The Everything Annuity White Paper

Annuities                                                                              FINRA® Letter

What is an annuity?

The contract between purchaser and insurance company

An annuity is a contract between you (the purchaser or owner) and the issuer (usually an insurance company). In its simplest form, you pay money to the annuity issuer, the issuer invests the money for you, and then the issuer pays out the principal and earnings back to you or a named beneficiary.

Two distinct phases to annuities

There are two distinct phases to the life of an annuity contract. One phase is called the accumulation (or investment) phase. This phase is the period when you invest money in the annuity. You can invest in one lump sum (called a single payment annuity), or you can invest a series of payments in an annuity. The payments may be of equal size over several years (e.g., $5,000 per year for 10 years), or they may consist of a series of variable payments. The second phase of the life of an annuity contract is the distribution phase. There are two broad options for receiving distributions from an annuity contract. One option is to withdraw earnings (or earnings and principal) from an annuity contract. You can withdraw all of the money in the annuity (both the principal and the earnings) in one lump sum, or you can withdraw the money over some time through regular or irregular payments. With these withdrawal options, you continue to have control over the money that you have invested in an annuity. You can withdraw just earnings (interest) from the account, or you can withdraw both the principal and the earnings from the account. If you withdraw both the principal and the earnings from the annuity, there is no guarantee that the funds in the annuity will last for your entire lifetime. A second broad withdrawal option is the guaranteed income (or annuitization) option.

TOO MUCH RISK?

Guaranteed income (annuitization) option

A second broad withdrawal option for an annuity is the guaranteed income option (also called the annuitization option). If you select this option, you will receive a guaranteed income stream from the annuity. The annuity issuer promises to pay you an amount of money on a periodic basis (monthly, quarterly, yearly, etc.). You can elect to receive either a fixed amount for each payment period (called a fixed annuity payout) or a variable amount for each period (called a variable annuity payout). You can receive the income stream for your entire lifetime (no matter how long you live), or you can receive the income stream for a specific time period (10 years, for example). You can also elect to receive the annuity payments over your lifetime and the lifetime of another person (called a “joint and survivor annuity”). The amount you receive for each payment period will depend on how much money you have in the annuity, how earnings are credited to your account (whether fixed or variable), and the age at which you begin the annuitization phase. The length of the distribution period will also affect how much you receive. If you are 65 years old and elect to receive annuity distributions over your entire lifetime, the amount you will receive with each payment will be less than if you had elected to receive annuity distributions over 5 years.

Over 10 years, you have accumulated $300,000 in an annuity. When you reach 65 and begin your retirement, you annuitize the annuity (i.e., elect to begin receiving distributions from the annuity). You elect to receive the annuity payments over your entire lifetime–called a single life annuity. You also elect to receive a variable annuity payout whereby the annuity issuer will invest the amount of money in your annuity in a variety of investment subaccounts. The amount you will then receive with each annuity payment will vary, depending in part on the performance of the subaccounts. In the alternative, you could have elected to receive payments for a specific term of years. You could have also elected to receive a fixed annuity payout whereby you would receive an equal amount with each payment.

Guarantees are subject to the claims-paying ability and financial strength of the annuity issuer.

Cannot outlive payments to you if you elect to annuitize for your entire lifetime

One of the unique features of an annuity is that you cannot outlive the payments from the annuity issuer to you (assuming you elect to receive payments over your entire lifetime). If you elect to receive payments over your entire lifetime, the annuity issuer must make the payments to you no matter how long you live. Even if you begin receiving payments when you are 65 years old and then live to 100, the annuity issuer must make the payments to you for your entire lifetime. The downside to this ability to receive payments for your entire life is that if you die after receiving just one payment, no more payments will be made to your beneficiaries. You have essentially given up control and ownership of the principal and earnings in the annuity.

Immediate and deferred annuities

There are both immediate and deferred annuities. An immediate annuity is one in which the distribution period begins immediately (or within one year) after the annuity has been purchased. For example, you sell your business for $1 million (after-tax) and then retire. You purchase an immediate annuity for $1 million and begin to receive payments from the annuity issuer immediately.

The second type of annuity is a deferred annuity. With a deferred annuity, there is a time delay between when you begin investing in the annuity and when the distribution period begins. For example, you may purchase an annuity with a single payment and then not begin receiving payments for 10 years. Alternatively, you may invest a series of payments in an annuity over 5 years before the distribution period begins.

Earnings tax-deferred

One of the attractive aspects to an annuity is that the earnings on an annuity (i.e., the interest earned on your money by the issuer) are tax-deferred until you begin to receive payments from the annuity issuer. In this respect, then, an annuity is similar to a qualified retirement plan. Over a long period, your investment in an annuity may grow substantially larger than if you had invested money in a comparable taxable investment. (However, like a qualified retirement plan, there may be a 10 percent tax penalty if you begin withdrawals from an annuity before the age of 59½.)

Four parties to an annuity

There are four parties to an annuity: the annuity issuer, the owner, the annuitant, and the beneficiary. The annuity issuer is the company (e.g., an insurance company) that issues the annuity. The owner is the individual who buys the annuity from the annuity issuer and makes the contributions to the annuity. The annuitant is the individual whose life will be used as the measuring life for determining the distribution benefits that will be paid out. (The owner and the annuitant are usually the same people, but they do not have to be.) Finally, the beneficiary is the person who receives a death benefit from the annuity upon the death of the contract owner.

What are some of the common uses of annuities?

Developed by insurance companies to provide retirement income

Life insurance companies first developed annuities to provide income to individuals during their retirement years. This function is in contrast to the benefits that a life insurance policy provides to your beneficiaries after your death. Although annuities were first developed to fund an annuitant’s retirement years, there is no requirement that an annuity is used only for retirement purposes. Annuities may be and are used to fund other financial goals, such as paying for a child’s education or starting a business.

Liz is a highly successful entrepreneur. Her business has grown far beyond what she has ever imagined, but her long hours have taken a toll on both her and her family. Liz plans to sell the company shortly and pursue her lifelong interest in landscape painting full-time. Even though she expects a modest income from the sale of her paintings, Liz will use the sale proceeds from her company to purchase an annuity that will provide her with regular, guaranteed income for the rest of her lifetime.

In contrast, Sam is the vice president for a small manufacturing company. Unfortunately, Sam’s company does not offer a retirement plan, and he has already contributed the maximum amount to his retirement account (IRA). Knowing that he can and needs to save more aggressively for retirement, Sam purchases an annuity to which he will contribute regularly until he retires. He will then receive a guaranteed income stream from the annuity in addition to receiving Social Security and income from his IRA.

Guarantees are subject to the claims-paying ability and financial strength of the annuity issuer.

How do annuities differ from other retirement plans?

Annuities differ from other types of retirement plans in several important ways.

Contributions are not tax-deductible

Unlike contributions to a qualified retirement plan, the money you invest in an annuity is not tax-deductible. Any money that you use to purchase an annuity will be after-tax income. (However, like a qualified retirement plan, interest and capital gains earned by an annuity will accrue tax-deferred until you begin withdrawing the money from the annuity.)

Contributions are unlimited

All qualified retirement plans have limitations on how much you can contribute each year. With many plans, the amount that can be contributed is quite low. However, there is no limitation on how much you can invest in an annuity. If you win a lump sum of $1 million in the lottery, you can invest the full amount (after paying the applicable income taxes, of course) in an annuity.

May receive income for life from the annuity

One of the unique features of an annuity is that you cannot outlive the income payments (assuming you elect to receive the payments over your entire lifetime). With some types of qualified retirement plans, you will receive payments from the plan only until all the money in the retirement account is depleted. There is the real possibility that you could outlive the money available in the account. Some qualified retirement plans do offer you the option to convert monies in the account into an annuity upon retirement.

Investment options

The money that you use to purchase an annuity may be placed in the annuity issuer’s general funds pool. The money is then invested and managed by the issuer’s money managers. Some types of annuities (called variable annuities) allow you to place your annuity funds in specific investment pools, typically called subaccounts. The funds are managed by an investment advisor. You may then be able to move your annuity investments between stocks, bonds, money markets, or other types of investments. The investment return and principal value of an investment option are not guaranteed. Because variable annuity subaccounts fluctuate with changes in market conditions, the principal may be worth more or less than the original amount invested when the annuity is surrendered.

Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk including the possibility of a loss of principal. Variable annuity contracts contain limitations, exclusions, holding periods, termination provisions, terms for keeping the annuity enforce, and contain charges including, but not limited to mortality and expense risk charges, sales and surrender (early withdrawal) charges, administrative fees for optional benefits and riders. Variable annuities are sold by prospectus. You should consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity contract and underlying investment options, can be obtained from the insurance company issuing the variable annuity or from your financial professional. You should read the prospectus carefully before you invest.

What are the advantages of annuities?

Earnings accrue tax-deferred

As noted, one of the main advantages of an annuity is that the interest generated by an annuity accrue tax-deferred. Over a long time, this deferral of taxes on earnings can be an advantage for an annuity over a comparable taxable investment. However, lower tax rates for capital gains and dividends, as well as the treatment of investment losses, could make the return for taxable accounts more favorable than tax-deferred accounts.

Guaranteed payments for life

Another advantage of an annuity is that you can receive payments from the annuity for your entire lifetime. As long as you elect to receive payments over your entire life when the payout period begins, you will receive the payments for as long as you are alive. Even if you live to the age of 100, the annuity issuer must make the payments to you.

No contribution limits

Unlike qualified retirement plans, there is no limit on how much you can invest in an annuity.

Many different types of annuities available

In recent years, there has been an increase in the number and variety of annuities available in the marketplace. There are numerous fixed annuities, variable annuities, and indexed annuities that an individual can choose.

Can delay payout until a later age

With most qualified retirement plans, you must begin taking money out of the plan by a certain age (usually 70½). With an annuity, there is no age limit at which you must begin receiving payments from the annuity. If you do not need the money from the annuity, you can continue to have the earnings accrue tax-deferred.

Proceeds avoid probate

If you die before the distribution period begins, then the money you have invested in the annuity (plus any accrued interest or earnings) does not have to be included in your probate estate if you have named a beneficiary on the annuity. The money in your annuity will pass directly to that named beneficiary. Because of the potential delays and costs in having your assets pass through probate, most estate planners recommend that you try to avoid having assets pass through probate.

What are the tradeoffs to an annuity?

Costly fees and expenses

Annuities normally entail higher fees and expenses when compared to other types of investments, such as mutual funds and bank deposits.

May have high surrender charges

Many annuities have high “back-end” surrender charges if you withdraw your money from the annuity within the first few years. In many instances, the surrender charge maybe 8 percent of any money you withdraw in the first year, then 7 percent of any money you withdraw in the second year, and continuing down to zero by the ninth year.

Contributions not tax-deductible

Another disadvantage to an annuity (in comparison to certain qualified retirement plans) is that investments in an annuity are not tax-deductible. You must use after-tax dollars to purchase an annuity. This is why it is normally best to place the maximum amount of funds in vehicles that allow for pretax contributions first.

Tax penalties for early withdrawals

Another concern when purchasing annuities is that the tax code imposes a 10 percent penalty tax (in addition to any other taxes owed on the payments) on withdrawals of any earnings from an annuity before you reach the age of 59½. There are certain exceptions to the imposition of this penalty, but in most cases, you will have to pay an additional tax penalty if you withdraw earnings from the annuity before you reach the cut-off age.

Payout plan is irrevocable once selected

Once you select a specific distribution plan, annuitize the annuity, and begin receiving payments, then that election is usually irrevocable. For example, you are not allowed to change an election to receive annuity payments for five years to an election to receive payments over your whole life.

Income from a fixed annuity may not keep up with inflation

Another tradeoff with certain types of annuities (specifically immediate annuities) is that the income from the annuity may not keep pace with inflation over the long term. Variable and indexed annuities have been increasing in popularity since their investment options may offer inflation protection and growth.

Must rely on the financial strength of annuity issuer

With certain types of annuities, specifically fixed but also some variable subaccounts, the money you invest in the annuity becomes part of the general funds of the annuity issuer. The annuity issuer then manages your money, its money, and other people’s money as one unit. If the annuity issuer has financial problems, your payments (or the number of your payments) may be in trouble. Unlike bank deposits at federally insured financial institutions, there are no federal guarantees on the money you invest in an annuity and only limited state provisions in the event of insolvency of the insurer. You are relying solely on the financial strength of the annuity issuer to repay your investment. For this reason, you should purchase an annuity only from an insurance company (or another annuity issuer) that has high financial ratings.

Why contribute to qualified retirement plans first?

Maximize contributions to qualified retirement plans first

If you are eligible to contribute to a qualified retirement plan either through your employer or if you are self-employed, it usually makes sense to contribute the maximum amount to one of these plans before you purchase an annuity. The primary reason for this fact is that contributions to qualified retirement plans are tax-deductible (up to certain limits), whereas contributions to an annuity must be made with after-tax money. Of course, with both qualified retirement plans and annuities, the money invested accrues tax-deferred until you begin withdrawals.

Why shop around for annuities?

Costs and returns may vary for annuities

Annuities tend to be more costly (in terms of fees, surrender charges, and other costs) than other types of investments, primarily because the annuity issuer provides additional benefits to you. Annuity issuers must, therefore, charge higher fees to cover the cost of these additional benefits. Furthermore, the returns that issuers pay on annuities can vary dramatically from one company to the next. Because new variations of annuities are constantly being introduced in the marketplace and because the financial services industry has become increasingly competitive, it can pay to shop around when buying annuities.

Fixed Annuities

What is a fixed annuity?

Interest rate and principal guaranteed

A fixed annuity is an annuity wherein the issuer (usually an insurance company) guarantees both the interest rate paid on invested dollars and the return of principal. The issuer guarantees that a minimum rate of interest will be paid on the annuity, but the actual rate of interest credited to the annuity is typically higher than the guaranteed rate. All of the premium payments that you make to the issuer will then compound (tax-deferred) at least at this guaranteed rate of return, subject to the claims-paying ability of the annuity issuer.

Distribution payouts are fixed

The second part of a fixed annuity that is “fixed” is the amount of benefit that will eventually be paid out to you during the distribution period (provided you elect to annuitize the annuity). Once the distribution period begins and you select your settlement option, the annuity distribution to you will be the same each month (or another period that you select).

Offers a guaranteed minimum interest rate

The issuer of fixed annuity guarantees that a minimum rate of interest will be paid for the life of the annuity. However, the annuity issuer will usually pay a higher rate of interest than the minimum guaranteed rate. The annuity issuer will typically pay a higher rate of interest on the annuity during the first year to induce people to purchase the annuity. The issuer will then usually adjust the interest rate in the following years to correspond with the ups and downs of the interest rate environment. When interest rates rise on other money market instruments or certificates of deposit, the annuity issuer will likewise increase or decrease the interest rate it pays on the annuity. However, the issuer cannot pay less than the guaranteed minimum rate without being in default.

Interest rates may be low on fixed annuities

Interest rates paid on fixed annuities are subject to the current interest rate environment. During periods of low-interest rates (some periods can go on for many years), the interest rates for an annuity can be low and remain low for quite some time. Low-interest rates could impact the potential growth of your annuity. However low the interest rate environment goes, the annuity cannot pay less than its guaranteed minimum rate.

When should you buy a fixed annuity?

Want to save money tax-deferred

A fixed annuity may be an excellent vehicle for individuals who want the benefits of tax-deferred earnings. The earnings on a fixed annuity (as with other types of annuities) are not subject to income tax until they are distributed. Thus, your annuity premiums and earnings may compound tax-deferred for many years.

John purchases a fixed annuity from an insurance company with a guaranteed interest rate of 4 percent. For the first year, the insurance company pays interest of 6.5 percent on the annuity. John plans to hold this annuity for 20 years. All of the interest that accrues on this annuity will be tax-deferred. John will not have to pay any taxes on the interest until he begins to withdraw money from the annuity. By that time, John may be in a lower income tax bracket. (This example is for illustration purposes only and does not reflect a particular investment or product).

Want a guaranteed fixed rate of interest on investments

A fixed annuity may also be a good investment for an individual who is a conservative investor. Because the annuity issuer promises to pay you a minimum rate of interest on the money invested in the annuity, there is little downside risk to a fixed annuity. With a fixed annuity, you know right at the beginning the minimum rate of return you may earn on your fixed annuity. Usually, the annuity issuer will pay a higher rate of interest than the minimum rate, but it will never pay less than the guaranteed amount. A risk you run with a fixed annuity is if the issuer has financial problems and becomes insolvent. In this case, it may not be able to continue to credit interest to your annuity or return the money you have invested in the annuity. Historically, there have been very few defaults on annuity contracts by insurance companies and other annuity issuers. Therefore, if you have a conservative investment outlook, buying a fixed annuity may be a good choice.

Guarantees are subject to the claims-paying ability of the annuity issuer.

A fixed annuity may be a good supplement to qualified retirement plan

You may also want to purchase a fixed annuity if you would like to put more money toward your retirement than what you have already contributed to your qualified retirement plans. If you are saving for your retirement, most financial advisors recommend that you first contribute as much as possible to any qualified retirement plans for which you are eligible. Thus, if your employer offers a 401(k) or another type of qualified retirement plan, you should contribute the maximum amount to that plan. Unlike the purchase of an annuity, contributions to a qualified retirement plan may be tax-deductible. However, if you have contributed the maximum amount to your qualified retirement plans and would still like to save more money for your retirement, then an annuity may be an excellent way to invest money whereby the earnings will be tax-deferred.

Annuities are investments for individuals with the long investment time horizon

Annuities tend to be good investments only for individuals who are investing money for the long term. One of the tradeoffs to the purchase of an annuity is that the insurance company will usually let you withdraw in the early years only a small percentage (10 percent, usually) of the money you have invested in the annuity without a penalty. If you want to withdraw more than this percentage each year, the annuity issuer will typically charge you a surrender charge. The surrender charge in the early years of the annuity may be as high as 5-10 percent of the amount you withdraw. The surrender penalty will then decline to zero after 5-10 years. (Basically, the annuity issuer does not want you to withdraw any of the invested money in the early years.) Furthermore, any distributions made before the annuity starting date (i.e., cash withdrawals, dividends, etc.) under an annuity contract entered into after August 13, 1982, will be taxable to the extent that the cash value of the contract exceeds the net investment in the contract at the time of the distribution.

Finally, if you withdraw money before the age of 59½, the tax code tacks a penalty of 10 percent onto the withdrawal. There are some very limited exceptions to this early-withdrawal penalty tax. Between the surrender charge, the potential income tax liability, and the early withdrawal penalty tax, a substantial part of your investment may be eaten up if you make an early withdrawal from the annuity. Thus, an annuity is usually a good investment only for people who can afford to keep their money in the annuity for 10-15 years and who will not begin withdrawals until after the age of 59½.

What are the strengths of fixed annuities?

Earnings are tax-deferred

Like other types of annuities, the earnings on the money you invest in a fixed annuity are tax-deferred until you begin withdrawing the money from the annuity. Thus, the interest that the annuity issuer pays on the annuity will accumulate tax-free until withdrawals are made or the distribution period begins. Over a long period, money that grows tax-free can accumulate faster than investments that are taxed each year. This can make an annuity more attractive than other traditional investment vehicles.

An issuer must pay guaranteed fixed rate of interest

Another benefit to a fixed annuity is that the annuity issuer (usually an insurance company) must pay a minimum fixed rate of interest on the annuity. With a fixed annuity, you will know before you purchase the annuity what the minimum rate of return will be. The annuity issuer typically pays a higher rate of interest than the minimum guaranteed rate but promises never to pay less than this minimum rate.

Can provide income for life

One of the unique features to a fixed annuity (as well as to other types of annuities) is that you can choose a stream of income that you cannot outlive, though choosing this option would result in lower periodic payments. If you elect to receive the annuity payout over your entire lifetime, the annuity issuer must make the annuity payments to you for as long as you live. For instance, if you begin receiving the annuity payments when you are 65 and you live until 100 years of age, then the issuer must make the payments to you for the entire 35 years. In a sense, an annuity can offer you protection against living too long. With other types of savings and investment vehicles, there is no guarantee that the money will last for as long as you live.

No limit on the amount you can invest in the annuity

Unlike qualified retirement plans such as a 401(k), or an IRA, there is no limit on how much you can invest in a fixed annuity. With most qualified retirement plans, there are limits on how much you can contribute each year. With a fixed annuity, though, you can contribute unlimited amounts of money to the annuity.

Have a choice of distribution payouts

Another strength of a fixed annuity is that you have a choice of payout plans once the distribution period begins. You can elect to withdraw only the earnings on the annuity and leave the principal intact. You can withdraw all of the funds in the annuity in one lump sum. You can also elect to annuitize the annuity and receive payments over your entire remaining lifetime or over a specific time (five years, for example). If you select a fixed annuity payout (annuitization), then you will receive a series of fixed payments. In other words, you will know the amount of each payment when the distribution phase begins.

Withdrawals, including annuitization, may subject the payments to income tax. Some withdrawals may also be subject to surrender charges which can reduce the amount of the withdrawal.

Annuities typically not subject to probate

Another advantage to annuities is that if you die before the annuity distribution period begins, the proceeds in the annuity will go directly to the named beneficiary or beneficiaries and not be subject to probate. Because of the time delays and costs potentially involved in probate, it generally is advantageous not to have your assets pass to your heirs through probate.

What are the tradeoffs to fixed annuities?

The fixed rate of return may not keep up with inflation

One of the tradeoffs to purchasing a fixed annuity is that the fixed rate of return may not be sufficient to keep up with inflation. If the annuity issuer pays an interest rate that does not outpace the inflation rate over the life of the annuity, then, in real dollars, the investment will lose money.

High fees

Another disadvantage to a fixed annuity is the surrender charges and management fees you have to pay to the issuer. If you withdraw your money from the annuity in the early years, you may have to pay high “back-end” surrender charges to the annuity issuer. Furthermore, there is an implicit annual management fee that is built into the interest rate. In other words, the annuity issuer pays you a lower interest rate than might otherwise be available. The difference represents its fee for managing the annuity. The issuer may also charge an annual contract fee on the annuity.

Early withdrawal penalties

Another tradeoff to a fixed annuity is that there is a 10 percent penalty tax that generally applies to withdrawals from a fixed annuity before the age of 59½ (there are a few limited exceptions to the imposition of this penalty). With certain other types of tax-free investments (such as municipal bonds), there are no penalties if you pull your money out before a certain age.

Annuities, not good short-term investments

Because of the substantial early surrender charges, the tax treatment of early withdrawals, and the penalty tax on withdrawals before the age of 59½, annuities are good investments only for people who can invest money for the long term. Annuities may not be good short-term investments or good investments for people who cannot tie up their money for a long period.

Fixed annuity only as secure as issuing company

Unlike a certificate of deposit issued by a bank or a savings account at a bank, there is no federal guarantee for the repayment of an annuity’s principal and interest. You have to rely solely on the financial strength of the issuing company. If the annuity issuer runs into financial difficulty, it may not be able to fully repay the principal and interest that it has promised to you. Over the past 20 years, there have been a few instances of insurance companies defaulting on the payment of interest and principal on annuities that they have issued. For this reason, you should carefully analyze the financial strength of any company from which you buy a fixed annuity. It may be worthwhile to research the financial ratings of the various annuity issuers.

What are the tax implications of fixed annuities?

Accumulated earnings are tax-deferred

A fixed annuity’s earnings accumulate tax deferred. This tax deferral can be a big advantage for a fixed annuity versus other taxable fixed-income investments, such as taxable bonds, certificates of deposit, savings accounts, and money market mutual funds. There is tax-deferred compounding of the money you invest in a fixed annuity. Earnings on your original investment compound tax-deferred as well. Also, earnings on the interest then compound tax-deferred. This tax-deferred compounding can result in greater overall accumulated funds than you would receive with a taxable investment.

Annuity payments partially a tax-free return of capital and partially taxable income

If you elect to annuitize your annuity when the distribution phase begins, then part of each payment you receive is treated as a tax-free return of capital, and part of each payment must be included in your gross taxable income. There is a ratio (called an exclusion ratio) that must be calculated to determine what part of the payment is subject to income tax and what part is not taxable. You first must calculate the amount you have invested in the annuity. Then, based on your estimated life span (taken from government tables), you must calculate how much the annuity will pay out to you over your whole life. You divide the amount you have invested in the annuity by the estimated total payout. This ratio is the amount of each payment that you may exclude from your taxable income. (Most annuity issuers will help you to calculate this exclusion ratio.) The remainder of each payment must then be included in your taxable income.

If the annuity starting date is after December 31, 1986, then the exclusion ratio applies only to payments until the investment in the annuity has been completely recovered. After this point, the entire annuity payment must be included in your gross taxable income.

John invests $100,000 in a fixed annuity contract. Based on his actuarial life span when he begins receiving annuity payments, John expects to receive $200,000 from the annuity throughout his lifetime. John’s exclusion ratio is 50 percent. If John receives $1,000 per month as an annuity payment, he could exclude $500 of this monthly payment from his taxable income and he would have to include $500 in his taxable income. Once John has recovered his $100,000 investment in the annuity (after 200 payments), the entire $1,000 monthly payment must be included in his taxable income.

Value of annuity contract may be included in your estate

The value of a commercial annuity will be included in your gross estate if (1) any beneficiary receives an annuity or other payment because of surviving you under any agreement, and (2) under that same agreement, you received or had the right to receive an annuity or payment (either alone or with someone else) for your life, for any period not ascertainable without reference to your death, or for any period that does not in fact end before your death.

Because only annuities where someone receives a payment because of surviving you are included in your gross estate, an annuity that expires at your death (such as a single-life annuity) will not be included in your gross estate. However, any payments from your annuity that you received during your life that you still own at your death (that you didn’t transfer or consume) will be included in your gross estate.

The two requirements (payment to a surviving beneficiary and your right to payments) may be met if you die before the annuity payments have begun or if you die after you have received payments. In either case, the amount included in your gross estate will be the value of the annuity as of the date of your death.

John is 50 years old and had purchased an annuity five years ago. The annuity is scheduled to begin paying benefits to John when he reaches 65, but John dies when he’s 60. The annuity has a value of $75,000 at the time John dies. This $75,000 must be included in John’s gross taxable estate, even if the annuity is payable to a beneficiary other than John’s estate (e.g., one of his children).

Now assume John has reached the age where the annuitization of the annuity he purchased 20 years ago is scheduled to begin. John selects the straight life settlement option whereby he will receive $2,000 per month for the rest of his life. John dies two years later. Because the payments stop at John’s death, there is nothing to include in his taxable estate. However, if John had selected a joint and survivor settlement option whereby the annuity payments would be paid out over the lives of both John and his spouse, then the value of the payments to John’s spouse would have to be included in John’s estate at his death.

Annuity Types

What are the different types of annuities?

There are hundreds of different annuity types–enough to boggle the mind of anyone at first glance. Furthermore, the companies that issue annuities are busy creating new types of annuities every day to meet the changing needs of consumers. However, when all the different types of annuities are clustered together, it is easy to see that most differ on just a few important variables. The remainder of this discussion identifies these major variables, and subsequent discussions will explore the various annuity types in more depth.

The following discussion includes references to certain guarantees made by issuers of annuities. Note that these guarantees are subject to the claims-paying ability of the issuing insurance company.

What are the different ways in which companies invest annuities?

A variable that separates one annuity from one another is how an issuer invests your money once you purchase an annuity. There are three broad methods that issuers use to invest your money: fixed, variable, and equity-indexed.

Fixed annuities

Historically, fixed annuities were the only type of annuities that companies issued. A fixed annuity pays a fixed, set rate of interest, which could change periodically, on the money invested in the annuity. In many cases, the annuity issuer will pay a guaranteed minimum rate of interest on the annuity account but also hold out the possibility that it will pay a higher rate of interest if market conditions permit (i.e., interest rates have risen on other money market instruments). To induce people to purchase fixed annuities, many issuers also will pay a much higher rate of interest for an initial period–usually a year. This higher rate of interest is sometimes called a bonus interest rate. Thus, the issuer may agree to pay 6 percent for the first year and then pay no less than 3 percent annually on the annuity after the first year. Usually, the annuity issuer will pay more than the minimum guaranteed rate on the fixed annuity. Fixed annuities are conservative investments for individuals who prefer fixed rates of return on their investments.

Variable annuities

Instead of receiving interest on the money invested in your annuity, you may choose a variable annuity that allows you to invest your annuity money in one or more investment subaccounts. The subaccounts (often called variable subaccounts, flexible accounts, or flexible subaccounts) will then invest in stocks, bonds, money market instruments, and other types of investments. Many variable annuity issuers may offer 6 to 10 different subaccounts. The annuity issuer will allow you to allocate your money among the different accounts in any way that you desire. Furthermore, most annuity issuers allow you to move money from one subaccount to another without incurring costs (and there are usually no tax consequences). With a variable annuity, the number of earnings that will be credited to your annuity account will depend on the performance of the underlying subaccounts. Unlike a fixed annuity, you assume the investment risk on the annuity. Some years, you may do very well, while in others, you may lose money. In recent years, variable annuities have become very popular, as people have been more willing to take the added risk to try to pursue higher returns than what is available on fixed annuities.

Variable annuities are sold by prospectus. You should consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity or from your financial professional. You should read the prospectus carefully before you invest.

Equity-indexed annuity

A third broad type of annuity is an equity-indexed annuity. This type of annuity is sort of a hybrid between a fixed annuity and a variable annuity. When you purchase an equity-indexed annuity, the issuer agrees to pay a return on your account that is tied to a stock market index–usually the S& P 500. However, the issuer also guarantees to pay you no less than a certain return in a given period if the return on that stock market index falls below that minimum percentage. Thus, if stocks do well, you earn above-average returns on your annuity, and if stocks fall in value, you will not lose money (as you would with many variable annuities).

One of the tradeoffs to an equity-indexed annuity is that the issuer will typically not pay you the full return on the equity index. Many equity-indexed annuities have caps (e.g., the most the issuer will pay you is 12 percent per year even if the equity index does much better than that). Furthermore, many issuers will pay you only a certain percentage of any given return in the equity index–called the participation rate. Assuming a 75 percent participation rate, if the equity index goes up 10 percent in a year, then the issuer may only credit your account with 7.5 percent for that period. Thus, with an equity-indexed annuity, you give up some of the upside potentials for some protection on the downside.

Guaranteed annuity contracts

The fourth type of annuity is a guaranteed annuity contract. This type of annuity covers a group of people (annuitants) who are usually linked through work or membership in a group or organization. A guaranteed annuity is similar in some respects to a fixed annuity because the issuer of the guaranteed annuity usually guarantees that the annuity will be credited with a fixed rate of interest for a certain period. The insurance industry has developed many specialized types of guaranteed annuities to meet the specific needs of corporate customers. For example, large corporations often use guaranteed annuities to fund their defined benefit pension plans.

Two-tier annuities

The fifth type of annuity is the two-tier annuity. A two-tier annuity is a type of fixed annuity in which the interest rate credited to the annuity varies depending on the distribution option that you choose. Typically, if you elect not to annuitize (and therefore maintain ownership of the money in the annuity), the annuity issuer will use a lower interest rate to credit your account. By contrast, if you elect to annuitize and receive a series of annuity payments over a while, the annuity issuer will use a higher rate of interest to credit your account.

Taxation of annuities is very complicated

Both the income and estate taxation of fixed annuities are extremely complicated.