When you think about annuities, what comes to mind? Perhaps you think about retirement planning, fees and penalties, bad investments, or a great wealth protection strategy. Do you really understand what an annuity is in terms of the good, bad and in between?
Today’s article will explore all aspects of annuities to try to offer a better understanding and starting point for evaluating what can be, in the right circumstances, a powerful financial tool. This article will be a broad overview and future articles on key areas will follow.
To fully understand annuities, the first important aspect to note is that, just like other insurance products, regardless whether we’re talking about convertible term life insurance, whole life insurance, universal life insurance, etc., annuities are a contract between the policy owner and the insurance company.
The History of the Annuity
The history of the modern annuity extends back to the Roman Empire and continued through the ages as a way to deposit a lump sum in exchange for a life time monthly payment. Annuities have not always been used for retirement. Under what was called the “tontine system” in England during the 17th and 18th centuries, annuities were used to provide the government with revenues to fight wars with France. English investors would purchase shares in an annuity plan (tontine) that would provide them with annual payments for life. The downside of the tontine system was that those who lived longest accrued considerable wealth at the expense of the other deceased participants.
Reforms of the tontine system in the mid 1700s lead to the first group annuity contracts and throughout the 19th century, annuities were only available through group contracts. If you weren’t part of the group, you couldn’t get an annuity. The first individual annuity in the United States was issued in 1912, although the safety and security that are foundations are the annuity’s appeal, as is the case with traditional whole life insurance, was NOT fully appreciated until the Great Depression of the 1930’s when their popularity took off.
As annuities became popular in the 1930s, the I.R.S. of course became interested and this led to a 1939 court case, Bodine v. Commissioner of Internal Revenue, to define what an annuity is to present day. The court defined an annuity as “a sum paid yearly or at other specified intervals in return for a payment of a fixed sum by an annuitant” and that the “annuity itself is the totality of the payments to be made under the contract”.
Understanding the Modern Annuity Contract
It is important if you’re considering an annuity to fully understand the contractual nature of the product. Just like any other contract, you need to understand the OBLIGATIONS of the PARTIES who are the insurance company (insurer) AND the owner (insured) before signing on the dotted line. There are a few important aspects to this contract to understand:
- Unilateral Contract
- Premium Payments
- Annuity Start Date (ASD)
- Annuity Costs
Annuities are a Unilateral Contract
Unilateral vs. Bilateral Contract is legal mumbo jumbo to describe whether only one party or both parties are bound to the performance of the contract. Annuities are unilateral because the annuity owner is NOT legally obligated to maintain the contract. ONLY the insurance company is legally obligated to perform as long as the owner fulfills his/her responsibilities under the contract. For the owner, the annuity contract may be surrendered at any time as will be discussed in more detail to follow.
Annuity Premium Payments
Annuities that are sold by life insurance companies are “cash based” contracts that are purchased with either a “single premium” or through a “series of premium payments”. This means that like other types of life insurance, the contract can either be funded by lump sum or series of installment payments.
Annuity Start Date
By definition, an annuity is an income stream funded by the liquidation of a sum of money (premium). Thus, all annuities have an annuity start date (ASD) which is when the income stream that is guaranteed for a specified period of time begins (based upon when the sum of money is “converted”). If an insurance contract is NOT issued with ASD, they fail to meet the I.R.S. definition of an annuity. The insurance company is legally bound to convert the sum of money into the specified monthly income stream.
ASD Tip: The decision to receive payments is usually irrevocable once the decision is made to annuitize the principal sum; however, the ASD is not set in stone and may be changed by the owner.
Like all other permanent life insurance products, there is a cost for the insurance protection that is part of owning an annuity. The issue of administrative costs are always a hot topic for both proponents and naysayers of life insurance alike. Just like life insurance, it can be difficult for consumers to figure out how and where insurers make their money due to the intangible nature these products.
Both annuities and life insurance contracts have expense charges that rely on assumptions of the future interest to be earned on contract funds. Annuities have a type of mortality charge that is a kind of “survivorship factor”. The key is that the consumer is required to receive a full disclosure of contract fees and charges.
Immediate vs. Deferred Annuity Contracts
Immediate annuities are funded with a single premium and the ASD would be immediate (because every annuity contract is an ASD). The principal sum would convert immediately into the stream of payments.
Deferred annuities, in contrast, delay the ASD to a future date chosen by the annuity owner and may either be funded by a single premium or a series of premiums. The ASD is flexible; however, it is important to remember that once payments begin, the decision to convert and annuitize is NOT revocable.
Strategic Tip: In general, deferred annuity contracts will be looked at with more scrutiny when marketed to seniors because they are typically used for tax deferred wealth accumulation as opposed to short term retirement planning.
Options for Annuity Investments
Annuities began, as did permanent life insurance, with a simple and clear contractually guaranteed rate of return based upon the insurance company’s general account. This model lasted into the early-1950s when life expectancy and retirement planning began to change. This changing market inspired the advent of variable annuities, and thereafter indexed products of various types.
Modern annuities offer a variety of investment options which include:
- Fixed Interest Annuities
- Variable Annuities
- Indexed Annuities (Interest and Equity)
Fixed interest annuities (FIA)
The Fixed Index Annuity (FIA) are the most conservative option in the annuity investment sphere, similar to participating whole life insurance, and are thus most appropriate as a safe bucket investment , as defined by Robert Kiyosaki, for those in need of a fixed and perhaps conservative guaranteed rate of interest. This approach may be most appropriate for many seniors with relatively short investment time frames.
These type of annuity are on the other end of the spectrum, similar to variable life insurance, and offer investment opportunities in the financial markets that are similar to mutual funds. This approach offers the highest potential for long term gains but also carries a greater risk of market losses than other approaches. Thus, variable annuities are most appropriate for those with an understanding and tolerance for risk and a relatively longer term investment time frame.
Indexed annuities are in the middle of the spectrum, similar to indexed universal life insurance, in offering safety of principal though a fixed interest feature AND the opportunity to gain returns by tying to any number of market indexes. Within the genre of indexed annuities, an interest indexed annuity would perhaps be more conservative than an equity indexed annuity with the comparison being the former tying the return to the bond index verses the S&P 500.
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Tax Treatment of Annuities
Annuity Premiums and Cash Value Accruals
Annuity premiums are NOT tax deductible unless they are Qualified Annuities vs. Non-Qualified Annuities. Annuities are never qualified UNLESS they are part of a QUALIFIED RETIREMENT arrangement in which case, premiums can be deducted in the same way that the I.R.S. allows deductions for other qualified plans such as IRA and 401(k) plans for retirement. Qualified annuities also are accompanied by the 10% penalty for withdrawals (similar to IRAs and 401(k) plans), for withdrawals taken prior to age 59 1/2.
Cash value accruals that are part of a deferred annuity are afforded deferred income taxation until withdrawn in a manner that is similar to the tax advantages of cash value life insurance. This tax deferred growth is a key feature of deferred annuities.
Tax Deferral Tip: tax deferred growth is NOT really tax free growth because ultimately taxes are due on the GAIN realized in the deferred annuity. Even if taxes were being paid, they would likely be paid with funds outside of the annuity, and thus the cash would accrue the same way. The difference with permanent life insurance is that withdrawals are NEVER required, and thus the tax free growth may never be taxed, and even if proceeds are taken in the form of a life insurance policy loan, these proceeds aren’t taxed either.
Capital Gains vs. Ordinary Income
Tax laws pertaining to annuities recognize gain as ordinary income verses capital gains and this can result in a much higher tax load on any distribution of annuity proceeds. This is an important consideration when looking at the end game for purchasing an annuity.
Penalties for Early Distributions
In order to stop people from using deferred annuities as short term investments and thus remedying their perception of an “unfair advantage” by the annuity companies, Congress passed the Tax Equity and Fiscal Responsibility Act of 1982, which drastically altered the taxation of deferred annuity withdrawals and distributions.
The tax laws require that distributions are first taxed as interest, and thus are immediate income and this is known as the last in first out approach (LIFO).
Also, the IRS does NOT make a distinction between full surrender and partial withdrawals for distribution made prior to the ASD.
The take away here is that the tax laws are in place to make people use annuities for the intended purpose which is to provide a stream of payments to the annuity owner based upon his/her life expectancy. It is also important to remember that tax consequences are separate from any surrender charges that may be required by the insurance company.
Regular Annuity Payments and Return of Basis
If the rules are followed, then the tax treatment becomes favorable because only a portion of the annuity income payments are typically taxed. The rule, similar to the tax treatment of distributions from a permanent life insurance policy, basically says that a portion of the regular payment is categorized as as a non-taxable return of basis and the remainder is taxable as income.
Policy Loans, Assignments and Gifts
Like other types of cash value life insurance policies which allow policy loans, most annuity contracts allow owners to borrow against the annuity contract’s accumulated cash value.
However, for annuities, policy loans DO NOT avoid the tax consequences that apply to premature distributions (prior to the ASD).
Like life insurance policy loans, loans secured by annuity cash value do not have to be repaid, and this means that they are subject to taxation just like any other “discretionary” distribution that is by definition NOT an annuitized payment.
Assigning an annuity contract to a third party is ALSO treated as taxable distribution as is the sale of a deferred annuity contract to a third party because there is presumably some kind of value exchanged. If no value is exchanged then gift taxation applies to the annuity contract.
Making a gift of an annuity contract potentially exposes the owner to both income and gift taxes under the current tax laws.
1035 Exchanges of Annuity Contracts
Just like tax free exchanges of “like kind” real estate under section 1031 of the I.R.S. Code and other exchanges of life insurance under section 1035, annuities may also be exchanged without taxation subject to some very important rules.
- A life insurance policy CAN be exchanged for an annuity contract.
- An annuity contract CAN be exchanged for another annuity.
- An annuity CANNOT be exchanged for a life insurance policy due to certain tax advantages of cash value life insurance that are not found in annuities.
Practical Tip: It is common reminder that a replacement contract, whether in the annuities or life insurance arena, must be well justified in order for the salesperson to pass scrutiny concerning things like “churning” or other tactics not in the consumer’s best interest.
Taxation of Distributions at Death
Death benefits for annuities mostly concern deferred annuities because the owner may die prior to ever receiving payments. Unlike most life insurance policies, the amount of death benefit will often depend upon the income taken from the contract. The death benefit to the owner’s beneficiaries may also depend upon the type of annuity contract and a formula used to calculate the remaining account value. The rules for calculating the death benefit, particularly for deferred annuities, can vary based upon the contract and state laws.
At the time of this writing, although this may be changing, the step up in basis that is afforded other types of assets upon death is NOT available for annuities. This is an important consideration when thinking about how annuities relate to your estate planning and federal estate taxes. Also, upon the annuity owner’s death, the estate is typically responsible to pay taxes on the income in respect to decedent (IRD).
Suitability Issues with Annuities
It is important to understand that certain types of annuity contracts may be deemed inappropriate for certain types of consumers. This issue is probably responsible for a certain amount of bad press that sprang up years ago surrounding deferred annuities that were being aggressively and inappropriately marketed to seniors.
Typically, deferred annuities may NOT be suitable for seniors who need regular income retirement as opposed to long term tax deferred growth.
Another aspect of suitability relates to the restrictions with deferred annuities, tax ramifications and surrender charges. If more control and liquidity is needed concerning the account, then a deferred annuity may be entirely unsuitable.
Annuity Pros and Cons
It’s time to distill all of the above down to some PROs and CONs that will only be touched on here and expanded in a future article.
- Predictable Income Stream for Life
- Insurance Protection
- Tax Deferred Account Accumulation
- Long Term Care Planning
- Asset Protection
Deferred and immediate annuities offer the ability to gain a guaranteed income stream for life (based upon life expectancy).
This is offered in a contract backed by the credit of a top rated life insurance company. Depending upon the investment structure, you can either lock in a conservative guaranteed rate of interest or opt for potential higher indexed based or even market based variable returns.
All products generally include protection against losses based upon a floor. In addition to protecting the income stream, deferred annuity contracts provide death benefit protection in the event the owner dies prior to receiving payments, and this is a safeguard when deferring payments to obtain the tax advantages.
Tax deferred growth is another pro despite the precautions mentioned above because taxes not paid now can theoretically be invested in other opportunities such real estate or permanent life insurance for infinite banking.
Long term care planning is offered as an additional benefit or long term care rider to many annuity contracts. This is important because long term care insurance planning is a critical part of asset protection and wealth preservation.
Most states afford some level of asset protection for the cash value in annuity contracts and with states like Texas and Florida offering the highest level of protection.
Restrictions on liquidity due to early withdrawal penalties for deferred annuities prior to the ASD are a significant drawback for those who want available capital for investments. In this situation, using a life insurance policy for wealth building and adopting an infinite banking strategy with life insurance may be a preferred option.
Tax ramifications, (the LIFO rules) for early withdrawals and the lack of step up in basis at death are two important drawbacks to consider.
In addition to tax consequences, most insurance companies have surrender charges for early account withdrawals as a way to protect themselves against early withdrawal of premiums prior to the ASD. It is therefore important to understand your annuity contract surrender charges.
The most important aspect of considering annuities is thorough due diligence and making sure you understand all aspects of the contract. Stay tuned for an in depth look at the topics touched on above and as always, reach out if you’re ready to learn more about what options are available to you.