An annuity is an insurance contract for retirement. An annuity contract is created when an individual gives a life insurance company money which may grow on a tax-deferred basis and then can be distributed back to the owner in several ways.
Phases of an annuity
There are two possible phases for an annuity:
The accumulation Phase : in which the customer deposits and accumulates money into an account.
The distribution phase : in which the insurance company makes income payments until the death of the annuitants named in the contract
Types of life annuity:
Based on Phase: Immediate Annuities & Deferred Annuities
Based on where money goes: Fixed annuities , Indexed Annuities & Variable Annuities
Immediate vs. Deferred Annuity
Immediate annuity is used as a payout vehicle. After a lump sum of money is contributed to the annuity, periodic payments will commence in accordance with your instructions, in ranging from one month to one year.
Deferred annuity can be used as an income-tax-deferred accumulation vehicle by making contributions during accumulation phase. Then funds are invested with your choices that are consistent with your risk-tolerance level. Annuity payout starts after one year.
Fixed Annuity
In accumulation phase, funds are invested in insurance company’s low-risk general account that accumulate fixed interest with minimum guaranteed interest rate set by the company.
In income phase, it provides fixed-dollar period payments based on the payout option chosen. It gives you a safe and secure feeling.
Annuity quotes can be obtained from insurance companies, based on annuitant’s statistics and payout option.
Fixed annuity was popular in the 1970s and 1980s when interest rate was at its peak. Now, guaranteed interest rate is down to 2 – 3% range. It is not a good long term investment vehicle, but only for asset preservation. Fixed annuity is used to fund 412(i) defined benefit plan.
Indexed Annuity
In addition to guaranteed interest account, indexed annuity offers the potential to earn higher interest based on the performance of a certain index, usually S&P 500 Index.
The annual interest compounds a certain percentage of positive gains up to an annually declared cap, e.g., 7%. If index decreases, no interest is credited.
*Some variable annuities have similar guarantees of 7% minimum portfolio increase without upper limit
It provides both upside potential and downside protection.
Variable Annuity
Funds are invested in insurance company’s separate account. The annuitant assumes all investment risks of the sub accounts where the funds are invested in. These sub accounts belong o insurance company’s separate account, which is separate from insurance company’s general account. What if insurance company goes under in this case?
In income phase, payments will vary in dollar amount in accordance with the performance of the investment.
Variable annuity is a good vehicle for long term investment. It is widely used in different retirement programs like 401(k), 403(b), IRAs, etc.
Access to Money
Partial or Complete Withdrawals
Systematic Partial Withdrawals (no surrender charge)
Contract Loans for Certain Qualified Contracts
Annuity Payments (The Income Phase)
•Fixed Annuity Payment Options
•Variable Annuity Payment Options
Lifetime Income with no period certain
Life with Period Certain, 10 or 20 years
Guaranteed Premium Refund
Joint and last survivor income
Qualified vs. Non-Qualified Annuity
Non-Qualified deferred annuity itself is a way of setting side money for future needs like retirement. It provides tax-deferred growth for annuity inside buildup. It is a useful tool for investors with high networth.
When a qualified plan, e.g., 401k, or IRAs, is funded with an annuity, the contracted is referred to as a qualified annuity. The annuity itself does not provide additional tax benefit. The purpose is to use guaranteed benefits of annuity contracts to help protect downside risk of investment
Annuity can fund a qualified plan or IRA under these circumstances:
Traditional and Roth IRA setup, generally $5,000/year, $500 recapture for age above 50
Qualified Plan Rollover to Traditional IRA when the owner leaves the previous employment that offers the qualified plan. The advantage is to take advantage of certain annuity features and enjoy much more freedom of investment choices.
Taxation on Annuity
Inside buildup of annuity value is tax-deferred.
For non-qualified annuity, earnings is taxed as regular income. Tax Reform Act of 1986 specified for funds deposited to the contract prior to 08/14/1982, withdrawals are treated as principal first and earnings last (FIFO), for funds deposited after this date, withdrawals are treated as LIFO, which means withdrawals are taxed immediately.
For qualified plans and IRAs, tax rules on these plans will apply to the corresponding annuity contracts.
Annuity is included in the estate at the time of owner’s death. Income tax has be to be paid by the decedent’s estate and estate tax will be levied as well unless the beneficiary is the spouse.
Advantages of Annuities:
Tax Deferral
Avoidance of Probate
Guaranteed Income (optional) for a fixed period of time,
or income for life
Death Benefit:
guaranteed minimum death benefits
Living Benefit: guaranteed living benefits
Restrictions of Annuity
IRA Rules + Insurance Rules
59 ½ (IRS)
Surrender period (Insurance Company)
Qualified/Non-qualified
Annuitization may apply
IRS Rule 72 T for Annuities and Qualified Retirement Plans
Penalty for pre-59 ½ distribution can be waived if:
Part of a series of substantially equal periodic payments ("SEPPs") not less frequently than annually, made for the life or life expectancy of the employee or the joint lives (or joint life expectancies) of such employees and his designated beneficiary [IRC Section 72(t)(2)(iv)]. The Payments under this exception must continue for at least 5 years or until taxpayer reaches age 59½, whichever is the longer period. If the payments under this exception are changed before the end of the required periods for any reason other than the death or disability of the owner, he or she will be subject to the 10% additional tax.