 20 years. Expected return is
         Expected return
                                                                   $240,000 (20 12 $1000). The exclusion ratio is
The investment in the contract (basis) is the total cost           0.45 ($108,000       $240,000). Each year, until the
of the annuity, which generally is the total amount of             net cost is recovered, Ben receives $5400 tax free
the premiums or other consideration paid for the                   (45%      $12,000), and $6600 is taxable. After the
annuity less any nontaxable distributions previously               net cost is recovered, the total payment would be
received.4 The expected return is the total amount                 taxable.

    In summary, annuities can be attractive to in-       Security and investment income, he or she could not
vestors who have made maximum contributions to           make an IRA contribution for that year.
other tax-advantaged plans and who wish to save              Second, the participant must be under age 701⁄2.
additional amounts on a tax-deferred basis. Also,        No IRA contributions are allowed for the tax year
because of the surrender charge, the investor should     in which the participant attains age 701⁄2 or any later
expect to remain invested for 10 or more years.          year.
    However, annuities are not for everyone. An
annuity should not be purchased if the funds will be     Annual Contribution Limits Prior to 2002, the
needed before age 591⁄2; the worker has not made         maximum annual IRA contribution was limited to
maximum contributions to other tax-advantaged            $2000 or 100 percent of earned income, whichever
plans, such as a Section 401(k) plan and an IRA;         was less. The new tax law substantially increases the
and the funds will not be invested for at least 10       maximum annual contribution to an IRA. Special
years (see Insight 20.1).                                catch-up rules also allow workers age 50 and over to
                                                         make additional contributions.
                                                             For 2002, the maximum annual IRA contribu-
INDIVIDUAL RETIREMENT ACCOUNTS                           tion is increased to $3000 or 100 percent of earned
                                                         compensation, whichever is less. Older workers age
An individual retirement account (IRA) allows            50 and over can contribute a maximum of $3500
workers with taxable compensation to make annual         each year to their plans. This provision will help
contributions to a retirement plan up to certain         older workers who have saved little or nothing for
limits and receive favorable income-tax treatment.       their retirement. If the participant has a nonworking
     The Economic Growth and Tax Relief Reconcil-        or low-earning spouse, the maximum annual IRA
iation Act of 2001 has substantially increased the       contribution is increased to $6000 (spousal IRA).
tax advantages of IRAs. Maximum annual contribu-         However, the maximum annual contribution to each
tion limits are increased, and special catch-up rules    account is limited to $3000.
allow older workers to make additional contribu-             The new tax law gradually increases the max-
tions. There are two basic types of IRA plans:           imum annual amounts that can be contributed to an
  I   Traditional IRA                                    IRA according to the following schedule:
  I   Roth IRA
                                                                   Maximum Annual           Maximum Annual
                                                                    Contribution              Contribution
Traditional IRA                                                      for Workers              for Workers
                                                         Year       Under Age 50            Age 50 and Older
A traditional IRA is an IRA that allows workers to
deduct part or all of their IRA contributions. The       2002            $3000                    $3500
investment income accumulates income-tax free on a       2003             3000                     3500
tax-deferred basis, and the distributions are taxed as   2004             3000                     3500
ordinary income.                                         2005             4000                     4500
                                                         2006             4000                     5000
Eligibility Requirements There are two eligibility       2007             4000                     5000
requirements for establishing a traditional tax-         2008             5000                     6000
deductible IRA. First, the participant must have
earned income during the year. Earned income in-         After 2008, the annual IRA contribution limit will
cludes wages and salaries, bonuses, commissions,         be indexed for inflation in increments of $500. IRA
self-employment income, and taxable alimony and          catch-up limits are not indexed for inflation.
separate maintenance payments. However, earned               The tax advantages of the new law are signifi-
income does not include investment income, pension       cant. For example, a worker age 25 who contributes
or annuity income, Social Security, and rental in-       the maximum annual amount under the new law
come. For example, if a person receives only Social      and earns an assumed 8 percent annual rate of
                                                                                         INDIVIDUAL RETIREMENT ACCOUNTS                  405

                          EXHIBIT 20.5
                          Tax Advantages of the New IRA Law Are Substantial.
                          How Will Higher IRA Contributions Affect You?

                            Future value of contributing $2,000 annually until retirement $ 608,487
                            Future value of increased IRA contributions                               $1,281,901
                            Benefit of increased contribution limits                                  $ 673,414

                                        $1,281,902                                       New law
                                            640,949                                      Old law
                                                           25 32 39 46 53 60 67

                          SOURCE: The illustration is hypothetical and is based on the interactive IRA calculator by
                 An eligible worker age 25 retires at age 67. Maximum annual contributions are
                          made in a lump sum at the end of each period beginning in 2001. The IRA contributions earn
                          an estimated 8 percent annually. The calculation does not include the possible 50 percent
                          catch-up provision for workers age 50 or older.

return on the IRA contributions would have a retire-                         figure shown on your tax return without taking into
ment fund of nearly $1.3 million at age 67 (see                              account the IRA deduction and certain other items.5
Exhibit 20.5).                                                               For 2002, a full deduction is allowed if the tax-
                                                                             payer’s modified adjusted gross income is $34,000
Income Tax Deduction of Traditional IRA Contri-                              or less ($54,000 or less for married couples filing
butions Traditional IRA contributions may be (1)                             jointly). As discussed later, the income limits for a
fully income-tax deductible, (2) partly deductible, or                       full deduction will rise gradually in the future.
(3) not deductible at all. A full deduction is allowed                            The full IRA deduction is gradually phased out
in two general situations. First, a worker who is not                        as a person’s modified adjusted gross income in-
an active participant in an employer-sponsored                               creases. For 2002, the phase-out range is $34,000
retirement plan can make a fully deductible IRA                              to $44,000 for single taxpayers and $54,000 to
contribution up to the maximum annual limit of                               $64,000 for married taxpayers filing jointly. For
$3000 ($6000 for a spousal IRA). The worker is                               example, in 2002, a single taxpayer with a modified
considered an active participant in a retirement plan                        adjusted gross income of $39,000 could contribute
if his or her employer or union has a retirement plan                        $3000 to an IRA but could deduct only $1500.
in which money is added to the worker’s account, or                               The phase-out limits will gradually increase in
if the worker is eligible for retirement credits. The                        the future according to the following schedule:
worker is considered an active participant even if
vesting has not been attained.                                                      Year                               Single Taxpayer
     Second, even if the worker is a participant in the
employer’s retirement plan, a full deduction is al-                                 2002                               $34,000–$44,000
lowed if the worker’s modified adjusted gross in-                                    2003                               $40,000–$50,000
come is below certain thresholds. Modified adjusted                                  2004                               $45,000–$55,000
gross income generally is the adjusted gross income                                 2005 or later                      $50,000–$60,000

                                      Married Taxpayer                               adjusted gross incomes of $150,000 or less. The
      Year                             Filing Jointly                                deduction is phased out for married couples with
                                                                                     modified adjusted gross incomes between $150,000
      2002                            $54,000–$64,000                                and $160,000.
      2003                            $60,000–$70,000                                     For example, Josh is covered under a Section
      2004                            $65,000–$75,000                                401(k) retirement plan at work. His wife, Ashley, is
      2005                            $70,000–$80,000                                a full-time homemaker. For 2002, their modified
      2006                            $75,000–$85,000                                adjusted gross income is $125,000. Ashley can make
      2007 and later                  $80,000–$100,000                               a tax-deductible IRA contribution of $3000 because
                                                                                     she is not considered an active participant, and the
     Taxpayers with incomes that exceed the phase-                                   couple’s combined modified adjusted gross income
out limits can contribute to a traditional IRA but                                   is less than $150,000. However, Josh cannot make a
cannot deduct their contributions. This type of IRA                                  tax-deductible contribution because his income ex-
is called a nondeductible IRA. In such cases, a Roth                                 ceeds the income threshold for active participants.
IRA (discussed later) should be considered.
                                                                                     New Tax Credit The new law also provides for a
Special Phase-Out Rule for Spouses A special                                         temporary tax credit to encourage low- and middle-
phase-out rule applies to married couples in situa-                                  income workers to save for their retirement. The
tions where one spouse is not an active participant                                  maximum tax credit is $1000 annually for single
in an employer-sponsored retirement plan, but the                                    taxpayers with an adjusted gross income of $15,000
other spouse is an active participant. As a result,                                  or less ($30,000 or less for married couples filing
most homemakers can make a fully deductible con-                                     jointly). The tax credit declines as income increases
tribution to a traditional IRA even though the other                                 and is limited to single workers with an adjusted
spouse is covered under a retirement plan at work.                                   gross income of $25,000 or less and to married cou-
In such cases, the maximum annual IRA deduction                                      ples with $50,000 or less (see Exhibit 20.6).
for a spouse who is not an active participant is
$3000, even if the other spouse is covered under a                                   Withdrawal of Funds With certain exceptions,
retirement plan at work. Eligibility for a full deduc-                               distributions from a traditional IRA before age
tion is limited to married couples with modified                                      591⁄2 are considered to be premature distributions. A

              EXHIBIT 20.6
              Topping It Off with a Tax Credit

                 Extra Credita
                 For tax years 2002 through 2006, the tax credit for making contributions to an IRA or workplace
                 savings plan is as follows:

                       Joint Filers                   Head of
                     Adjusted Gross                Household Filers                   Other Filers                                Maximum
                      Income (AGI)                      AGI                              AGI                      Credit           Credit

                      $0–$30,000                      $0–$22,500                      $0–$15,000                  50%               $1,000
                 $30,001–$32,500                 $22,501–$24,375                 $15,001–$16,250                  20%                $400
                 $32,501–$50,000                 $24,376–$37,500                 $16,251–$25,000                  10%                $200
                     Over $50,000                    Over $37,500                    Over $25,000                  0%                   $0
              a Tobe eligible for a tax credit, you must be age 18 or older, cannot be a full-time student, and cannot be claimed as a dependent
              on someone else’s tax return.
              SOURCE: Adapted from Fidelity Investments, Tax Relief Act Special Report, (2001).
                                                                     INDIVIDUAL RETIREMENT ACCOUNTS             407

10 percent tax penalty must be paid on the amount               In addition, as noted earlier, a 10 percent tax
of the distribution included in gross income. How-          penalty applies to premature distributions taken be-
ever, the penalty tax does not apply to distributions       fore age 591⁄2.
that result from any of the following:
  I   Death of the individual                               Establishing a Traditional IRA Traditional IRAs
  I   Disability of the individual                          can be established with a variety of financial organi-
  I   Substantially equal payments paid over the life       zations. You can set up an IRA with a bank, mutual
      expectancy of the individual or the individual        fund, stock brokerage firm, or life insurer. Con-
      and his or her beneficiary                             tributions to a traditional IRA can be made anytime
  I   Portions of any distributions treated as a return     during the year or up to the due date for filing a tax
      of nondeductible contributions                        return, not including extensions.
  I   Distributions used to pay for unreimbursed med-            There are two types of traditional IRAs: (1) an
      ical expenses in excess of 71⁄2 percent of adjusted   individual retirement account, and (2) an individual
      gross income                                          retirement annuity.
  I   Distributions used to pay medical insurance pre-        I   Individual Retirement Account. An individual
      miums for the worker, spouse, and dependents if             retirement account is a trust or custodial ac-
      the worker has received unemployment compen-                count set up for the exclusive benefit of the
      sation benefits for 12 consecutive weeks                     account holder or beneficiaries. The trustee or
  I   Distributions to pay for qualified education ex-             custodian must be a bank, a federally insured
      penses                                                      credit union, a savings and loan institution, or
  I   Qualified acquisition costs for a first-time home             an entity approved by the IRS to act as trustee
      buyer (maximum of $10,000)                                  or custodian. Contributions must be in cash,
    Distributions from a traditional IRA must start               except for rollover contributions (discussed
no later than April 1 of the year following the cal-              later) that can be in the form of property other
endar year in which the individual attains age 701⁄2.             than cash. No part of the contributions can be
The funds can be withdrawn in a lump sum or in                    used to purchase a life insurance policy. Like-
installments. If taken as installments, a minimum                 wise, IRA assets cannot be pledged as collateral
annual distribution requirement must be met. The                  for a loan.
minimum annual payments are based on the life ex-             I   Individual Retirement Annuity. A traditional
pectancy of the individual or the joint life expect-              IRA can also be established by purchasing an
ancy of the individual and his or her beneficiary. If              individual retirement annuity from a life insurer.
the distributions are less than the amount required               The annuity must meet certain requirements.
by law, a 50 percent excise tax is imposed on the                 The annuity owner’s interest in the contract
excess accumulation. The purpose of this require-                 must be nonforfeitable. The contract must be
ment is to force participants in traditional IRAs to              nontransferable by the owner. In addition, the
have the funds paid out over a reasonable period so               annuity must permit flexible premiums so that if
that the federal government can collect taxes on the              earnings change, the IRA contributions can be
tax-deferred amounts.                                             changed as well. Contributions cannot exceed
                                                                  $3000 in any year, and the distributions must
Taxation of Distributions Distributions from a tra-               begin by April 1 of the year following the year
ditional IRA are taxed as ordinary income, except                 in which the annuity owner reaches age 701⁄2.
for any nondeductible IRA contributions, which are
received income-tax free. Part of the distribution is       IRA Investments IRA contributions can be invested
not taxable if nondeductible contributions are made.        in a variety of investments, including certificates
The other part is taxable and must be included in           of deposit, mutual funds, and individual stocks
the taxpayer’s income. A complex formula and an             and bonds in a self-directed brokerage account.
IRS worksheet must be used to compute the nontax-           Contributions can also be invested in U.S. gold and
able and taxable portions of each distribution.             silver coins, certain platinum coins, or gold, silver,

palladium, or platinum bullion. However, the con-
                                                                                    Roth IRA
tributions cannot be invested in insurance contracts
or collectibles, such as baseball cards or antiques.                                A Roth IRA is another type of IRA that provides sub-
                                                                                    stantial tax advantages. The annual contribution
IRA Rollover Account A rollover is a tax-free distri-                               limits discussed earlier for a traditional IRA also
bution of cash or other property from one retire-                                   apply to a Roth IRA. However, the maximum annual
ment plan, which is then deposited into another                                     contribution that an individual can make to all IRA
retirement plan. The amount you roll over is tax free                               accounts (both traditional and Roth) is $3000 for
but generally becomes taxable when the new plan                                     workers under age 50, not counting rollover contri-
pays out that amount to you or to your beneficiary.                                  butions. However, as stated earlier, the maximum
For example, if you quit your job and receive a                                     annual contribution limits will rise in the future.
lump-sum distribution from your employer’s quali-                                        Unlike a traditional IRA, the annual contribu-
fied retirement plan, the funds can be rolled over or                                tions to a Roth IRA are not tax deductible. How-
deposited into a special IRA rollover account. If you                               ever, the investment income accumulates income-tax
receive the funds directly, the employer must deduct                                free, and qualified distributions are not taxable if
20 percent for federal income taxes. The tax can be                                 certain requirements are met. A qualified distribu-
deferred, however, if the employer transfers the                                    tion is any distribution from a Roth IRA that (1) is
funds directly into the IRA rollover account.                                       made after a five-year period beginning with the first
     The assets in the IRA rollover account can be                                  tax year for which a Roth contribution is made, and
paid out as income when the worker retires. Exhibit                                 (2) is made for any of the following reasons:
20.7 shows how long the payments will last given                                         I   The individual is age 591⁄2 or older.
selected rates of return and withdrawal rates.                                           I   The individual is disabled.

              EXHIBIT 20.7
              How Long the Money Will Last (in Years)

                                                                                 Rate of Return
                                       1%       2%       3%       4%      5%       6%         7%     8%       9%      10% 11% 12%
                       12%               7       8        8        8        8       9         9      10       10       11       12       13
                        11               8       8        9        9        9       10        10     11       12       13       14       15
                        10               9       9       10       10       10       11        12     13       14       15       17       19
                         9              10       10      11       11       12       13        14     15       16       18       21       26
                         8              11       11      12       13       14       15        16     18       20       24       30        *
                         7              12       13      14       15       16       18        20     22       27       36        *        *
                         6              14       15      16       18       19       22        25     31       44        *        *
                         5              17       18      20       22       24       29        36      *        *        *
                         4              20       22      25       28       33       42         *      *        *
                         3              25       28      33       39        *        *         *      *
                         2              35       40      50        *        *        *         *
                         1               *        *       *        *        *        *

              NOTE: For example, if you have saved $700,000 for retirement and initially withdraw 5 percent of the money ($35,000), your
              money will last 36 years, assuming a 7 percent annual return. The table assumes that your initial withdrawal is increased each
              year to keep up with an inflation rate of 3 percent, the historical average.
              SOURCE:, “Making Sure Your Money Lasts,” Basics: Cracking Your Nest Egg (2001).
                                                                                                         SUMMARY         409

    I   The distribution is paid to a beneficiary or to the     I   A fixed annuity pays periodic income payments to an
        estate after the individual’s death.                       annuitant that are guaranteed and fixed in amount. A
    I   The distribution is used to pay qualified first-time         fixed annuity can be purchased so that the income pay-
        home buyer expenses (maximum of $10,000).                  ments start immediately or can be deferred to some
                                                                   later date. Deferred annuities typically provide for flex-
     Unlike a traditional IRA, contributions to a Roth
                                                                   ible premiums.
IRA can be made after age 701⁄2, and the minimum
distribution rules after attainment of age 701⁄2 do not        I   Annuity settlement options typically include the fol-
apply to Roth IRAs.                                                lowing:
Income Limits Roth IRAs have generous income                           Life income (no refund)
limits. The maximum annual IRA contribution can                        Life income with guaranteed payments
be made by single taxpayers with modified adjusted                      Installment refund option
gross incomes of $95,000 or less, and by married                       Joint-and-survivor annuity option
couples filing jointly with modified adjusted gross
incomes of $150,000 or less. Maximum annual IRA                I   A variable annuity pays a lifetime income, but the
contributions are phased out for single taxpayers                  income payments will vary depending on the invest-
with modified adjusted gross incomes between                        ment experience of the subaccount in which the pre-
$95,000 and $110,000, and for married couples                      miums are invested. The purpose of this type of annu-
filing jointly with modified adjusted gross incomes                  ity is to provide an inflation hedge by maintaining the
between $150,000 and $160,000.                                     real purchasing power of the periodic payments.
                                                               I   During the accumulation period, variable annuity pre-
Conversion to a Roth IRA A traditional IRA can be                  miums purchase accumulation units, which are then
converted into a Roth IRA. The right to convert is                 converted into annuity units at retirement. The number
limited to taxpayers with annual adjusted gross                    of annuity units remains constant during retirement,
incomes of $100,000 or less. Although the amount                   but the value of the annuity units changes periodically
converted is taxed as ordinary income, qualified dis-               so that the income payments will change over time.
tributions from the Roth IRA are received income-              I   Variable annuities typically pay a guaranteed death
tax free. Many investment firms, including Fidelity                 benefit if the annuitant dies before retirement. The typ-
Investments and Charles Schwab, provide interac-                   ical death benefit is the higher of two amounts: the
tive calculators on their Web sites that investors can             amount invested in the contract or the value of the
use to determine if conversion to a Roth IRA is                    account at the time of death.
financially desirable.                                          I   Variable annuities have numerous fees and charges.
     In summary, a traditional or Roth IRA can pro-                These charges include an investment management fee,
vide substantial tax advantages, and regular contri-               a charge for administrative expenses, a management
butions to one can substantially increase a person’s               and expense risk charge for the guaranteed death ben-
retirement income. IRA contributions can accumu-                   efit and other guarantees, and a surrender charge that
late to sizable amounts, especially if the plan is                 declines over time. In the aggregate, total fees and ex-
started at an early age. Even high school students                 penses can be substantial.
with part-time jobs can benefit from an IRA.
                                                               I   An equity-indexed annuity is a fixed, deferred annuity
                                                                   that allows the annuity owner to participate in the
                                                                   growth of the stock market and also provides downside
SUMMARY                                                            protection against the loss of principal and prior inter-
I   An annuity provides periodic payments to an annui-             est earnings if the annuity is held to term.
    tant, which continue for either a fixed period or for the   I   The key elements of an equity-indexed annuity are (1)
    duration of a designated life or lives. The fundamental        the participation rate, (2) the cap on the maximum per-
    purpose of a life annuity is to provide lifetime income        centage of gain credited to the contract, (3) the indexing
    that cannot be outlived.                                       method used, and (4) the guaranteed minimum value.

I   An exclusion ratio is used to determine the nontaxable
    and taxable portions of the periodic annuity payments.
                                                                KEY CONCEPTS AND TERMS
    The exclusion ratio is determined by dividing the in-       Accumulation period             Installment refund option
    vestment in the contract by the expected return.            Accumulation unit               IRA rollover account
I   The major types of IRAs are (1) a traditional IRA, and      Annuitant                       Joint-and-survivor annuity
    (2) a Roth IRA.                                             Annuity                           option
                                                                Annuity settlement options      Life income (no refund)
I   A traditional IRA allows workers to deduct part or all
                                                                Annuity unit                    Life income with
    of their IRA contributions. The investment income
                                                                Cash refund option                guaranteed payments
    accumulates income-tax free on a tax-deferred basis,
                                                                Deferred annuity                Liquidation period
    and the distributions are taxed as ordinary income.
                                                                Equity-indexed annuity          Nondeductible IRA
I   To be eligible for a traditional IRA, the participant       Exclusion ratio                 Roth IRA
    must have taxable compensation and be younger than          Fixed annuity                   Single-premium deferred
    age 701⁄2.                                                  Flexible-premium annuity          annuity
I   The maximum annual IRA contribution is limited to           Immediate annuity               Spousal IRA
    $3000 ($3500 if age 50 or older) or 100 percent of          Individual retirement           Traditional IRA
    earned income, whichever is less. If the participant has      account (IRA)                 Variable annuity
    a nonworking or low-earning spouse, the maximum
    annual IRA contribution is increased to $6000 (spousal
    IRA).                                                       REVIEW QUESTIONS
I   IRA contributions to a traditional IRA are income-tax
                                                                 1. How does an annuity differ from life insurance?
    deductible if the participant (1) is not an active parti-
    cipant in an employer-sponsored retirement plan or           2. Describe the major characteristics of a fixed annuity.
    (2) has taxable compensation below certain income            3. Identify the annuity settlement options that are typi-
    thresholds.                                                     cally found in a fixed annuity.
I   Distributions from a traditional IRA are taxed as ordi-      4. Describe the basic characteristics of a variable annuity.
    nary income, except for any nondeductible IRA contri-        5. Explain the major characteristics of an equity-indexed
    butions, which are received income-tax free.                    annuity.
I   With certain exceptions, distributions from a traditional    6. Explain the eligibility requirements for a traditional
    IRA before age 591⁄2 are considered to be a premature           IRA.
    distribution. A 10 percent tax penalty must be paid on
    the amount of the distribution included in gross income.     7. What are the annual contribution limits to an IRA?

I   Distributions from a traditional IRA must start no later     8. Explain the basic characteristics of a traditional IRA.
    than April 1 of the year following the calendar year in      9. Describe the major characteristics of a Roth IRA.
    which the individual attains age 701⁄2.                     10. What is an IRA rollover?
I   IRA contributions to a Roth IRA are not income-
    tax deductible. However, the income accumulates free
    of taxation, and qualified distributions are received        APPLICATION QUESTIONS
    income-tax free if certain requirements are met.             1. Although both fixed and variable annuities can pro-
I   A qualified distribution from a Roth IRA is any distri-          vide lifetime income to annuitants, they differ in
    bution that (1) is made after a five-year period begin-          important ways.
    ning with the first tax year for which a Roth contribu-          a. Compare and contrast (i) a fixed annuity with
    tion is made, and (2) is paid when the individual                  (ii) a variable annuity with respect to each of the
    attains age 591⁄2, becomes disabled, dies, or is used to           following:
    pay qualified first-time home buyer expenses. Unlike                 (1) Determining how the premiums are invested
    a traditional IRA, contributions to a Roth IRA can                 (2) Stability of income payments after retirement
    be made after age 701⁄2, and the minimum distribution              (3) Death benefits if the annuitant dies before
    rules after attainment of age 701⁄2 do not apply.                        retirement
                                                                                         SELECTED REFERENCES             411

   b. Explain the method for determining the nontax-                 d. Eligibility, if any, of a nonworking spouse in the
      able and taxable portions of the periodic income                  home to make an IRA contribution
      payments from an individual annuity.
2. An equity-indexed annuity and a variable annuity are
   both similar and different in many respects.                  SELECTED REFERENCES
   a. Explain the major similarities between an equity-
      indexed annuity and a variable annuity.           Making Your Money Last for a
   b. Identify the major differences between an equity-               Lifetime: Why You Need to Know About Annuities,
      indexed annuity and a variable annuity.                         March 14, 2001.
                                                                 Cascarelli, Joseph C. “Equity-Indexed Annuities: What
3. Travis, age 25, graduated from college and obtained a              They Are and How to Sell Them Suitably,” Journal
   position as a tax accountant. He is ineligible to par-             of Financial Service Professionals, vol. 55, no. 6
   ticipate in his employer’s retirement plan for one year.           (November 2001), pp. 41–45.
   a. Assume that Travis has a starting salary of $45,000        Black, Kenneth Jr., and Harold D. Skipper, Jr. Life &
       for 2002 and does not participate in the employer’s            Health Insurance, 13th ed. Upper Saddle River, NJ:
       retirement plan. Is Travis eligible to establish a tra-        Prentice-Hall, 2000, ch. 8.
       ditional tax-deductible IRA? Explain your answer.         Commerce Clearing House. 2001 Tax Legislation: Law,
   b. Assume the same facts in (a). Is Travis eligible to             Explanation, and Analysis, Economic Growth and
       establish a Roth IRA? Explain your answer.                     Tax Relief Reconciliation Act of 2001. Chicago, IL:
4. A traditional IRA and a Roth IRA have both similari-               CCH Inc., 2001.
   ties and differences. Compare and contrast (i) a tradi-       Graves, Edward E., ed. McGill’s Life Insurance, 4th ed.
   tional IRA with (ii) a Roth IRA with respect to each               Bryn Mawr, PA: The American College, 2002.
   of the following:                                             Kaster, Nicholas, et al. 2002 U.S. Master Pension Guide,
   a. Income-tax treatment of IRA contributions and                   2001 Tax Law Changes Included. Chicago, IL: CCH
       distributions                                                  Inc., 2002.
   b. Income limits for eligibility                              Littell, David A., and Kenn Beam Tacchino. Planning for
   c. Determining how the IRA contributions are in-                   Retirement Needs, 5th ed. Bryn Mawr, PA: The Amer-
       vested                                                         ican College, 2001.

Case Application
 Richard and Nicole are married and file a joint tax              c. Assume that Richard graduates and the couple’s
 return. Richard is a graduate student who works part-              modified adjusted gross income is $120,000. Both
 time and earned $10,000 in 2002. He is not eligible to             Richard and Nicole participate in their employers’
 participate in his employer’s retirement plan because he           retirement plans. Can either Richard or Nicole, or
 is a part-time worker. Nicole is a high school teacher             both, establish a Roth IRA? Explain your answer.
 who earned $42,000 in 2002 and is an active partici-            d. Nicole has a baby and withdraws from the labor
 pant in the school district’s retirement plan. Assume              force to raise the couple’s child. She is no longer an
 you are a financial planner and the couple asks for your            active participant in the school district’s retirement
 advice. Based on the preceding facts, answer each of the           plan. Richard receives a promotion and continues
 following questions.                                               to participate in his employer’s retirement plan.
                                                                    His annual salary is $110,000. Can Nicole make a
   a. Is Richard eligible to set up and deduct contribu-
                                                                    tax-deductible contribution to a traditional IRA?
      tions to a traditional IRA? Explain your answer.
                                                                    Explain your answer.
   b. Is Nicole eligible to set up and deduct contribu-
                                                                 e. Explain to Richard and Nicole the advantages of a
      tions to a traditional IRA? Explain your answer.
                                                                    Roth IRA over a traditional IRA.

                                                                 paid loans that you received by the later of the annuity
NOTES                                                            starting date or the date on which you received your
 1. A deduction for administrative expenses and sales            first payment; (2) any additional premiums paid for
    expenses is ignored. Some individual variable annuity        double indemnity or disability payments; and (3) any
    contracts have a front-end load.                             other tax-free amounts you received under the con-
 2. The actual number of annuity units will depend on the        tract or plan before the later of the dates specified in
    market value of the account, the attained age of the         item 1. In addition, an adjustment must be made for
    annuitant, the number of guaranteed payments, the            any refund features in the annuity. The IRS provides
    conversation rates, the assumed investment return,           worksheets for making these calculations.
    and other factors.                                        5. Modified adjusted gross income is essentially the ad-
 3. The 10 percent penalty tax does not apply to individ-        justed gross income figure shown on your tax return
    uals who attain age 591⁄2 or become totally disabled;        without taking into account any IRA deductions, stu-
    when the distribution is received by a beneficiary or         dent loan interest deduction, foreign earned income
    estate after the individual dies; when the distribution      exclusion, foreign housing exclusion or deduction,
    is part of substantially equal payments paid over the        exclusion of qualified bond interest, and exclusion of
    life expectancy of the individual or individual and          employer-paid adoption expenses.
    beneficiary; or when the distribution is from an
    annuity contract under a qualified personal injury set-
    tlement. Certain other exceptions also apply.
 4. The procedure for determining the total cost of an                   Students may take a self-administered test
    annuity is complex. Total cost must be reduced by (1)                on this chapter at
    any refunded premiums, rebates, dividends, or unre-

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