Basic Planning Guide to Annuities.
Tuesday, February 24th, 2009Annuities are the only investment vehicles that can guarantee investors that they will not outlive their income, and they do this in a tax favored manner. In
addition, annuities are available with a host of features to meet a wide variety of investor needs. The taxation of annuities is governed by Internal Revenue
Code Section 72.
Technically, annuities are contracts providing for the systematic liquidation of principal and interest in the form of a series of payments over time.
However, this really refers to the “payout” phase of an annuity; in point of fact, annuities can (and often do) have an accumulation phase that also lasts
for a substantial period of time.
An annuity is established when an investor makes a cash payment to an insurance company, which invests the money—this may be a single large cash payment or a series of periodic payments over time. The money remains invested with the insurance company and is periodically credited with some growth factor—this is the accumulation phase of the annuity. In return for making a deposit into an annuity, the insurance company ultimately agrees to pay the owner (or owners) a specified amount (the annuity payments) periodically, beginning on a specified date—this is the payout phase of the annuity.
If the specified date for payouts to begin is within one year of the date the contract is established (i.e., a single cash payment is made and the insurance
company begins a systematic liquidation of the payment back to the owner within one year), the annuity is called an “immediate annuity.” If, alternatively,
the specified date for payouts to begin is later than one year, the annuity is called a “deferred annuity” (because deposits are made now, but the payout is
deferred). An immediate annuity only has a payout phase; a deferred annuity has both an accumulation and a payout phase.
If the payout phase of the annuity is a life annuity, the company promises that payouts will continue for as long as the annuitant (or annuitants) live the income stream can never be outlived. (Note: although often the same, technically the owner of the annuity does not necessarily need to be the annuitant as well; occasionally these are different individuals.) If the payout phase is a fixed period annuity (also called a term certain annuity), the company promises to pay stipulated amounts for a fixed or guaranteed period of time independent of the survival of the annuitant. An annuity payout can also utilize a combination of the life and fixed period options, such as “for the greater of 10 years or the life of the annuitant(s).”
In addition to differentiating between immediate and deferred annuities and fixed and term certain payouts, annuities are also categorized as to whether they
are fixed or variable. (Be careful not to confuse a “fixed annuity” with a “fixed period payout.”) Classification as a fixed or variable annuity refers to the underlying investments during the accumulation phase of the annuity: a fixed annuity is invested in the general fixed account of the insurance company,
while a variable annuity is invested in separately managed sub-accounts (that function similarly to mutual funds) selected by the annuity owner. Variable
annuities often have additional features to help manage the risk of their underlying investments, such as guaranteed death benefits or newer “living
benefits” that provide company guaranteed payments for owners or beneficiaries even if (or especially if) they would be higher than actual investment performance would provide for.
Newer annuities may also offer a variable option during the payout phase (whether for a fixed or term certain period). A “variable annuitization” has payments that may fluctuate up or down depending upon the performance of the underlying sub-account investments. A “fixed annuitization” has payments that
remain the same through the payout phase (or occasionally increase by some set rate to keep pace with inflation; however, this rate is predetermined and
contractual, is still invested in the insurance company’s general account, and is thus still considered a “fixed payout”).
Annuities purchased from an insurance company are called “commercial annuities” while those purchased from a person or entity that is not in the business of selling annuities are called “private annuities.” Technically, the living proceeds received from a life insurance contract are also considered annuities if they consist of periodic payments of both principal and interest.
Annuities grow tax deferred during the accumulation phase, although withdrawals during this phase are taxed on a LIFO (last in, first out) basis—meaning that withdrawals during the accumulation phase are considered to be withdrawals of growth first (fully taxable) and principal second. Payouts during the annuitization phase are split: a portion of each payment is considered principal, and a portion is deemed interest/growth. The proportion of each is
determined at the annuity’s beginning payment date and is based upon the already accumulated growth, an assumed internal growth factor for the payout period, and the expected length of the payout period. All amounts distributed that are considered interest/growth are taxed as ordinary income, regardless of the phase or timing of the withdrawal. In addition, certain withdrawals before the age of 59 1/2 may be subject to an additional 10% tax penalty.
Although annuities have tax deferral features that can be quite advantageous, the primary reason annuities should be purchased are for their risk management
features. Annuities can provide a variety of guarantees, whether protecting against interest rate risk, reinvestment risk, superannuation (living too long,
such as outliving one’s assets), or certain market volatility risks. Annuities are first and foremost a risk management tool.
