What are they

1
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• What are they?
• Contracts providing for the systematic
  liquidation principal and interest in the form of
  a series of payments over a period of time
• Taxation is governed by IRC section 72
• Accumulation phase
• Investor makes cash payments to the insurance
  company
• The money remains invested with the insurance
  company and is periodically credited with some
  growth factor
• Payout phase
• The insurance company agrees to pay the owners a
  specified amount (the annuity payments)
  periodically beginning on a specified date

2
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• What is it? (cont'd)
• Immediate annuity
• Payout begins within one year of the date the
  contract is established
• Deferred annuity
• Payout begins more than one year of the date the
  contract is established
• Life annuity
• Payouts will continue as long as the annuitant
  lives
• Fixed period annuity
• Company promises a payout for a fixed or
  guaranteed period of time, independent of the
  survival of the annuitant
• Combination of life and fixed period payout
• Example For the greater of ten years for the
  life of the annuitant

3
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• What is it? (cont'd)
• Fixed annuity
• Invested in the general fixed account of the
  insurance company
• Variable annuity
• Invested in the separately managed sub-accounts
  selected by the annuity owner
• Additional features
• Guaranteed death benefits
• Living benefits - company guaranteed benefits
  for owners or beneficiaries
• That would be higher than actual investment
  performance would provide for
• Variable annuitization
• Payments fluctuate depending on the investment
  performance of the underlying sub-accounts

4
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• What is it? (cont'd)
• Taxation
• Accumulation phase
• Growth is tax deferred
• Withdrawals during this phase are taxed on a LIFO
  basis
• Withdrawals are consider to be withdrawals of
  growth first and principal second
• Payout phase
• A portion of each payout is considered a return
  of principal
• A portion of each payout is considered interest
  or growth
• Calculation of those portions (the exclusion
  ratio) depends on the principal invested, the
  period of the payout and an internal growth
  factor for the payout period

5
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• When is the use of this tool indicated?
• When a person wants a retirement income that
  cannot be outlived
• When an individual wants a retirement income
  higher than their other conservative investments
  and is willing to have principal liquidated
• To avoid probate and pass a large sum of money by
  contract to an heir and reduce the possibility of
  a will contest
• When tax deferred growth is desired for an
  investment
• When an investor wants to be free of the
  responsibility of investing and managing assets
• As a supplement to an IRA

6
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• When is the use of this tool indicated? (cont'd)
• For fixed annuities
• Safety of principal is paramount
• Investor wants guarantee level of interest
• When a conservative complement to other
  investments is desired
• For variable annuities
• When an investor wants more control over the
  investments and is willing to bear the risk
• When a person is looking for potentially
  increasing retirement income
• When an individual desires to be invested in
  variable sub-accounts
• But also desires some aspect of risk management
• Guaranteed death benefits / living benefits

7
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Advantages
• Guarantees of safety, interest rates and lifelong
  income
• Protects and preserves persons cash reserves
• Allows investment in the market while moderating
  risk
• Client can time the receipt of income and shift
  it into lower tax bracket years
• Annuity paying the same rate of interest as a
  taxable investment will result in a higher
  effective yield
• Variable annuities client may take on greater
  risk in the underlying investment options
  (equities, small market capitalizations, high
  yield bonds etc.) while still maintaining a
  reasonable risk exposure due to the underlying
  guarantees

8
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Advantages (cont'd)
• Adjusted Gross Income (AGI) may be reduced in
  years where the annuity id held without
  withdrawals
• Lower taxable income may be recognized during the
  payout phase
• Due to partial recovery of basis associated with
  each payment
• Disadvantages
• Receipt of lump sum could result in significant
  tax burden
• Income averaging may not be available
• Cash flow received may not keep pace with
  inflation
• A 10 penalty tax imposed on withdrawals prior to
  age 59 ½

9
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Disadvantages (cont'd)
• Corporate owned annuities
• Growth is subject to taxation
• Liquidation in the early years
• Management, maintenance fees could prove
  expensive
• Management fees and mortality charges could run
  from 1 to 21/2 of the value of the contract
• Back end surrender charges
• Investment earning taxed at owners ordinary
  income tax rate
• Regardless of the source or nature of the return
• Returns associated with long term capital
  appreciation do not enjoy the capital gains tax
  rate

10
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Tax implications
• Exclusion Ratio Formula
• Investment in the contract
• Expected Return
• Applies to each annuity payment equally
  throughout the payout phase
• Example 70 yr old pays 12,000 for the annuity.
  His expected return throughout the payout phase
  is 19,200.
• The exclusion ratio is 62.50
• If the monthly payment is 100, then
• 62.50 is considered a return of principal
• 37.50 is considered taxable income
• Once the entire investment in the contract has
  been recovered, then 100 of each annuity payment
  received is taxable income

11
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Tax implications (cont'd)
• Expected Return
• Total amount the annuity owner should receive
• Payments specified x life expectancy (or term
  certain if elected)
• Life expectancy based on IRS Table V (single
  lives) or Table VI ( joint lives)
• If annuitant dies before receiving the full
  amount guaranteed under a refund or period
  certain annuity
• Balanced received will not be taxed (unless it
  exceeds the investment in the contract)
• For joint and survivor annuities
• Surviving owner excludes from income the same
  percentage of each payment that was excludible by
  the first annuitant
• An income tax deduction may be available to the
  survivor owner to the extent inclusion of the
  annuity in the estate of the first annuitant
  generated an estate tax (IRD)

12
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Tax implications (cont'd)
• Owner makes a partial withdrawal and takes a
  reduced annuity
• Partial withdrawal subject to income tax
• Owner takes a partial withdrawal chooses same
  payments for different term
• To the extent cash value exceeds investment in
  the contract, gain will be realized in the form
  of a taxable withdrawal of interest
• Variable Annuities
• No tax will be paid until the earlier of
• Surrender of the contract
• Withdrawals from the contract
• Time that payments commence from the annuity
• To obtain annuity treatment the underlying
  investments must be adequately diversified under
  IRS regulations

13
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Tax implications (cont'd)
• Variable annuities (cont'd)
• Different Exclusion Ratio
• Investment in the contract
• of years of expected return
• Example
• Male 65 purchases variable annuity for 20,000
• Life expectancy of 20 years (Based on Table V)
• He can exclude 1,000 from each payment (20,000
  / 20)
• Assume at age 70 he receives only 200 (800 less
  than his excludible amount)
• Assume at age 70 his life expectancy is 16 years
• He can add 50 (800/16) to his 1,000 excludible
  amount

14
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Tax implications (cont'd)
• Annuitant dies before payments received equal
  cost
• Loss deduction allowed
• For amount of un-recovered investment
• itemized deduction
• Amounts payable under a deferred annuity at the
  death of annuitant
• Partially taxable as ordinary income to the
  beneficiary
• Equal to excess of death benefit over gross
  premiums
• Dividends, loans, cash withdrawals and other
  amounts taken out before the annuity starting
  date
• Taxed as ordinary income to extend the cash value
  exceeds the investment in the contract
• LIFO basis

15
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Tax implications (cont'd)
• Premature Distributions
• Subject to ordinary income tax plus 10 penalty
  tax
• Tax applies to amount of distribution included in
  income
• Penalty for premature distributions does not
  apply to
• Payments that are part of a substantial equal
  periodic payments made for life
• Payments on or after age 59½
• Payments made on account of contracts owner
  disability
• Payments from qualified retirement plans and
  IRAs
• Payments to beneficiary after death of annuitant
• Distributions under an immediate annuity contract
• Annuity purchased on the termination of certain
  qualified employer retirement plans
• Payments allocable to investment in the contract
  before August 14th, 1982

16
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Tax implications (cont'd)
• If annuitant dies before annuity starting date
• Cash value must be distributed within 5 years of
  death or
• Used within one year to provide for a life
  annuity or installments payments not longer than
  the beneficiaries life expectancy
• If spouse is the beneficiary
• Spouse can elect to become the new owner of the
  contract instead
• Annuity contract transferred by gift
• Tax deferral allowed on the inside build-up is
  terminated
• Tax-free build-up is allowed only to natural
  persons
• For non-natural persons income is treated as
  ordinary income in the year received

17
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Tax implications (cont'd)
• Tax-free build-up is allowed only to natural
  persons
• For non-natural persons income is treated as
  ordinary income in the year received
• Exceptions
• Annuities received by the executor of a decedent
• Annuities held by a qualified retirement plan or
  IRA
• Annuities considered qualifying funding assets
• Structured settlements
• PC companies funding periodic payments for
  damages
• Annuities purchased by an employer on termination
  of a qualified plan
• Immediate annuities

18
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Alternatives
• Municipal bond funds
• Income exempt from federal and some state income
  taxes
• Money can be withdrawn without tax penalty
• Example - Taxable equivalent yield of 8.6 for a
  bond yielding 6 (30 tax bracket)
• Disadvantage
• Lack of guaranteed return
• Potential for capital losses
• If interest rates rise and bonds sold before
  maturity
• Single Premium Life Insurance

19
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Alternatives (cont'd)
• Single Premium Life Insurance
• Tax free death benefit
• Tax deferred growth of cash surrender values
• Withdrawals loans subject to LIFO taxation and
  10 penalty if distribution occurred before age
  59 1/2
• Mutual funds
• Do not enjoy tax deferred accumulation
• Tax on capital appreciation is deferred until
  gains are realized
• Realized gains are taxed either as short term or
  long term gains
• Step up in basis at death

20
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Fees and acquisition costs
• Investment management fees
• Typically from .25 to about 1
• Administrative expense and mortality risk charge
• Typically from a low of about .5 to as high as
  2
• Annual maintenance charge
• Typically 25 to 100
• Charges per fund exchange
• 0 to 10.
• Some companies permit a limited number of
  charge-free exchanges per year

21
Annuities
Chapter 8 Tools Techniques of Life Insurance
Planning

• Fees and acquisition costs (cont'd)
• Maximum surrender charge
• Vary from company to company
• Generally phase out over a number of years
• Selecting the best policy
• Spreadsheet costs and features
• Fixed annuities compare the total outlay with
  the total annual annuity payments
• Variable annuities - Evaluate the total returns
  for the variable annuity sub-accounts over
  multiple time periods
• Morningstar and Lipper Analytical Services Inc.
• Compare the relative financial strength of the
  company
• Rating agencies - A.M. Best / Moodys/ Standard
  Poors