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Annuity Introduction | Annuity Types | CD versus Annuity | Annuity Quote | Glossary | Links|
Two Main Annuity Types:
Immediate and Deferred 
The difference between deferred and immediate annuities is just about what you'd think. With an immediate annuity your income payments start right away (technically, anytime within 12 months of purchase). You choose whether you want income guaranteed for a specific number of years or for your lifetime. The insurance company calculates the amount of each income payment based on your purchase amount and your life expectancy.
A deferred annuity has two phases: the accumulation phase, where you let your money grow for a while, and the payout phase. During accumulation, your money grows tax-deferred until you take it out, either as a lump sum or as a series of payments. You decide when to take income from your annuity and therefore, when to pay the taxes. Gaining increased control over your taxes is one of the key benefits of annuities.
The payout phase begins when you decide to take income from your annuity. For most people, this is during retirement. As your needs dictate, you can take partial withdrawals, completely cash-out (surrender) your annuity, or convert your deferred annuity into a stream of income payments (annuitization). This last option is essentially the same as buying an immediate annuity.
Single Premium Immediate Annuities (SPIAs) are purchased by a single deposit. They usually start making regular monthly payments to you immediately after the date you make that deposit. The key ingredient for an immediate annuity is the exchange which takes place between the insurance company and the buyer. The company promises to pay a monthly income for the life of the annuitant and the buyer gives up his rights to ever receiving his deposit back in a lump sum. Once an immediate annuity makes its first payment, it generally cannot be cashed in.
An immediate annuity can be purchased with funds from a variety of possible sources, such as: a maturing Certificate of Deposit (CD); monies which have accumulated in a Deferred Annuity account (see below); or funds from a tax-qualified defined benefit or profit-sharing plan, or from an IRA account.
Why should I consider buying an Immediate Annuity? What are its advantages to me?
Immediate annuities provide many advantages to the buyer, such as:
(1) Security - the annuity provides stable lifetime income which can never be outlived or which may be guaranteed for a specified period;
(2) Simplicity - the annuitant does not have to manage his investments, watch markets, report interest or dividends;
(3) High Returns - the interest rates used by insurance companies to calculate immediate annuity income are generally higher than CD or Treasury rates, and since part of the principal is returned with each payment, greater amounts are received than would be provided by interest alone;
(4) Preferred Tax Treatment - it lets you postpone paying taxes on some of the earnings you've accrued in a "tax-deferred" annuity when rolled into an immediate annuity (only the portion attributable to interest is taxable income, the bulk of the payments are nontaxable return of principal);
(5) Safety of Principal - funds are guaranteed by assets of insurer and not subject to the fluctuations of financial markets; and
(6) No sales or administrative charges.
SPIAs are particularly suitable for providing income in the following situations:
(1)Retirement from Employment; (2) Terminal Funding or Pension Terminations (including deferred commencements); (3) Retired Life Buyouts: (4)Professional Sports Contracts; and (5) Credit Enhancement and Loan Guarantee Transactions.
Fixed Tax Deferred Annuity
Fixed Tax-Deferred Annuity Defined
A Fixed Tax-deferred annuity, also referred to as a tax-deferred annuity, is a contract between you and an insurance company for a guaranteed interest bearing policy with guaranteed income options. The insurance company credits interest, and you don't pay taxes on the earnings until you make a withdrawal or begin receiving an annuity income. Your annuity contract earns a competitive return that is very safe.
Fixed Annuity Features
In a fixed annuity, the insurance carrier:
Declares a current rate of interest for a specified time period. Once the time expires the company will set a new rate which may be higher or lower than the original rate.
Guarantees a minimum interest rate of return which is specified in the contract, and at no time may the current or renewal interest rate fall below it.
Guarantees the principal.
Tax-Deferred
Tax-deferred means postponing your taxes on interest earnings until a future point in time. In the meantime you earn interest on the money you're not paying in taxes. You can accumulate more money over a shorter period of time, which ultimately will provide you with a greater income.
Savings Advantages
Many people today are using tax-deferred annuities as the foundation of their overall financial plan instead of certificates of deposit or savings accounts. Although CD's and Annuities are very similar there are significant differences between the two. The most important difference is that annuities allow for the deferral of the taxes due on the interest earned until the interest is withdrawn! By postponing the tax with a tax-deferred annuity, 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 a monthly income, your taxes can be less because they will be spread out over a period of years. Like Certificates of Deposits, annuities have a penalty for early surrender, however most annuity contracts have a liberal "free withdrawal" provision.
Tax Advantages
You pay NO taxes while your money is compounding. You can also pay a lower tax on random withdrawals because you control the tax year in which the withdrawals are made, and only pay taxes on the interest withdrawn. Tax deferral gives you control over an important expense - your taxes. Any time you control an expense, you can minimize it. The longer you can postpone this particular expense, the greater your gain when compared to the gain you would make with a fully taxable account.
The Tax-Deferred Advantage
To illustrate the increased earnings capacity of tax-deferred interest, compare it to fully-taxable earnings. $25,000 at 6.0% will earn $1,500 of interest in a year. A 28% tax bracket means that approximately $420 of those earnings will be lost in taxes, leaving only $1,080 to compound the next year. If these same earnings were tax-deferred, the full $1,500 would be available to earn even more interest. The longer you can postpone taxes, the greater the gain.
Tax-Deferred vs. Fully Taxable Safety
Your tax-deferred annuity is safe. A qualified legal reserve life insurance company is required to meet its contractual obligations to you. These reserves must, at all times, be equal to the withdrawal value of your annuity policy. In addition to reserves, state law also requires certain levels of capital and surplus to further increase policyholder protection. Legal reserve refers to the strict financial requirements that must be met by an insurance company to protect the money paid in by all policyholders.
These reserves must be at all times, equal to the withdrawal value (principal plus interest less early withdrawal fees, if any) of every annuity policy. State insurance laws also require that a life insurance company must maintain certain minimum levels of capital and surplus, which provide additional policyholder protection.
Form 1099's
There is no withholding tax while your annuity is compounding; it is completely tax-deferred. If you request a distribution (random withdrawals or annuity income), taxes will be withheld - unless you elect differently. Your election not to withdraw can be made at the time you make your request. Because the interest is tax-deferred, it is not necessary to issue a Form1099 while your money is compounding. Only when your interest is distributed (withdrawal or annuity income) will a Form 1099 be sent, reflecting the amount of interest actually received.
Maturity
An annuity policy does not "mature" like a bond or certificate of deposit. Both your principal and interest will automatically continue to earn interest until withdrawn or you reach age 100. You can let your money continue to grow, make withdrawals, or begin receiving an annuity income at any time.
Penalty Tax
An IRS penalty tax, currently 10%, will be payable on any withdrawal of interest or qualified premium made prior to age 59 1/2.
Avoid Probate
If a premature death should occur, the accumulating funds within your annuity may be transferred to your named beneficiaries, avoiding the expense, delay, frustration and publicity of the probate process. Like most assets, the annuity is part of your taxable estate. Your heirs can chose to receive a lump sum payment, or a guaranteed monthly income
Variable Annuities
A variable annuity has two types of accounts:
Fixed Accounts
In a fixed account, principal and interest are guaranteed by the insurance company. Interest rates are usually guaranteed for one year but can be longer.
Variable Accounts*
In a variable account, the annuity owner bears the investment risk. Policy values vary directly with market performance and may result in a loss of principal and prior earnings. Earnings are tied directly to the performance of various underlying investment vehicles which are available within the variable annuity and are selected by the owner. *
Variable annuities offer a guarantee that in the event of death the beneficiary will receive at least all the premiums paid less any withdrawals made no matter what the value of the account.
This means if the account fund is valued less than the original investment, the beneficiary will receive the original investment.
Equity-Indexed Annuities
An equity-indexed annuity is an annuity that earns interest that is linked to a stock or other equity index. One of the most commonly used indices is the Standard & Poor's 500 Composite Stock Price Index (the S&P 500).
With an Equity-Indexed Annuity, return is tied to the increase in one of several stock market indexes, such as the S&P 500. However, if the stock market goes down, you do not lose any of your money. In fact, most Equity-Indexed Annuities will even GUARANTEE you a minimum annual return (typically 3%), even if the index you invested in goes down the entire time you are invested.
Equity Indexed Annuity Benefits
Annuity Income Payments
One of the most important benefits of deferred annuities is the right to use the value built up during the accumulation period to provide income payments during the payout period. While income payments are usually made monthly, you can often choose more or less frequent payments. The size of income payments is based on both the accumulated value in your annuity and the annuity's "benefit rate" that is in effect when income payments begin.
The insurance company uses the benefits rate to compute the amount of income payment it will pay you for each $1,000 of accumulated value in your annuity. The benefit rate usually depends on your age and sex, and the form of annuity payment you have chosen. You can usually choose from many forms of annuity payments. You might choose payments that continue as long as you live, or as long as either you or your spouse live, or payments that continue for a set number of years.
Death Benefit
Annuities provide a variety of death benefits. The most common death benefit is either the guaranteed minimum value or the value determined by the index-linked formula.
Tax Deferral
Federal income tax on interest accumulated in an annuity is deferred until you take the interest out of the annuity. You may be required to pay taxes then on the tax-deferred accumulation. You may have to pay a tax penalty if you withdraw the accumulation before you are age 591/2. The advantage of tax deferral is that you will probably be in a lower tax bracket in retirement than while you are employed. Also, during the accumulation period, you will be earning interest on money that you would otherwise have used to pay taxes. Tax-qualified annuities are subject to different rules. In any case, you should consult your own tax advisor.
* Equity Indexed Annuities
An Equity-Indexed Annuity (EIA) has interest rates that are linked to growth in the equity market as measured by an index such as the S&P 500. The EIA owner enjoys the upside potential of equities but is not exposed to downside risk. Subject to fixed minimum guarantees, the value of an EIA can only increase due to market growth - it will never decline due to market movement. There are many variations in product design. No two of the EIAs are exactly alike, and some are very different from each other. However, all the various types fall into three general categories: annual high-water mark with look-back.
The following is a simple definition of each. Please contact us if you would like to know more.
Annual Reset - Also known as the annual ratchet design, the annual reset design resets the starting index point annually. It also credits index increases (interest) annually and compounds annually.
Point-to-Point - The point-to-point design measures the change in the index from the start of the term to the end of the term.
Annual High-Water Mark with Look-Back - The annual high-water mark with look-back can be viewed as a variation on the point-to-point design, except that it measures the index from the start of the term to the highest anniversary value over the term.
* Some annuities allow the insurance company to change participation rates, cap rates or spread/asset/margin fees either annual or at the start of the next contract term. If an insurance company subsequently lowers the participation rate or cap rate or increases the fees, this could adversely affect an investor's return. Therefore, a prospective investor must carefully review his or her contract in order to examine these issues.
Withdrawal
Withdrawals may be made at any time. However, the withdrawal may be subject surrender charges and if done before age 59 1/2 there will be a 10% IRS penalty. Some contracts allow an annual 10% withdrawal free of surrender charges.
The owner may pre-authorize a systematic periodic withdrawal plan. The owner of the contract instructs the company to withdraw a percentage or a level dollar amount from the contract on a monthly, quarterly, semiannual, or annual basis.
Difference From Other Fixed Annuities
An equity-indexed annuity is different from other fixed annuities because of the way it credits interest to your annuity's value. Most fixed annuities only credit interest calculated at a rate set in the contract. Equity-indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited. How much additional interest you get and when you get it depends on the features of your particular annuity.
The equity-indexed annuity, like other fixed annuities, also promises to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate even if the index-linked interest rate is lower. The value of the annuity also will not drop below a guaranteed minimum. For example, many single premium annuity contracts guarantee the minimum value will never be less than 90 percent (100 percent in some contracts) of the premium paid, plus at least 3% in annual interest (less any partial withdrawals). The insurance company will adjust the value of the annuity at the end of each term to reflect any index increases.
Additionally, Equity-Indexed Annuities are a good option for people who already own annuities and have seen their interest rates drop substantially. Many people do not realize that you can easily trade-in an older, possibly under-performing annuity for one that better suits your needs. This exchange can be accomplished with no out-of-pocket expense or current taxes to pay!
Contract Features
Two features that have the greatest effect on the amount of additional interest that may be credited to an equity-indexed annuity are the indexing method and the participation rate. It is important to understand the features and how they work together. The following describes some other equity-indexed annuity features that affect the index-linked formula.
Indexing Method
The indexing method means the approach used to measure the amount of change, if any, in the index. Some of the most common indexing methods, which are explained more fully later on, include annual reset (ratcheting), high-water mark and point-to-point.
Participation Rate
The participation rate decides how much of the increase in the index will be used to calculate index-linked interest. For example, if the calculated change in the index is 9% and the participation rate is 70%, the index-linked interest rate for your annuity will be 6.3% (9% x 70% = 6.3%). A company may set a different participation rate for newly issued annuities as often as each day. Therefore, the initial participation rate in your annuity will depend on when it is issued by the company. The company usually guarantees the participation rate for a specific period (from one year to the entire term). When that period is over, the company sets a new participation rate for the next period. Some annuities guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified maximum.
Cap Rate or Cap
Some annuities may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the annuity will earn. In the example given above, if the contract has a 6% cap rate, 6%, and not 6.3%, would be credited. Not all annuities have a cap rate.
Floor on Equity Index-Linked Interest
The floor is the minimum index-linked interest rate you will earn. The most common floor is 0%. A 0% floor assures that even if the index decreases in value, the index-linked interest that you earn will be zero and not negative.
Averaging
In some annuities, the average of an index's value is used rather than the actual value of the index on a specified date. The index averaging may occur at the beginning, the end, or throughout the entire term of the annuity.
Margin/Spread/Administrative Fee
In some annuities, the index-linked interest rate is computed by subtracting a specific percentage from any calculated change in the index. This percentage, sometimes referred to as the "margin," "spread," or "administrative fee," might be instead of, or in addition to, a participation rate. For example, if the calculated change in the index is 10%, your annuity might specify that 2.25% will be subtracted from the rate to determine the interest rate credited. In this example, the rate would be 7.75% (10% - 2.25% = 7.75%). In this example, the company subtracts the percentage only if the change in the index produces a positive interest rate.
Common Indexing Methods
Annual Reset
Index-linked interest, if any, is determined each year by comparing the index value at the end of the contract year with the index value at the start of the contract year. Interest is added to your annuity each year during the term.
High-Water Mark
The index-linked interest, if any, is decided by looking at the index value at various points during the term, usually the annual anniversaries of the date you bought the annuity. The interest is based on the difference between the highest index value and the index value at the start of the term. Interest is added to your annuity at the end of the term.
Point-to-Point
The index-linked interest, if any, is based on the difference between the index value at the end of the term and the index value at the start of the term. Interest is added to your annuity at the end of the term.
IRA Qualified Annuities
Like many Americans, you may own an IRA. One of the most common misconceptions among IRA owners is that they must keep their IRA where it is. When in fact, nothing could be further from the truth. As an owner of an IRA, you have complete control over where you want to invest your IRA funds. Especially if you are unhappy with its current rate of return or the service you are receiving from the institution where your IRA is presently held. You can transfer an IRA to another IRA qualified investment without penalty or having to pay any income tax.
This is done via an IRA Rollover or a Direct Transfer. Annuity products are a safe and secure alternative - and with interest rates that are better than most bank CDs, Savings Accounts or Money Market Funds. Also, if your IRA is currently in a Mutual Fund and you are concerned about the risk to your principal, an Annuity is an excellent way to guarantee your principal with an opportunity for greater growth.
In these uncertain times, protecting your nest egg and earning a competitive return on your IRA is more important than ever. With annuity products, IRA funds grow without the risk associated with the stock market and at a higher interest rate than is generally offered by Bank CDs, Savings Accounts or Money Market Funds!
IRA Rollover
If you want to rollover an IRA, either Traditional or Roth, you need to request a check from the current custodian or institution that handles your IRA. As long as you put the money from the old IRA into a new IRA within 60 days, your IRA remains intact and you won't owe any federal income tax or tax penalties on the money. So, as you can see, it's important to make sure that the money is put back into your new IRA account within 60 days. The IRS allows you to "Rollover" your IRA in this fashion, once every 12 months.
Direct Transfer
In many cases you may wish to transfer your money directly from one IRA custodian to another. By doing a "Direct Transfer" you avoid the risk of owing any federal income tax or tax penalties and you don't have to worry about the 60-day requirement. Unlike a "Rollover", which can only be completed once every 12 months, the IRS does not limit the number of times you can "Transfer" your IRA.
1035 Exchange 1035 refers to a provision in the tax code which allows for the direct transfer of accumulated funds in a life insurance policy, endowment policy or annuity policy to another life insurance policy, endowment policy or annuity policy, without creating a taxable event.
Title 26, Subtitle A, Chapter 1, Sub chapter O, Part III, Section 1035 states that "no gain or no loss shall be recognized on the exchange" of:
A life insurance policy for another life insurance policy or endowment or annuity policy.
An endowment for another endowment with a maturity no later than the maturity date of the endowment being replaced.
An annuity policy for that of another annuity policy.
The 1035 exchange is one of the few parts of the tax code that works in your favor. For example, when you sell shares of stock to buy shares of a different company, the profits on your investment are subject to taxes. With annuities, you can exchange one company's product for another's with the earnings from your original investment still tax-deferred until you take money out of annuities for good.
Disclaimer:
The material presented on our web site may contain concepts that have legal, accounting and tax implications. It is not intended to provide legal, accounting or tax advice, you may wish to consult a competent attorney, tax advisor, or accountant. Note: Any reference to the word guarantee is based on the claims paying ability of the underlying insurance company.
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