8 - 1 Annuities What are they? Contracts providing for the systematic liquidation principal and...

8 - 1

Annuities

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

Chapter 8Tools & Techniques of Life

Insurance Planning

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Annuities

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


Insurance Planning

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Annuities

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


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Annuities

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


Insurance Planning

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Annuities

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


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Annuities

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


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Annuities

Advantages Guarantees of safety, interest rates and lifelong income

Protects and preserves person’s 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


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Annuities

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


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Annuities

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 2&1/2% 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


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Annuities

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


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Annuities

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)


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Annuities

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


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Annuities

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


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Annuities

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


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Annuities

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 IRA’s 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 14 th, 1982


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Annuities

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


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Annuities

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 P&C companies funding periodic payments for damages

Annuities purchased by an employer on termination of a qualified plan

Immediate annuities


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Annuities

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


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Annuities

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


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Annuities

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


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Annuities

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 / Moody’s/ Standard & Poor’s


Insurance Planning

8 - 1 Annuities What are they? Contracts providing for the systematic liquidation principal and...

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