What is it

1
What is it?

• Annuities are contracts providing for the
  systematic liquidation of principal and interest
  in the form of a series of payment over time.
  
• Primarily refers to the payout phase.
• Many annuities also have an accumulation phase.

2
What is it?

• An annuity is established when the investor makes
  a cash payment to an insurance company.
  
• May be a single large cash payment or a series of
  periodic payments over time.
  
• The insurance company invests the money.
• The money is periodically credited with some
  growth factor.
  
• Known as the accumulation phase of the annuity.
• The insurance company agrees to pay the owner (or
  owners) a specified amount (the annuity payments)
  periodically, beginning on a specified date
  
• Known as the payout phase of the annuity

3
What is it?

• Immediate annuity
• The specified date for payouts to begin is within
  one year of the date the contract is
  established.
  
• Only has a payout phase
• Deferred annuity
• The specified date for payouts to begin is at
  least one year later
  
• Has both an accumulation phase and a payout phase

4
What is it?

• Life annuity
• The payout phase continues for as long as the
  annuitant (or annuitants) live
  
• Fixed period annuity (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.
  
• Fixed annuity
• Invested in the general fixed account of the
  insurance company.

5
What is it?

• Variable annuity
• Invested in separately managed sub-accounts
  selected by the annuity owner.
  
• Has additional features to manage the risk of the
  underlying investments
  
• Guaranteed death benefits or newer living
  benefits
  
• Variable annuitization
• Payments that may fluctuate up or down depending
  upon the performance of the underlying
  sub-account investments

6
What is it?

• Fixed annuitization
• Payments that remain the same through the payout
  phase
  
• Can be occasionally increased by some set rate to
  keep pace with inflation
  
• This rate is pre-determined and contractual
• Commercial annuities
• Annuities purchased from an insurance company
• Private annuities
• Annuities purchased from a person or entity that
  is not in the business of selling annuities

7
What is it?

• Annuities grow tax-deferred during the
  accumulation phase.
  
• Withdrawals during this phase are taxed on a LIFO
  basis
  
• Withdrawals are considered to be growth first
  (fully taxable) and principal second.

8
What is it?

• 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
  annuitys beginning payment date and is based
  upon
  
• The already accumulated growth
• An assumed internal growth factor for the payout
  period
  
• 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.
  
• Certain withdrawals before the age of 59 ½ may be
  subject to an additional 10 tax penalty.

9
What is it?

• The primary reason annuities should be purchased
  are for their risk management features.
  
• They can provide a variety of guarantees, whether
  protecting against
  
• Interest rate risk
• Reinvestment risk
• Market volatility risk
• Risk of living too long and outliving ones
  assets.

10
When is the use of this tool indicated?

• When a person wants a retirement income that can
  never be outlived
  
• When an individual wants a monthly income equal
  to or higher than other conservative investments
  and is willing to have principal liquidated
  
• When the person would like to avoid probate and
  pass a large sum of money by contract to an heir
  to reduce the possibility of a will contest
  
• When a tax-deferred accumulation of interest is
  desired
  
• The interest earned inside an annuity owned by an
  individual grows income tax-free and is not taxed
  until it is withdrawn.

11
When is the use of this tool indicated?

• When an investor wants to be free of the
  responsibility of investing and managing assets
  
• Applies in the case of a fixed annuity or an
  annuity payout
  
• As a supplement to an IRA
• There are limited opportunities for pre-tax
  contributions to IRAs
  
• Fixed annuities would be indicated
• When safety of principal is a paramount
  consideration
  
• When an investor wants a guarantee that a given
  level of interest will be credited to his
  investment for a long period of time
  
• When a conservative complement to other
  investment vehicles is desired

12
When is the use of this tool indicated?

• Variable annuities would be desired
• When an investor wants more control over his
  investment and is willing to bear the risk
  associated with his investment selections
  
• When a person is looking for potentially
  increasing retirement income
  
• When an individual would like to be invested in
  variable sub-accounts, but desires some aspect of
  risk management

13
Advantages

• The guarantees of safety, interest rates, and
  particularly lifelong income (if selected) give
  the purchaser peace of mind and psychological
  security.
• An annuity protects and builds a persons cash
  reserve.
  
• The insurer guarantees principal and interest (in
  the case of a fixed annuity), and the promise (if
  purchased) that the annuity can never be outlived.

14
Advantages

• An annuity allows a client to invest in the
  market while moderating risk.
  
• The insurer may provide guarantees of death
  proceeds or a certain annuitization amount (if
  purchased) within a variable annuity.
  
• Unavailable to a client that purchased the
  underlying investments directly
  
• A client can time the receipt of income and
  shift it into lower tax bracket years.
  
• An annuity paying the same rate of interest
  (after expenses) as a taxable investment will
  result in a higher effective yield.
  
• The interest on an annuity is tax-deferred.

15
Advantages

• A client may be able to take on greater risk in
  the underlying investment options while still
  maintaining a reasonable overall risk exposure
  due to the underlying guarantees.
• Particularly in variable annuities
• Adjusted Gross Income (AGI) may be reduced in
  years where the annuity is held with no
  withdrawals.
  
• Due to the tax-deferral features of the
  accumulation phase
  
• Lower taxable income may be recognized during
  payout phase due to the partial recovery of basis
  associated with each payment.
  
• A reduced AGI can bring tax savings, as many
  other income tax rules are calculated based upon
  AGI.

16
Disadvantages

• Receipt of a lump sum could result in a
  significant tax burden because income averaging
  is not available.
  
• This can be moderated if the proceeds are
  annuitized.
  
• The cash flow stream of a fixed payout may not
  keep pace with inflation.
  
• Particularly for longer-term payout phases such
  as a life annuitization

17
Disadvantages

• A 10 penalty tax is generally imposed on
  withdrawals of accumulated interest during the
  accumulation phase.
  
• Prior to age 59½ or disability
• May also apply to the annuitization phase if the
  annuity was not an immediate annuity and certain
  short payout terms are selected.
  
• If an annuity contract is held by a corporation
  or other entity that is not a natural person, the
  contract is not treated as an annuity contract
  for federal income tax purposes.
• Income on the contract for any taxable year is
  treated as current taxable ordinary income to the
  owner of the contract regardless of whether or
  not withdrawals are made.

18
Disadvantages

• If the client is forced to liquidate the
  investment in the early years of an annuity,
  management and mainte-nance fees and sales costs
  could prove expensive.
• Total management fees and mortality charges can
  run from 1 to 2½ of the value of the contract.
  
• There may be a back end surrender charge if the
  contract is terminated within the first few
  years.
  
• Investment earnings are taxed at the owners
  ordinary income tax rate when the owner receives
  payments.
  
• Regardless of the source or nature of returns

19
Tax Implications

• A clients investment in an annuity is returned
  in equal tax-free (return of capital) amounts
  during the payout phase.
  
• Any additional amount received is taxed at
  ordinary income tax rates.
  
• Exclusion ratio Determines the amount of each
  periods payment that will be considered
  nontaxable
  
• Investment in Contract divided by Expected
  Return
  
• Expressed as a percentage
• The full amount of each annuity payment received
  would be tax free if the investment in the
  contract exceeds the expected return.

20
Tax Implications

• The excludable portion of any annuity payment may
  not exceed the unrecovered investment in the
  contract.
  
• Unless the annuity started before January 1,
  1987
  
• Unrecovered Investment in the Contract
• The policyowners premium cost, reduced by any
  dividends received in cash or used to reduce
  premiums, and by the aggregate amount received
  under the contract on or after the annuity
  starting date to the extent it was excludable
  from income.
• The unrecovered investment in the contract is
  reduced each time an annuity payment is made by
  the amount of the payment that is excluded from
  income by the exclusion ratio.
• Once an annuitant has fully recovered his
  investment in the contract (which generally
  occurs at the end of the expected payout term),
  100 of each subsequent payment will be taxable.

21
Tax Implications

• Some annuities provide a refund if the annuitant
  dies before recovering his entire cost.
  
• The present value of the refund option must be
  ascertained by government tables and subtracted
  from the investment in the contract.
  
• Expected Return
• The total amount that the owner (or owners)
  should receive given the payments specified
  (which include an assumed internal growth rate)
  multiplied by the certain term or life expectancy
  according to the governments tables.
• Table V for single lives
• Table VI for joint and survivor annuities

22
Tax Implications

• When an annuitant dies before receiving the full
  amount guaranteed under a refund or period
  certain life annuity, the owner or beneficiary
  receiving the balance of the guaranteed amount
  will have no taxable income.
• Unless the amount received by the beneficiary
  plus the amount that had been received tax free
  by the annuitant exceeds the investment in the
  contract.

23
Tax Implications

• If the refund or commuted (present) value of the
  remaining installments is applied by the owner or
  beneficiary to purchase a new annuity, payments
  received will be taxed under the annuity rules to
  the beneficiary.
• The refund amount will be considered the
  beneficiarys investment in the new contract and
  a new exclusion ration must be determined.

24
Tax Implications

• If the owner was receiving payments under a joint
  and survivor annuity, the surviving owner
  excludes from income the same percentage of each
  payment that was excludable by the first
  annuitant.
• Assuming that the joint annuitants were joint
  owners
  
• An income tax deduction may be available to the
  survivor owner/annuitant to the extent inclusion
  of the annuity in the estate of the first to die
  generated an estate tax.
• When an owner makes a partial withdrawal from the
  contract and takes a reduced annuity for the same
  term, a portion of the amount withdrawn will be
  subject to income tax.

25
Tax Implications

• When an owner makes a partial withdrawal from the
  contract and chooses to take the same payments
  for a different term, gain will be realized in
  the form of a taxable withdrawal of interest.
• To the extent the cash surrender value of the
  contract exceeds the investment in the contract.
  
• The purchase of a variable annuity is not taxed
  on income during the accumulation period.
  
• No tax will be payable until the earlier of
• The surrender of the contract
• Withdrawal from the contract
• The time payments under the annuity begin
  (annuitization)

26
Tax Implications

• Exclusion ratio for a variable annuity
• Investment in Contract divided by Number of Years
  of Expected Return
  
• If there is a period certain or refund guarantee,
  the investment in the contract is adjusted
  accordingly.
  
• If payments drop below the excludable amount in
  any given year, the annuitant can elect to
  redetermine the excludable amount in the next tax
  year in which he receives an annuity payment.

27
Tax Implications

• If an annuitant dies before the investment in the
  contact has been recovered, a loss deduction can
  be taken by the owner for the amount of the
  unrecovered investment.
• It is an itemized deduction, but not a
  miscellaneous deduction
  
• It is not subject to the 2 floor.
• It can be taken by the estate or any other
  beneficiary

28
Tax Implications

• Amounts payable under a deferred annuity contract
  at the death of an annuitant (prior to the
  contracts maturity) will be partially taxable as
  ordinary income to the beneficiary.
• The taxable amount is equal to the excess of
• The death benefit (plus aggregate dividends and
  any other amounts received tax free), over
  
• Total gross premiums

29
Tax Implications

• Amounts withdrawn before the annuity starting
  date are taxable as income the the extent that
  the policy cash value exceeds the investment in
  the contract.
• Results in a LIFO type of treatment where all
  interest/growth is taxed before any tax-free
  return-of-capital payments can occur.
  
• Interest-first rule Imposed to discourage the
  use of annuity contracts as short-term investment
  vehicles
  
• A loan is considered a cash withdrawal
• To the extent the contract is used as collateral
  for a loan, amounts borrowed will be taxable.
  
• To the extent that the amount received is less
  than or equal to the gain inherent in the contract

30
Tax Implications

• Premature distributions are subject to a
  penalty tax of 10.
  
• Penalty does not apply to the following
• Payments that are part of a series of
  substantially equal periodic payments made for
  the life (or life expectancy) of the taxpayer or
  the joint lives (or joint life expectancies) of
  the taxpayer and his beneficiary
• Payments made on or after the time the contract
  owner becomes age 59½
  
• Payment made on account of the contract owners
  disability
  
• Payments made from qualified retirement plans and
  IRAs
  
• Payments made to a beneficiary on or after the
  death of the annuitant
  
• Distributions under an immediate annuity
  contract
  
• An annuity contract purchased on the termination
  of certain qualified employer retirement plans
  and held until the employee separates from
  service
• Payments allocable to investment in the contract
  before 8/14/1982

31
Tax Implications

• If an annuity owner dies before the starting date
  of the annuity payments, the cash value of the
  contract must either be distributed within 5
  years of death or used within 1 year to provide a
  life annuity or installment payments payable over
  a period not longer than the beneficiarys life
  expectancy
• Spouse can elect to be the new owner of the
  contract

32
Tax Implications

• If the annuity contract is transferred by gift,
  the tax deferral on the inside build up that was
  allowed to the original contract owner is
  terminated.
• The donor of the gift is treated as having
  received non-annuity income in an amount equal to
  the excess of the cash surrender value of the
  contract over the investment in the contract at
  the time of the transfer.
• Tax-free build-up is allowed only to natural
  persons.

33
Tax Implications

• Exceptions from the natural persons rules allow
  tax-free build-up of the following annuities
  
• Annuities received by the executor of a decedent
  at the decedents death
  
• Annuities held by a qualified retirement plan or
  IRA
  
• Annuities considered qualifying funding assets
• Used to provide funding for structured
  settlements and by property and casualty
  insurance companies to fund periodic payments for
  damages
• Annuities purchased by an employer on termination
  of a qualified plan and held until all amounts
  under the plan are distributed to the employee or
  his beneficiary
• Annuities which are immediate
• Those which have a starting date no more than one
  year from the date the annuity was purchased and
  provide for a series of substantially equal
  periodic payments to be made at least annually

34
Alternatives

• Municipal Bond Funds
• The income they produce is exempt from federal
  and, in many cases, state income tax.
  
• Single Premium Life Insurance
• Offers many of the same advantages of annuities,
  but incorporates a death benefit at issuance that
  is higher than the cash deposit
  
• Mutual Funds
• Tax on the capital appreciation of the assets in
  a mutual fund is deferred until the gains are
  realized.
  
• Realized gains are taxed as either long- or
  short-term capital gains, depending on the
  holding period.
  
• All gains and income on the assets in the
  separate accounts of a variable annuity are taxed
  at ordinary income rates.

35
Where and How do I get it?

• Almost all life insurance companies offer
  annuities.
  
• These companies distribute annuities to customers
  through
  
• Life insurance agencies
• Many stock brokerage firms
• Independent insurance agents and financial
  planners
  
• Independent insurance brokerage firms
• Direct to consumers through the mail and
  internet
  
• Variable annuities can only be offered by agents
  who are licensed and who have passed the
  applicable securities examination.
  
• Prospective buyers must be given a prospectus.

36
What fees or other costs are involved?

• There are five typical fees or charges that are
  usually incurred when purchasing annuities,
  particularly variable annuities.
  
• Investment Management Fees .25 to 1
• Administration Expense and Mortality Risk Charge
  .5 to 2
  
• Annual Maintenance Charge 25 to 100
• Often waived once total investments exceed a
  specified amount
  
• Charge per Fund Exchange 0 to 10
• Limited amount of charge-free exchanges per year
• Maximum Surrender Charge
• Vary by company and generally phase-out over a
  number of years
  
• Fees should be listed in prospectus

37
How do I select the best of its type?

• Compare the costs and features of selected
  annuities.
  
• Consider all of the five costs discussed above as
  well as how much can be withdrawn from the
  contract each year without fee.
  
• Compare the total outlay with the total annual
  annuity payment in the case of fixed annuities.
  
• Incorporate time value of money
• In an analysis of variable annuities, evaluate
  the total return for the variable annuity
  sub-accounts over multiple time periods.
  
• Compare the relative financial strength of the
  companies through services such as A.M. Best.
  
• Insist on a credit rating of A.

38
Where can I find out more about it?

• Newspapers
• Wall Street Journal
• Three major statistical sources
• A.M. Best Co
• Lipper Analytical Services Inc.
• Barrons
• Insurance brokerage firms