An annuity is a contract that allows an individual to place a sum of money with a life insurance company in exchange for future income. The future income can be received either as a lump sum or as a guaranteed stream of income over a predetermined period of time.
Guaranteed income can be received by the annuitant (i.e., the person whose life the annuity contract is purchased on) over a fixed number of years or for the annuitant's entire lifetime. Until the income is distributed, all interest which accumulates within the annuity contract is tax-deferred.
An annuity can be a great complement to an individual’s long-term financial plan; however, they are not right for everyone. To help you determine if an annuity is appropriate for you, we have provided two quick checklists.
- Annuities may be appropriate when you…
Annuities may not be appropriate when you…
- …want guaranteed income for life.
- …desire safety of principal.
- …want a higher rate of return than certificates of deposit or other similar investments.
- …want to accumulate earnings tax-deferred.
- …want to contribute additional income into a retirement fund that does not have contribution limits.
- …want to avoid the mandatory withdrawal requirement at age 70 ½ of other retirement accounts (e.g., traditional IRA).
- …want to receive a stream of income which is guaranteed for as long as you are alive.
- …have not established an emergency fund to cover living expenses for at least three to six months.
- …have not contributed to other more tax-advantaged retirement accounts, such as a 401(k), 403(b), Roth IRA, etc..
- …plan on receiving the money before age 59 ½.
- …are not sure that you are able to meet planned future expenses (e.g., house down payment, renovations, etc.) with other funds.
A life insurance contract is designed to meet the needs of survivors (i.e., the beneficiary) with a sum of money that far exceeds the value of the premium(s), if the insured should die while the contract is in force. An annuity contract is designed to support the owner's future income requirements by providing a vehicle that can accumulate and/or liquidate a sum of money during his/her lifetime.
Should an annuitant die while the annuity contract is in force, the beneficiary(ies) may receive the contract’s accumulation value, the remaining premium payments, or nothing at all. Death proceeds for annuity contracts will be determined by the type of annuity contract purchased.
Annuity contracts may be classified in a number of ways. The following are design features that differentiate the various types of annuities.
- Funding Method (Single Premium vs. Installment Premium)
- Accumulation Period (Deferred vs. Immediate)
- Payout Option (Limited Pay vs. Life Pay)
- Number of Lives Covered (Single Life vs. Joint Life)
- Investment Style (Fixed vs. Variable)
Once you are ready to receive income, you may choose from several payout options. The most common forms of payout methods are:
- Fixed Period - Payments are scheduled to be paid out over a predetermined period of time, usually between 1 to 30 years. The monthly amount distributed is calculated by the number of distribution years elected.
- Fixed Amount - A predetermined amount of income will be received until the funds are fully paid out.
- Straight Life - Payments are guaranteed to be paid out as long as the annuitant is alive. Once the annuitant dies there are no further payments available to be passed on to a beneficiary.
- Life with A Period Certain - An annuitant will receive income for the Member’s entire life with the guarantee that payments will continue to a beneficiary for the remainder of the elected “period certain.” A 5, 10, 15, or 20 year period certain may be chosen at the time the contract is purchased. For example, if a 10 year period certain is elected and the annuitant dies at the beginning of year 8, the beneficiary will continue to receive payments for 2 years (10 minus 8). If the annuitant’s death occurs after the period certain, no additional payments will be paid.
- Joint and Survivor - The annuity is paid for as long as both annuitants are alive. At the time of the first death, payments may remain the same or be decreased, as determined by the survivor election, which is made at the time the contract is purchased. In addition, a period certain may also be available.
An annuity may cover a single life or more than one life. A contract that is purchased on a single life is a single-life annuity while one purchased on two or more lives is referred to a joint annuity or a joint-and-survivor annuity. A joint annuity will only provide payments until one of the covered annuitants dies, while payments on a joint-and-survivor annuity will continue until the death of the surviving annuitant. Annuity contracts covering more than two annuitants are rarely sold. In addition, if a joint-and-survivor annuity is purchased, you may have the option to state what percentage (e.g., 100%, 66%, 50%) of your original income (i.e., income amount before the first death) will continue to the survivor.
You may choose to place the funds with the company to invest or you may choose the investments yourself. With a fixed annuity, you are giving the money to the insurance company to invest in exchange for the guarantee that a payment of both principal and interest are made in the future (subject to certain charges). The insurance company is able to provide this guarantee because it will invest your money primarily in bonds or other conservative fixed investments.
A variable annuity does not guarantee the principal and interest; rather, the annuity can fluctuate up and down as a result of changes in the performance of the underlying investment portfolio, which you have chosen. Investment choices can range among stocks, bonds, and cash equivalent vehicles. If the investments you choose for your annuity perform well, your returns may outperform the fixed annuity returns; however, if they don't, you may lose not only prior returns but also principal.
There are various tax rules that are applied to annuities. The tax rules will be determined by how the annuity is classified. The two classifications we are talking about are qualified and nonqualified.
A qualified plan is a retirement savings plan which can be created by either an employer or an individual as set forth by federal regulations. Typically, a qualified plan can help you defer taxes in two ways: 1) interest accumulates tax-deferred while in the annuity and 2) contributions to the contract can be made on a pre-tax basis. A qualified plan however requires that you begin taking minimum distributions on 1 April of the year after you reach age 70 ½.
The minimum amount that must be paid out is calculated through a formula based primarily on your life expectancy and that of your beneficiary. If minimum distributions are not taken, you will pay an excise tax equal to 50 percent of the difference between your withdrawal and the required minimum that year. Once you begin receiving money from your qualified plan, taxes will be assessed on the full amount which is distributed.
Nonqualified plans are purchased with after-tax dollars with earnings growing tax-deferred. Since your contributions are with after-tax dollars, you will only pay taxes on the portion of the distributions which are considered earnings. The administrator of your nonqualified annuity will calculate the ratio of your payout which is considered nontaxable. Nonqualified plans do not require that distributions be made before age 70 ½. Nonqualified plans are available to anyone and should be considered if you are not eligible for a qualified plan.
The current tax law discourages people from taking money from their annuity contract prior to age 59 ½ by assessing a 10% penalty tax on any taxable distributions. The 10% tax penalty can be avoided if you elect to receive substantially equal payments, made at least annually, over your lifetime.
At the time of death, annuities do not get passed on to beneficiaries tax-free like a life insurance death benefit nor do they receive a step-up in basis.
It is always advised that you consult with a tax advisor prior to purchasing an annuity so that you understand all the current tax rules and have all your tax questions answered.
Charges can vary widely from one annuity contract to the next. Some charges may be fixed while others will vary during the life of the contract. Some charges you may see are:
- Contract Fee: A dollar amount charged either at the time of purchase or annually.
- Transactions Fee: A charge assessed against various allowable transactions made on the contract (e.g., withdrawals).
- Premium Charge: This is generally called a "load" and is deducted from each premium payment paid.
- Surrender Charge: If you elect to surrender your contract, this charge which will lower the value of the policy. This charge typically is reduced or eliminated after the contract has been in force for a certain number of years.
Companies and contracts may have very different fee structures. Typically, variable annuity contracts have higher fees than fixed annuity contracts because they have more features. Because companies and annuity contracts have different fee structures, always ask about all the possible contract charges.
Once you have determined which type(s) of annuity contract would best meet your needs, your next step is to find the most competitive contract(s). Here are several considerations when shopping for the best contract.
- Always compare the same type of annuity (apples to apples).
- Shop around and get quotes from several different companies.
- Compare the future accumulation values or monthly income amounts.
- Understand all the possible contract charges.
- Understand all the guarantees and features of the contract.
- Ask about the financial rating of the company.
Before taking any action to cancel or replace your current annuity, you should first ask yourself several questions: Are you allowed to cancel your current contract? Does this annuity still meet your needs? Does it provide the desired level of safety? Is the return on the annuity contract competitive? Will there be significant charges and/or taxes if you surrender or replace the contract?
The answers to these questions will help guide your decision. If your decision is to replace your current contract, request to have the contract transferred through a 1035 Exchange. The 1035 Exchange will allow you to transfer your existing contract to a new contract tax-deferred. There are several requirements you must meet in order to qualify for a 1035 Exchange, so be sure to talk with your annuity representative to determine if it is possible.