Annuities

Annuities are especially attractive to retirees because they assure an income for life. They’re often held as deferred annuities as a back up for those later retirement years as a supplement to other retirement income or when savings become depleted. But many retirees will die before tapping their deferred annuity. What are the tax consequences to the annuity beneficiary and should other options be arranged?

A deferred annuity offers a distinct tax-benefit. It’s earning grow tax-deferred. For the same annual return as a taxable investment, a tax-deferred investment compounds faster because none of the earnings are taxed away each year. However those tax-deferred earnings will eventually be taxed upon withdrawal, whether by you or the annuity beneficiary. Your contributions to the annuity, though, will not be taxed. This is the case in ‘nonqualified’ annuities which are funded with after tax contributions.

Annuitant’s taxation
If a partial withdrawal is made, the IRS presumes that earnings come out first – so that these are completely taxable. But under regular monthly payments – a portion of each payment is not taxed but treated as a return of your nontaxable contributions. An exclusion ratio calculated by the insurance company designates that untaxed portion. When, after some number of payments and you’ve received all your contributions, all future payments will be fully taxed as income.

Beneficiary taxation
After tax contributions made by the deceased owner will remain  untaxed when received by the beneficiary. And of course, all those tax-deferred earnings within the annuity will be taxed as ordinary income to the beneficiary.

Usually, if the annuitant had begun receiving lifetime payments, no benefits would be left for the annuity beneficiary. But if the contract called for a fixed term guaranteed payments, the beneficiary would received those remaining payments taxed at the deceased’s exclusion ratio.

If the annuity owner died before beginning annuitization, provision may be made for either a lump sum distribution or a series of payments. For the lump sum payment, the beneficiary would only pay tax on the earnings portion.

But in the case of a series of guaranteed payments, the beneficiary would not be required to pay taxes on any of the payments until the deceased owner’s contribution were fully received. Any payments beyond that would be fully taxed as ordinary income.

An annuity beneficiary, who earns a substantial income already, can lose a lot of that taxable portion of the annuity as he’s pushed into a high tax bracket. So, if annuity owner decides not to annuitize, he may use his annuity’s value to switch to another option better suited to his beneficiary.

Note: Annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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Sometimes, investors don;t understand the benefit of tax deferral.  They believe if they need to pay the tax eventually, what difference does it make to defer the tax.  This article explains the benefit clearly so you make the right decisions with IRAs, annuities and other tax deferred opportunities.

The secret to growing your investments is its compounding rate. The higher it is, the faster your investment grows. But that’s only half the story. Increasing the compounding rate from 6% to 8% will produce more than that 33% increase in your investment over the years -see first table. That’s the magic! And that’s why tax-deferred investments are such an advantage. Let’s take a look at some results…

Taxable accounts are those that generate interest or dividend earnings that are subject to annual taxation. If your investment return is 10% and your income tax bracket is 28%, then 28% of that 10% (i.e. 2.8%) of that investment return is lost to taxation. This leaves only 7.2% (rather than the full 10%) as the compounding rate of that investment.

But tax-deferred accounts suspend yearly taxation of such earnings. So, no taxation would reduce the 10% investment return and it would remain the compounding rate.

Recognizing taxation’s effect on compound rates, we’re interested now in how much higher an earnings rate must a taxable account have to match the growth of a lower earnings tax-deferred account. And this depends also on the tax bracket of the investor.
 
This is important to retirees who may be interested in putting money aside to purchase an immediate annuity in later years in case they live longer than the expected. Should they put their money in secure investments like treasury bonds or in a deferred annuity to grow for the day they’ll need it. Often, such secure investments grow through earnings that are subject to yearly taxation – as are bonds. They need a basis for comparing the growth rates of different investments.

Your tax bracket determines the tax rate on those extra earnings you receive. So your bond interest earnings would be added to your normal income – from part-time work, your pension, and possibly your social security if taxable and be subject to your (highest) tax bracket. The tax brackets range from 10% to 35%.

The table shows what taxable earnings rate (i.e. subject to yearly taxation) you must receive to achieve a compounding rate equal to the tax-deferred earnings rate based on the tax bracket those taxable earnings are taxed at.

Want a quote on deferred annuities’ earning rates? Just use the deferred annuity calculator.

Note that annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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In retirement, a guaranteed income can reduce your stress and allow you a less-panicked approach to investing. With no pension, you may be relying on Social Security as your only assured income. Buying a life annuity can guarantee that extra income, but you lose both control of your assets and their use as your legacy. What’s a solution to this dilemma?

The fixed term SPIA solution
Use a single premium immediate annuity (SPIA). In this case we’re looking at a fixed term SPIA where you purchase the SPIA for an immediate payout, but only for a fixed term – perhaps 5, 10 or 15 years.

The idea is to buy the fixed term ingle premium immediate annuity with only 50% of your savings. The term you choose depends on how much extra assured income you need and what you plan to do with your other 50% of savings. Let’s see some examples for this approach.

New retiree – getting adjusted
Take this hypothetical example. If you’re a 66 year old man beginning retirement with $400,000 in savings but no company pension, you may want to complement your Social Security income with single premium immediate annuity income while you pursue some endeavour for the first 10 years of your retirement. But you don’t want to lose control over your assets for later alternative choices.

As an option, you could purchase a 10 year term single premium immediate annuity that would pay  you $2,084.01 per month to supplement your social security benefits for about $200,000.  This would leave you with $200,000 in savings that you can invest to grow over the next 10 years. With the assurance of the annuity income, you can invest this remainder of your savings more aggressively.

Investing at a hypothetical 7% or 8% growth rate may allow you to recover your $400,000 over those 10 years if things go as intended.  The growth you can reasonably expect will depend on your choice of investment and if that money is in a tax-deferred account. The latter would allow you tax-deferred high income investments.  Or, you could buy a deferred annuity at a guaranteed rate. But, you’re in control of those assets.

Older retiree – worrying about a legacy and living expenses
Let’s consider another hypothetical example. Let’s take an 80 year old woman with $200,000 in savings and a house with no mortgage. She’s drawing down her savings at about $2,000 per month and is worried about depleting her savings and losing her legacy for her children.

She could purchase a single premium immediate annuity for a fixed term – perhaps 10 years - with a fraction of her savings to pay the monthly drain on her savings. And, invest the remainder in a deferred annuity to grow for later use or as a legacy. Her house’s equity can also be a source of income under a reverse mortgage if necessary.

Note: Note that annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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When you buy an immediate annuity, you pay a lump sum to an insurance company and begin receiving monthly payments right away. An immediate life annuity is attractive to retirees because it guarantees them a lifetime income. But should they choose an immediate variable annuity (IVA) or an immediate fixed annuity (IFA)?

The IFA gives you a guaranteed but fixed payment – generally monthly for your lifetime. That’s because the underlying annuity investment relies on long term bond investments purchased by the insurance company. But in twenty years the purchasing power of that fixed monthly payment may be significantly less due to inflation.
 
The IVA also offers a lifetime (monthly) payments, but those payments will vary. That’s because the underlying annuity money is invested in the subaccounts that fluctuate with the underlying securities (e.g. stocks and bonds). The attraction of the IVA is based on the hope that over time, the investment markets will rise and help offset inflation by producing larger monthly payments. The danger is that the stock market can go into a slump and reduce those payments.    

With the IVA, you can change how your annuity is invested among subaccounts associated with it. You can also opt for a guaranteed minimum payment despite how far down the market goes and your subaccount investment earnings fall. But that kind of guarantee will add to the cost of the contract.

If you’re especially concerned about future inflation, perhaps you’ve got a better option than locking yourself into an IVA. Instead of investing all that ‘annuity’ money into an IFA, just invest a portion – perhaps half of it. Then invest the remaining half in a conservative mix of bonds and stocks that’ll potentially generate both growth and earnings.

Use only the earnings of this that you need. This gives you more control of your investment money with your own guaranteed minimum from your IFA. Years later you can always opt to invest the balance into an IFA too. Your increased age alone will produce a higher monthly return for yourself because the later in life you start your annuity payments, the larger the payments.  You can see how this works with the immediate annuity calculator.
Note: Annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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CD versus Deferred Annuity Comparison Safety, Return, and Investment Time

Retirees with cash often seek an investment with a lot of safety. Holding a certificate of deposit (CD) gives you that safety but sacrifices investment return. Let’s compare a CD to a deferred fixed annuity for safety, return and investment time. Then you can choose what’s best for you.

The Safety Issue
Banks offer CDs. The Federal Deposit Insurance Company (FDIC) guarantees any investment in a bank up to $250,000 (through 2009) against the bank’s failure. If you plan to invest more than that, spread it between different banks – not different accounts in the same bank – so all your holdings are FDIC guaranteed.  Bank failures are not all that uncommon.

A deferred fixed annuity hasn’t any FDIC protection. But it’s still considered a conservative investment. First it’s backed by the financial strength of the company that issues the annuity. So, before buying a deferred fixed annuity, check the insurance company’s financial rating. Independent rating companies such as Moody’s, A.M. Best, Standard & Poor’s and Fitch provide this information to you.

As a safety backup in case of failure, many insurance companies are affiliated with a guaranty association in their state. One example is the Georgia Life and Health Insurance Guaranty Association in Georgia. It provides total annuity cash surrender protection per owner per insurance company of $100,000 (read these guaranty association terms carefully—some state that the guarantee is conditional on the association having funds).
 
The Return Issue
Your return for CDs and deferred fixed annuities depend on their interest rate earnings and taxation. CDs offer guaranteed interest rate for a fixed term – generally, the shorter the term, the lower the rate. All CD earnings are taxed annually – whether you withdraw money or not. This yearly taxation loss reduces the annual compounding of a CD’s return.

A deferred fixed annuity can guarantee an interest rate for an initial period or for multiple years.  But earnings of annuities are tax-deferred. So at equal interest rates, your savings will compound annually faster than for a CD. Annuity earnings are taxed only when you withdraw them.

The Investment Time Issue
Withdrawing money before term for a CD will bring a penalty. And an early surrender from a deferred annuity will do so too. So if you’re planning on using most of that money within a year or two, then a CD is probably the better choice. But if you plan on holding for the long term a deferred fixed annuity may be more advantageous.

Refer to the table for a quick summary of comparison issues. You just need the current interest rates and early withdrawal penalty features of CDs and deferred annuities to make an informed decision.

Note on Annuities: With tax deferred investments, income taxes may be due upon withdrawal of funds, withdrawals prior to age 59½ are subject to a 10% penalty. Annuities have surrender charges or expenses associated with them while CDs have early withdrawal penalties. The purchase of annuities may incur commission and annuities may not be as liquid as CDs. CDs are FDIC insured to $250,000 per owner while annuities are not and are guaranteed by the claims paying ability of the insurance company.

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When couples are in their retirement, circumstance may arise where a wife is in jeopardy of losing a living income when her husband dies. Perhaps the husband – before a late marriage - had opted for a ‘single life’ payout for his pension or annuity. Or, perhaps a 50% reduction of his pension payout for his wife just won’t be enough. How can one spouse assure an adequate income for his surviving spouse when a pension or Social Security benefit is involved?   

Normally, you might say, ‘just go out and buy life insurance on the husband’s life so the wife can live off the death benefit’. But buying permanent life insurance may be too expensive for a retiree. And then there’s the issue about whether or not the wife can manage it to maintain an income for her life.

A reversionary annuity as an alternative
A reversionary annuity would supply an immediate annuity payout for the life of the wife at the death of the husband.  The funding for the ‘immediate annuity’ comes from the life insurance death benefit associated with the husband’s reversionary annuity premium payments.

The reversionary annuity is similar to a combination of term life insurance policy, a permanent life insurance policy, and an immediate annuity. The premiums that the husband would pay for the reversionary annuity may be less than those of a permanent policy and possibly competitive with a those of a term life policy. Yet the policy doesn’t stop at a given date like a term life policy does.

Most reversionary annuities dictate that once you chose the beneficiary, you can’t change it.   Thus, the premiums are typically less than typical life insurance because the issuing company can better estimate their total payout based on the known beneficiaries age.  Clearly, insurance companies can play the life expectancy statistics game for both the husband and beneficiary wife for such contracts to produce attractive policy premiums compared to the original permanent life insurance option.

Taxation of reversionary annuity payout
When the payout begins for the beneficiary, she’ll be taxed on only a portion of each payout in a fashion similar to most annuity payouts. The untaxed portion of each payment arises from the tax-free return of the reversionary annuity’s value at the time of the husband’s death. This is pro-rated by dividing that value by the remaining life expectancy of the beneficiary in months – for a monthly payment scheme.
 
An additional advantage is that annuity income attributed to principal is not included when calculating the taxability of Social Security benefits.

Although a reversionary annuity may offer an affordable way to provide a guaranteed income to protect your beneficiaries’ standard of living, not all of them are alike. Some have a return of premium benefit in case the insured outlives the beneficiary; some have inflation protection for payouts, and some don’t require the beneficiary to bypass a medical exam. But watch out, since premiums can increase over time. Read the fine print.

Note: that annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses. The purchase of life insurance involves costs, fees, expenses and potential surrender charges and depends on the health of the applicant.  Not all applicants are insurable. If a policy is structured as a modified endowment contract, withdrawals will be subject to tax as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.

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Have a deferred retirement annuity you might not get to use? You can pass its tax-deferred earnings advantage to your annuity beneficiary and supply her income over much of her life.
 
A non-qualified annuity is one you funded with after tax dollars. You can provide your assigned annuity beneficiary – after you die - with a lifetime income stream from it. Its holdings can be “stretched out” over the beneficiaries’ lifetime, creating what’s known as a non-qualified stretch annuity.
 
The ability to stretch out distributions to a beneficiary comes from IRC section 72(s) which requires non-lump-sum annuity distributions to begin within one year of the annuity owner’s death. But the option to stretch out this distribution must be elected within 60 days of after the benefit is payable. So this rule preserves the non-qualified annuity’s tax-deferral advantage for the beneficiary and allows him to avoid a high taxation rate that an all-at-once payout would produce.

How long can your beneficiary stretch annuity payments?
He can either have payments made to him over the IRS’ projected remaining life expectancy for his age or simply have the payments annuitized under one of the insurance company’s annuitization options.

These options would be a life annuity (retirement annuity), a life annuity with a period-certain guarantee or a customizing distribution over a designated period. Depending on the age of the beneficiary, the annuity issuer may require that the term of years be reduced to the IRS’s projected remaining life expectancy for him.
 
According to the IRS table I for ‘projected’ single life expectancy , a 40 year old beneficiary has 43.6 years statistically projected to live. If this beneficiary chose to take yearly payments under the IRS required distribution scheme, his first annual payment would equal the value of the annuity at the end of the year of the owner’s death divided by 43.6 years. The subsequent annual payment would be the previous year end annuity divided by 42.6 (i.e. one less than 43.6). The following year would be a similar evaluation but divided by 41.6 (i.e. one less than 42.6), etc.

Stretching annuity payments over a long time can really increase the total amount of money generated by the retirement annuity.

The 5 year alternate distribution term

If you don’t invoke the one-year rule to permit the stretch annuity options, then the beneficiary must receive all the annuity holdings within 5 years after the owner’s death. The tax-deferral growth advantage remains in effect. So the beneficiary could choose to deferral all withdrawals to the end the 5 year period before emptying the retirement annuity.
Note:  Annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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For retirees, the most attractive feature of fixed annuities is the assurance that it’ll provide a fixed income for life. But all investments have their good and bad points; and fixed annuities are no different. Let’s overview some of their advantages and disadvantages summarized in the table.

Advantages
The three important features of an annuity are tax-deferred accumulation, guarantee of principal, and guaranteed life income.  The tax-deferred accumulation – in comparison to a similar taxable investment - allows for greater accumulation since earnings are not taxed away annually.

Annuities have been conservative vehicles for investment. Of course you should always check out the strength of any insurance company you’re considering buying from.   A good source is to get the Comdex rating of 80 or better from Vital Signs (see a financial professional) or a Weiss rating of B or better.

With the guaranteed life income payout option, you don’t have to worry about market downturns that could rob you of income. Also if you can put off your payout until later, you’re monthly payout will increase not only from increased earnings but from your reduced life expectancy.
 
Disadvantages
Because an annuity is a long-term investment with tax-deferred status, the IRS will levy a 10% excise tax penalty on any withdrawal before age 59 ½.

Annuity fees can significantly cut into any withdrawals taken early in the accumulation years. So plan on holding off for 10 years or so to let your earnings offset this effect.

Since your money is placed with an insurance company in an annuity contract, you have little control over the rate of return on your investment. When you buy, find a company that has a history of providing competitive returns If you ask for the interest rate history, you will get it).

Although with a fixed annuity you’ve eliminated the possibility of market risk on your investment you have created the risk of losing purchasing power. After beginning payments to you you’re not able to make any adjustments in case of higher inflation rates. However, if the rate history looked good, the company may be more reactive to raising rates when possible.

Choosing a lifetime income leaves generally leaves no residual investment for your heirs. You can choose options that remedy this, but at the cost of a lower monthly payout.

Annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

–Bob Richards

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Live to 100. Sounds great. But what are the downsides of longevity? “How can there be downsides?” you may ask. After all, you’d have more time to golf, go fishing, and spend with the grand-kids. Well, the risk may be that if you hadn’t planned to live that long you could end up running out of money.  Very few people have sufficient retirement savings to live to 100.  Yet, if you are already age 70, life expectancy of living to age 100 is 3% (one of every 33 people).  If you make it to age 80, then your life expectancy to 100 jumps to 4% (one out of 25 people).

So how long of a retirement should you plan for?  How can you prepare for significant longevity?

According to the IRS longevity tables, a 70-year-old person is expected to live for 17 more years to age 87. However, this is an average. Half of the 70-year-olds will live longer, and half will not. Therefore, a 70-year old individual who is basing his or her retirement plan and spending habits on living to 87 is rolling the dice. Furthermore, when you consider that there are more than 70,000 U.S. centenarians  who represent the fastest-growing segment of our population, there is reason to take notice.

However, planning too conservatively could be detrimental as well. After all, you don’t want to cut your standard of living down to the point that you’ll be miserable. And of course, you always have the option to make adjustments in your spending as time goes on.

All of this comes down to two simple facts; you can control how long your money will last, but you only have a limited ability to predict how long you will live. So what can you do to reduce the risk of running out of money too soon?

A fixed immediate annuity offers an income that will continue for a lifetime, no matter how long you live, and it will help you plan for the possibility of living to 87, 107, or beyond.  The other option is a reverse mortgage–your ace in the whole should you ever need it.

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There’s a type of annuity that pays you more if your health profile is not good.  This may sound strange, but here’s how it works:

SPIA, which stands for Single Premium Immediate Annuity (also referred to as health adjusted immediate annuity), has long been a popular investment for obtaining a fixed income which cannot be outlived (income for life).  With the income for life option, the issuing insurance companycalculates the size of your monthly payment based on standard life expectancy tables, based on an analysis of your health.  Once calculated at the beginning, you continue to receive the same monthly amount, regardless of how long you live.  It’s almost like getting a second social security check.

companies take into account your individual health condition and use that information to calculate your life expectancy.  If your health records indicate conditions that could lower your life expectancy, this is factored into the monthly payment you receive and increases the monthly payment.  You then receive this fixed monthly amount no matter how long you live.|

Take this hypothetical example.  A man age 70 decides to obtain a SPIA.  He deposits a $100,000 premium and based on his standard life expectancy of 16 years, his monthly payment is $871.05 (a 10.4% annual payout rate).  He will receive this fixed monthly amount regardless of how long he lives.  However, if he has a negative health profile and the insurance companies calculate his life expectancy at only 10 years, his monthly payment will jump to $1393.68.  Because of the negative health history, this annuitant receives more income for life.

SPIAs have been most popular with single individuals who are not concerned with leaving an inheritance.  That’s because, once the initial premium is paid, the SPIA cannot be surrendered for value.  Rather, you receive a fixed monthly income for life.  For those people who like the idea of increasing their monthly income and do want to leave funds to heirs, remember that you would use only a part of your assets for a SPIA and other assets can be designated for heirs.

If you’ve been relying on other sources for tax-sheltered income such as municipal bonds, you may find that an SPIA will increase your monthly tax sheltered income.

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