Annuities

· Annuity Basics

· Single Premium Immediate Annuity

· Deferred Annuity

· Annuity Advantages

· Annuity Tax Facts

· Annuity Concepts (Triple-Split Annuity)

 

What is an annuity?

To put it simply, an annuity is a contract between an individual (called the annuity owner) and an insurance company for an interest-bearing policy with guaranteed income options. These income options are payments made from the principal and interest applied within the annuity and can be guaranteed for the lifetime of the individual or for a specified period of time. The annuity can be further categorized into two types — the Single Premium Immediate Annuity or SPIA, and the Deferred Annuity.

 

Single Premium Immediate Annuity

What is a Single Premium Immediate Annuity, or SPIA?

A SPIA, commonly referred to as an immediate annuity, makes it possible for an individual to turn a lump sum of cash into a guaranteed income stream. Unlike the deferred annuity, which is allowed to accumulate interest over time, an immediate annuity skips the accumulation phase and begins to issue income payments soon after it is purchased — usually after 30 days. How does an immediate annuity work?

After an immediate annuity is purchased, the owner must select an income payment option, which is known as a settlement option. The settlement option determines how the insurance company will distribute the income payments. For example, if a “Life” option is selected, the insurance company will provide the owner with an income for as long as he or she lives — guaranteed. This payment option is based on the life expectancy of an individual known as the “annuitant,” which may or may not be the owner. (In some cases it is also possible to receive payments over the combined life expectancies of both the annuitant and his or her spouse.) The amount of each payment is determined by the frequency of the payment, the size of the original premium, the interest applied and the annuitant’s life expectancy. If a “Period Certain” option is selected, the insurance company will provide an income payment for a specified period of time, such as 10 years. Once a payment option amount has been established, it cannot be changed. (These examples are only two out of a variety of settlement options available. Please click here for more information on other possible settlement options such as “Life with Period Certain,” “Joint and Survivor,” ”Cash Refund,” “Installment Refund,” etc.)

 

How much of the periodic payment is taxable on a non-qualified immediate annuity?

On a non-qualified annuity only, each payment is part nontaxable return of principal and part taxable interest income. In order to determine what percentage of the monthly payment is nontaxable, the Exclusion Ratio must be applied. The Exclusion Ratio for each individual annuity is the ratio of the total investment to the total expected return. For example, if the investment in the annuity is $12,650 and the expected return is $16,000, the Exclusion Ratio is $12,650 divided by $16,000 — which equals 79.1% (rounded to the nearest tenth of a percent). Hence, if the monthly payment is $100, the portion that is nontaxable is $79.10 (79.1% of $100), and only $20.90 a month is taxable.

 

Who should consider buying an immediate annuity?

Immediate annuities are commonly used for individuals who have already retired and need annuity income right away. This type of annuity is also commonly used for an individual who is concerned about outliving his or her income, because if an annuitant chooses a “Life” settlement option, the income payments are guaranteed to continue as long as he or she lives — even if the annuitant outlives his or her life expectancy.

 

What are some other benefits of an immediate annuity?

In addition to the feeling of security that comes from knowing you cannot outlive your income, there are many other reasons to purchase an immediate annuity. First of all, immediate annuities offer simplicity because you do not have to manage your investment or even watch the market, and the payments can be deposited directly into your banking account. Annuities also offer an additional tax benefit on investments that are non-qualified because part of each check is a nontaxable return of your original investment, which results in lower annual income taxes.

 

Deferred annuity

What is a deferred annuity?

A “deferred” annuity is one that defers or postpones the payment or income options until a future point in time after purchase, as opposed to an immediate annuity, which starts the payments right away or at least within one year of purchase. “Deferred” can also mean “tax-deferred,” which means postponing your taxes on interest earnings until a future point in time. This is possible under Internal Revenue Code (I.R.C.) Section 72(e), which states that interest earned in an insurance contract (an annuity is an insurance contract) is not taxable to the owner until it is withdrawn. As long as the funds remain with the insurance company, the interest can accumulate completely tax deferred.

 

What are the phases of a deferred annuity?

A deferred annuity is made up of two phases: an accumulation phase and an annuity payout phase, which is also called annuitization.

The Accumulation Phase begins when a deposit of premium is used to purchase a deferred annuity. Some deferred annuities are purchased with a one-time payment of premium. With this type of deferred annuity, called a Single Premium Deferred Annuity, no additional deposits of premium are allowed. If an individual wants the ability to add monies to the deferred annuity after the initial deposit, he or she must purchase a Flexible Premium Deferred Annuity, which allows the owner to add monies either systematically or at random.

It is during the accumulation phase (which usually lasts 5 to 10 years or longer), that the deferred annuity earns interest. The interest rate for each deferred annuity is determined at the time of purchase by the individual insurance company that is selling the contract. These rates vary from company to company and can fluctuate on a yearly basis. However, deferred annuities are guaranteed to earn at least a minimum interest rate for the life of the contract, usually around 3.0%. Some deferred annuities will have a declared interest rate guaranteed for multiple years, rather than one year at a time. These deferred annuities are called Multi-Year Guarantee Annuities and the guaranteed rate also becomes the minimum guaranteed rate for the specified term.

According to I.R.C. Section 72(e), no interest earned during the accumulation phase will be reduced by current state or federal taxes in the year it is earned, but is left untouched to earn even more untaxed interest. In this way a deferred annuity can accumulate more money over a shorter period of time, often called tax-deferred growth. This tax-deferred growth will ultimately provide a greater annuity income or return on investment. One of the benefits of tax-deferral is the effect of “triple compounding,” which means that the deferred annuity is earning interest on principal, interest on interest and interest on the money that normally would be paid in taxes.

The Annuity Payout Phase is when the funds are paid out according to the method selected by the owner. The owner must select an income payment option, which is known as a settlement option. The settlement option determines how the insurance company will distribute the income payments. Annuity owners may opt to receive a “lump sum” payment, meaning that the owner simply receives the total accumulation value of the annuity (premium plus interest less any withdrawals) in a check or has it directly deposited to his or her bank account. (If the funds are received in this manner, the owner must claim all of the interest earned as taxable income for the current year.)

If an owner does not wish to select a “lump sum” option, he or she may choose an income payment option known as “annuitization.” For example, if a “Life” option is selected, the insurance company will provide the owner with an income for as long as he or she lives — guaranteed. (In some cases it is also possible to receive payments over the combined life expectancies of both the annuitant and his or her spouse.) If a “Period Certain” option is selected, the insurance company will provide an income payment for a specified period of time, such as 10 years. The amount received for each payment is determined by the annuity’s total accumulation value, the applicable interest applied and the specified period of time. If a “Life” option or a “Life with Period Certain” option is selected, then the life expectancy of the annuitant is also factored in to determine the payment amount. Once this payout option has been established, it cannot be changed. These examples are only two out of a variety of annuity payment options available. Please click here for more information on other possible settlement options.

 

How much of the periodic payment is taxable?

On “qualified” annuity distributions, the entire payment is taxable to the owner. On “non-qualified” annuity distributions, each payment is part nontaxable return of principal and part taxable interest income. In order to determine what percentage of the payment is nontaxable, an Exclusion Ratio must be applied. The exclusion is the ratio of the total investment to the total expected return. For example, if the investment is $100,000 and the expected return over 10 years in payout is $156,393, the Exclusion Ratio is $100,000 divided by $156,393 — which equals 63.9% (rounded to the nearest tenth of a percent). If the monthly payment is $1,000, the portion that is nontaxable is $639.00 (63.9% of $1,000), and only $361.00 a month is taxable. (Note: The actual Exclusion Ratio for an annuity depends on several factors including current rates and the selected settlement option. This example only demonstrates the general concept and is not an exact calculation.)

 

Can any money be withdrawn during the accumulation phase?

Many deferred annuities allow the owner to take up to 10% of the accumulation value each year without surrender or withdrawal charges. There are also many insurance companies that allow the annuity owner to make systematic withdrawals of interest earnings with no charges. However, it is important to remember that annuity distributions received prior to age 59 ½ may be subject to a 10% IRS tax penalty (excise tax), unless the specifications of Pre-LERO (I.R.C. Section 72(t)) are followed. If you are under the age of 59 ½ and want to learn more about the beneficial Pre-LERO option.

 

What is an “early surrender charge”?

Deferred annuities are designed as long-term accumulation instruments. Most deferred annuity contracts levy a “charge” against full or partial surrenders of the contract during a designated period of years after the annuity is purchased. This period varies from one annuity to another and usually runs anywhere between 5 to 15 years. The charge is expressed as a percentage of the funds received and typically decreases with each passing year to zero at the end of the term. The “early surrender charge” allows the insurance company to recover its costs if the contract does not remain in force over the long run. This “early surrender charge” is a company-applied charge, as opposed to the IRS tax penalty, and would be applied for transfers into another contract, if applicable.

 

Why choose a deferred annuity?

Many people today are choosing deferred annuities as the foundation of their overall financial plan. Why? The traditional savings dollar is taxed every year. By postponing that tax with a deferred annuity (tax-deferred growth), your money compounds faster because you can earn interest on dollars that would have otherwise been paid to the IRS. Later, if you decide to take these extra dollars as a guaranteed income, your taxes can be less because they will be spread out over a period of years through the use of a periodic payment schedule.

There are three categories of deferred annuities:

Variable, Fixed and Equity-Indexed Annuities

What is a variable annuity?

Variable annuities are securities-based instruments that may incur fees and a risk to principal because of the investments associated with this type of deferred annuity. The purpose of this website is to educate the consumer on annuities that hold no risk to principal (amounts invested). Therefore, variable annuities will not be explored on this website.

 

What is a fixed annuity?

A fixed annuity is one that is based on safe, no risk investments. Therefore, the insurance company can declare a set or “fixed” interest rate and guarantee that rate for a specified period of time. The specified period may be for one year at a time or for a certain number of years, such as 5 years, 7 years or 10 years. When an interest rate is declared and guaranteed for more than one year at a time, it is often referred to as a Multi-Year Guarantee Annuity, or MYGA.

 

What is an equity-indexed annuity or EIA?

An equity-indexed annuity or EIA is a fixed annuity. What makes this type of deferred annuity different is how the gains are credited. Instead of crediting a company-declared interest rate of say 4, 5 or 6 percent, the gains are linked or indexed directly to the performance of a leading stock market index, such as the Standard & Poor’s 500. Like other fixed annuities, there is a 100% guarantee of principal plus minimum interest (usually around 3 percent). An individual cannot lose a penny, as long as he or she stays in the contract for the full contract term. Unlike other fixed annuities, however, the owner has the potential to make more money if the index goes up. If the index goes down, the owner does not lose anything and is still guaranteed 100% of principal plus minimum interest. In an EIA, there are no sales charges, management fees, expense charges or mortality costs, so 100% of the premium is used to accumulate interest. Plus, equity-indexed annuities provide an incredible opportunity for stock market-like gains with absolutely no risk!

 

How does the volatility of the Standard & Poor’s 500 (S&P 500) affect an equity-indexed annuity?

The vast majority of equity-indexed annuities are linked to the S&P 500 Index (although some may be indexed to the NASDAQ, Dow, Russell 2000, etc). As the name indicates, the S&P 500 consists of 500 U.S. stocks from 10 economic sectors. These are not necessarily the 500 largest companies, but all of these stocks are widely held and the total market value of the 500 exceeds $6 trillion. The S&P 500 represents 80 percent of the market value of companies on the New York Stock Exchange. The S&P 500 is widely regarded as the most accurate benchmark for overall stock market performance.

No one knows for sure how the stock market or the S&P 500 is going to perform in the future, but most people agree that one of three things will happen:

One – The index could go down each and every year. In this case, the owner would simply get all of his or her money back plus a small return. It is guaranteed that not a penny can be lost due to market conditions as long as the EIA is maintained until the end of the specified term.

Two – The index could go up each and every year. In this case, the owner would get all of his or her money back plus a large percentage of the index gains.

Three – The index could go up and then go down over the next few years. In this case, the account value would be credited with the gains but not affected by the declines. The account value can only go up and can never go down.

 

How are the interest earnings determined for an equity-indexed annuity?

The movement of the S&P 500 ultimately determines the interest earnings. To translate the index movements into actual credited gains, however, a crediting method must be used. There are three basic crediting methods used with equity-indexed annuities — Annual Reset (Ratchet), High Water and Point-to-Point.

The Annual Reset method, or Ratchet method, is perhaps the most versatile of the three methods. This method measures each year’s market performance from contract anniversary to contract anniversary. If the market goes up, a gain is credited for that year, and the new value generally forms the basis for any future compounding of EIA gains. This new value can never be reduced, regardless of any future market declines. If the market goes down the next year, for example, the EIA is simply credited with zero gain, with no reduction to the accumulation value. At the end of each contract year, the S&P 500 Index starting point is reset to measure the change in the market for the next year — hence the name "Annual Reset." The graph shows that the EIA would be credited a gain at the end of the 1st year because the market went up. In the 4th year, however, the market went down, so the EIA would be credited zero gains. This crediting method works best for when the market is volatile (going up and down). Looking at the graph, for example, the new starting index level will be low in the 5th year, providing greater growth potential.

The second method is the High Water method. With this method, the index gain is the difference between the index level at contract issue and the highest index level achieved at any of the contract anniversaries. With this method, the index gain cannot be determined until the end of the entire contract term. At the contract end, a "look back" feature is used to determine the highest index level achieved during the contract term, called the "High Water Value." The owner would then be credited a gain based on this "High Water Value." As the graph indicates, if the market went up, up, up and then down, down, down, the owner would benefit from the high value achieved at the end of the 5th year, without being affected by any of the subsequent declines.

The third method is the Point-to-Point method. This crediting method is the easiest for a company to administer. As the name describes, the index gain is simply measured as the difference between two points — the starting index level at the beginning of the contract and the ending index level at the end of the contract term. This method ignores all of the fluctuations between the beginning and the end. Nothing is credited in between nor does the annual statement reflect any credited gains until the end of the term. This graphic example shows that at the end of this contract term, the owner would be credited a gain based on the index growth. However, if there is a market correction at the end of the contract term, the owner could lose all or part of the previous growth. The original deposit, however, remains unaffected, and the owner would still receive at least minimal interest.

 

EIA Variations

Many companies also use averaging techniques with the crediting method to help smooth out downward movement of the index during volatile growth. Averaging can be applied daily, monthly, quarterly or semi-annually. These averaging techniques can ease the risk of having the gains reduced or eliminated through the misfortune of determining the S&P 500 value at one single point in time. It reduces the impact of short-term declines while retaining strong growth potential. The disadvantage of averaging is that it limits gain in large growth performance years.

In addition to averaging, there are a few other factors that affect the potential credited gains, namely participation rates, spreads (margins) and caps.

The participation rate is the percentage of the gain of the S&P 500 that the owner receives or participates in. For example, if the S&P 500 experienced a growth of 15% and the EIA contract guaranteed a participation rate of 75%, the owner would receive an 11.25% increase (15% × 75%).

A spread is a percentage that is deducted from the index growth before being credited to the EIA. For example, if the index experienced a growth of 15% and the EIA contract stated a spread of 2.5%, the owner would receive a 12.5% increase (15% - 2.5%). A cap is the maximum interest earnings that can be credited to the annuity. No matter how much the market goes up, the owner can never receive a credited gain that is higher than the cap. For example, if the index experienced a growth of 15% and the EIA contract is set up with a 10% cap, the owner would receive no more than a 10% increase.

In short, the equity-indexed annuity marketplace has many different product designs, approaches and variations of the three basic crediting methods, and new possible variations and combinations are being introduced all the time. It is important to understand that any given indexed annuity could utilize any, none, or all of the aforementioned variations. Just remember that there is no magic in the design of any of these crediting methods. There is a simple investment strategy that supports each and every design variation. Click here for help to determine which crediting method design has the features and benefits best suited to fulfill your individual needs.

 

Why choose an equity-indexed annuity?

Many people agree that the stock market offers the greatest opportunity for growth. For many of us, however, it is our perception of the risk associated with the market that keeps us from participating in the stock market. What is so exciting about the EIA concept is that you can now participate in the growth potential of the stock market with the peace of mind that comes with knowing you have absolutely no market risk!

 

Annuity Advantages

Tax-Deferred Growth

All annuity dollars are able to accumulate interest completely tax deferred. This means an individual can delay taxation of growth until the money is needed. Thus annuity owners are able to reduce their current taxes and can control the timing of the taxes in the future. Triple Compounding

Because annuity owners do not pay current taxes on earnings, they are able to benefit from triple compounding — earning interest on their principal, interest on their interest and interest on the money that normally would be paid in taxes.

 

Guaranteed Lifetime Income

Annuities can provide the annuitant with a monthly income for as long as he or she lives — guaranteed. Furthermore, the guaranteed lifetime income can be continued to the beneficiary, or in some cases, a lump sum distribution option is available.

 

Higher Return (Increased Yield) on Safe Money

Historically, annuities have paid higher interest rates than other safe money investments of similar risk, such as money market funds, CDs and Treasury bills, etc.

 

Reduced Social Security Taxation

Interest earned in annuity accounts is not included to determine an individual’s modified adjusted gross income, which is used to determine how much of an individual’s Social Security benefits are subject to taxation. By keeping assets in an annuity instead of another investment such as a CD, an individual can avoid increased taxation of their Social Security benefits. Guaranteed Safety

With annuities, your principal is 100% safe and you are guaranteed to earn at least a minimum interest rate. There is no market risk and your account value is guaranteed to increase.

 

Avoid Probate

As long as the annuity owner designates a “named” beneficiary other than his or her estate, the beneficiary will receive the annuity dollars without the delay, expense and hassles of probate proceedings.

 

Annuity Tax Facts

Funds held in a tax-deferred annuity can accumulate free of current income tax because of Internal Revenue Code Section 72(e) which states that interest earned in an insurance contract (an annuity is an insurance contract) is not taxable to the owner until it is withdrawn. When funds are withdrawn from an annuity before the owner is age 59 ½, the IRS imposes a 10% tax penalty (excise tax) for premature withdrawals. (Note: the penalty only applies to any interest withdrawn.)

Internal Revenue Code Section 72(t) (Pre-LERO) allows individuals younger than 59 ½ to receive distributions from their qualified retirement plans without paying the 10% penalty, as long as certain requirements are met.

Each annuity payment is part nontaxable return of principal and part taxable interest income. An Exclusion Ratio is applied to determine what percentage of the monthly payment is nontaxable. The Exclusion Ratio for each individual annuity is the ratio of the total investment to the total expected return.

The IRS has specified that all owners of qualified retirement plans such as IRAs (other than Roth IRAs), 403(b)s, 457s, etc., must begin receiving required minimum distributions no later than April 1st of the year following the year in which the owner attains age 70 ½ — even if he or she is not retired. If, however, no distribution is taken or if the distribution is not large enough (as determined by using an age-based IRS distribution table), the IRS imposes a tax penalty equal to 50% of the amount by which the required minimum distribution amount exceeds the actual amount distributed.

In 2002, the IRS changed the rules governing required minimum distributions. The new rules establish much smaller required minimum distributions and allow individuals to maintain and maximize the benefits of their IRA by making it possible to "stretch" those mandatory distributions over the life expectancies of themselves and their beneficiaries. With Roth IRAs, the contributions are made with dollars after they have been taxed, but once these dollars are in a Roth IRA, they grow tax-free. All distributions (from both contributions and earnings) are then received completely free of all income taxes, as long as the account has been established for five years and the owner is at least age 59 ½.

Traditional IRA rules require that the owner start taking required minimum distributions no later than age 70 ½, or pay a 50% tax penalty. Roth IRA participants, however, can choose to never take a withdrawal from their plan for as long as they live.

In some cases, an individual can transfer the full value of one deferred annuity to another deferred annuity without any tax penalties. With this method, a person will not have constructive receipt of his or her funds and thus the transfer will not be considered a taxable withdrawal. (For non-qualified deferred annuities the rules of I.R.C. Section 1035 are used. Revenue Ruling 73-124, Code Section 1035, allows this exchange. This ruling does not apply to qualified plans.) Deferred annuities are designed as long-term accumulation instruments. Most deferred annuity contracts levy a “charge” against full or partial surrenders of the contract during a designated period of years after the annuity is purchased. This period varies from one annuity to another and usually runs anywhere between 5 to 15 years. The charge is expressed as a percentage of the funds received and typically decreases with each passing year to zero at the end of the term. The “early surrender charge” allows the insurance company to recover its costs if the contract does not remain in force over the long run. This early surrender charge is a company-applied charge, as opposed to the IRS tax penalty, and would be applied for transfers into another contract, if applicable.

(The information contained in this website is not intended to be legal or tax advice. Please consult with your attorney, accountant or tax advisor for more information regarding your specific circumstances.)

 

What is a triple-split annuity?

In the Learning Center, three categories of annuities — immediate, fixed and equity-indexed — have all been explained. But which one is the best financial tool? What if an annuity owner could combine all three types to create a safe yet incredibly effective annuity concept? Well now it can be done — by using an innovative concept called the triple-split annuity. This exciting new concept is excellent for the annuity owner who needs a guaranteed income, yet who wants to continue to accumulate wealth as well. Best of all, this concept lets the annuity owner participate in the growth potential of the stock market with absolutely no market risk!

The guaranteed income is generated by an immediate annuity. (Please visit the "Immediate Annuity" link for more information.) Additional funds accumulate with interest in a MYGA fixed annuity (Multi-Year Guarantee Annuity). These earnings are not taxed until withdrawn, so the annuity owner benefits from tax-deferred growth. In a defined number of years, this growth will equal the original premium value. In addition, the ability to participate in the upside potential of the stock market with no downside risk by using an EIA gives the annuity owner the potential for a hedge against inflation.

By combining all three annuities — a single premium immediate annuity, a MYGA fixed annuity and an equity-indexed annuity — the annuity owner gains tax advantages that may assist them in reaching their financial goals. (Please visit the "Deferred Annuity” and “Immediate Annuity” links for more information.)

 

How does a triple-split annuity work?

The triple-split annuity concept is simply allocating a lump sum of money into three different annuities to create a highly effective annuity plan. For example, if an individual had $125,000 to invest, it could be split in the following three ways: (Please note: if all the funds for a split annuity are qualified monies, all distributions from the annuities will be taxable.)

The first step is to take $100,000 and divide it into two parts — $44,945 into a single premium immediate annuity ("SPIA Income") and $55,055 into a MYGA fixed annuity (Multi-Year Guarantee Annuity). For this example, both of these annuities have a contract term of ten years. The 10-year term SPIA, which generates the same income for either a male or a female, could provide a guaranteed monthly income of $456.87, which is an annual income of $5,482.44. Eighty-two percent of each monthly payment is a return of premium (called the Exclusion Ratio) and is not taxable with non-qualified funds. This means that only 18% of each payment is considered taxable income, so $374.63 of monthly income or $4,495.60 of annual income is not taxable. The ten-year result is that an individual would be guaranteed to be paid $54,824.40, of which $44,956.00 would be not taxable. The $55,055* that was put in the MYGA would grow to $100,000 at the end of ten years. (*This result is based on a 6.15% 10-year Multi-Year Guarantee Annuity.)

The remaining $25,000 is placed into an equity-indexed annuity. This annuity is very similar to other fixed annuities, but with one basic difference — the way the gains are credited. Instead of crediting a company-declared interest rate, the gains are linked or indexed directly to the growth of a leading stock market index, such as the S&P 500. Like other fixed annuities, there is a 100% guarantee of principal plus minimum interest — guaranteed even if the market goes down. An individual cannot lose a penny, as long as he or she stays in the contract for the full contract term. Unlike other fixed annuities, however, the owner has the potential to make more money if the index goes up. Thus, the potential for a hedge against inflation is available. Many people agree that the stock market offers the greatest opportunity for growth. However, for many people it is their perception of the risk associated with the market that keeps them from participating in this growth potential. What is so exciting about this concept is that the annuity owner can now participate in the growth potential of the stock market with the peace of mind that comes with knowing they have absolutely no market risk!

In short, regardless of the volatility (ups and downs) of the stock market, interest rate fluctuations or changes in the economy, the total investment is secure with this annuity plan. Plus, the income payments are guaranteed to continue. The strong guarantees of annuities provide an individual with the peace of mind that can free him or her from worrying about the future.

 

Is the triple-split annuity right for me?

This answer may depend on many factors, but if you are searching for a way to preserve your wealth and increase your spendable income, the triple-split annuity concept might be just what you are looking for. With the right annuity plan you can enjoy the peace of mind that comes with a guaranteed income, the preservation of your capital and a possible reduction in your current taxes. A triple-split annuity is a valuable planning tool that could help you enjoy the retirement lifestyle you deserve.