Annuities, What Every Accountant Should Know
Deborah M. Lavinsky
People approaching retirement have three major concerns: outliving their income, not receiving Social Security and the impact of taxes and inflation on their nest egg. Thanks to healthier lifestyles and medical advances, we are living longer than ever. It is now possible to live 30 or more years in retirement. It is critical that advisors and accountants consider new methods of creating permanent income. Annuities can ease these concerns by guaranteeing an income stream until death by creating a “personal pension plan.” This article will cover annuity basics— types, tax treatment, living benefit and death benefit riders, payout methods, investment options, and learn how to distinguish between good and bad annuities.
What is an annuity?
An annuity is a tax-deferred investment contract issued by a life insurance company. In return for your purchase payments, the issuer agrees to make periodic payments to you (if you elect this option), beginning either immediately or at some future date. The annuity owner is called the “annuitant.”
There are six common reasons for purchasing an annuity:
• Providing income to supplement Social Security, pension plans, and other employer-sponsored retirement plans.
• Creating a lifetime income stream.
• Maintaining financial independence.
• Investing for any specific purpose or long-term goal, such as providing a legacy for your heirs or making a charitable gift.
• Growing funds on a tax-deferred basis.
• Avoiding probate with a named beneficiary.
Annuity premium payments are made with after-tax dollars and are not tax deductible. It is advisable to fund tax-deductible retirement plans like 401(k)s and IRAs first. However, if the maximum has already been contributed to these plans and one wants to save more towards retirement, an annuity can be an excellent choice.
How soon is income needed?
Immediate annuities start providing income shortly after money is deposited in a lump sum. They are designed to pay out an income stream for a desired period of time or life. The payments are calculated based on the amount of the premium payment and the age of the annuitant. Once the payments begin, they are irrevocable. Each distribution is part tax-free return of premium and part ordinary income, depending on the age and the distribution method. Immediate annuity payments are often used to guarantee long-term care costs.
If income is not needed right away, a deferred annuity has an accumulation period, during which the annuity value grows over time and a payout period that is deferred until a later date. Deferred annuities are commonly used for retirement planning and have many different options for accumulation and payout.
Annuities can be funded with a single premium or flexible premiums. Examples of a single premium would be a pension distribution or an inheritance. Flexible premiums allow for a series of payments over time as allowed by the contract.
Types of Annuities
Fixed annuitiesoffer a fixed interest rate, that may change at any time. Fixed annuity contracts offer a guaranteed minimum rate of interest. The insurance company assumes the risk for the annuity account value. Fixed annuities can be an appropriate choice for clients with a low risk tolerance to principal fluctuation.
Variable annuities(VAs) offer greater potential growth than fixed annuities; however the contract owner assumes all of the investment risk. The premiums are invested in one or more professionally managed sub-account portfolios that can contain stocks, bonds, and cash equivalents. Annuitants can benefit from asset allocation strategies with VAs. The issuer may collect fees for administration, sub-account fees, investment advisory, and mortality and expenses directly from the investment return.
Equity-Indexed Annuity (EIA) is a third type of annuity that falls under the fixed category, but has been confused with variable annuities. An EIA uses stock market indexes (ex. S&P 500, NASDAQ 100) to credit interest to the annuity. The method that the interest is credited can vary with individual EIA contracts, but the important thing to remember is that the contract value is not invested in the stock market. EIAs can offer the potential of a greater return than a traditional fixed annuity without the downside risk potential of direct stock market investing.
Annuities have a surrender charge, which is a contingent deferred sales charge. Essentially, the annuitant must continue the contract over a stated period of time or be penalized for withdrawing the money prematurely. Most contracts do allow for partial withdrawal, typically 10-15 percent of the contract value per year. Many contracts offer waivers of the surrender charge for disability or nursing home care. The surrender charge is separate from the IRS tax and penalties for early withdrawal. This is another key component of determining the suitability of using an annuity.
Deciding on a payout method is an important and frequently irrevocable decision. Annuitization means giving control of the contract to the insurance company in exchange for a lifetime income guarantee. To receive the largest payout choose the “straight life” option, however if the annuitant dies just one day into the payout period, the balance of the contract value remains with the insurance company. Choosing “life with period certain” avoids that scenario in that death within the “period certain” will give the remaining payments to named beneficiaries. “Joint and survivor” pays a benefit to the annuitant and the spouse until the last person dies. Sometimes the payment decreases after the first death. Many pension plans use this method. One can choose a lump sum payment or flexible payouts without annuitizing.
Distributions are first made from any gains/interest earned and taxed at ordinary income rates; tax-free return of premium is distributed last (LIFO). A 10 percent IRS penalty is assessed on the gains withdrawn before the annuitant reaches age 59 and a half years old.
Annuity Innovations
Variable annuities offer an innovation called “living benefits” or GMIB. Living benefits can include guaranteeing future income over a period of time, principal protection, locking in contract gains, and guaranteeing a minimum income payment no matter what happens to the contract value due to stock market fluctuations. Some contracts require annuitization (giving control of the contract to the insurance company in exchange for a lifetime income guarantee) and some contracts allow the annuitant to utilize the GMIB without annuitization. Another innovation is a guaranteed minimum death benefit (GMDB). This allows for the greater of the full contract value or the purchase payments to be paid at the death of the annuitant, less any withdrawals. Both the GMIB and GMDB benefits may have additional fees, but do provide a level of insurance that mutual funds and stocks do not have.
I am often asked, how does one distinguish between a “good” annuity and a “bad” annuity? Knowing your client and determining suitability is your first step. Second, read the fine print. Does the contract offer a large interest bonus— if so, how many years does the contract owner have until the surrender period is over? Does the contract owner have to annuitize to receive any bonuses or guarantees? If so, is the contract owner aware that it is an irrevocable decision? It is important that all disclosures have been discussed with the client and documented appropriately. Lastly, strong insurance company ratings should also be a consideration in purchasing annuities, especially if a long deferral period is anticipated.
As many baby-boomers dream of retiring early, they are blissfully unaware that they may spend as many years in retirement as they did in the workforce. They therefore run the risk of outliving their money unless they plan accordingly. Advisors and accountants would serve their clients well to consider and utilize the new innovations of annuities to protect their clients’ hard-earned nest eggs.
Deborah M. Lavinsky, Investment Advisor Representative, Kokopelli Financial, LLC assists her clients with accumulating, protecting and transferring their wealth. For more information on annuities and retirement planning, Deborah can be reached at (602)795-4934 or deb@kokopellifinancial.com.
AZ CPA – June 2006
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