Annuities
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Annuities
Written by Peggy Erland. Published by Erland Education Services (formerly Erland Education Financial Services.) Edited by Patricia Hangartner Material contained in this course has previously been published by EFES under the titles Deferred and Immediate Annuities, Fixed and Equity-Index Annuities, and Variable Annuities. No part of these courses may be reproduced, transmitted in any form or by any means, electronic or mechanical, for any purpose, without the express permission of Erland Education Services (formerly Erland Financial Education Services). Although great effort has been made to ensure this publication contains accurate, timely information, it is provided with the understanding that the author is not engaged in rendering legal, accounting, tax, or other professional service. If professional advice is required, the services of a competent legal advisor should be sought. Copyright © Erland Education Services (formerly Erland Financial Education Services) 1995, 1996, 1997, 1998, 2000, 2001, 2003, 2004, 2006, 2009, 2011. 2012
Table of Contents INTRODUCTION ............................................................................................ 1 CHAPTER ONE: ANNUITIES - AN OVERVIEW ..................................... 2 SINGLE PREMIUM IMMEDIATE ANNUITIES ...................................................... 2 DEFERRED ANNUITIES ..................................................................................... 2 Flexible Premium Deferred Annuities ......................................................... 4 Single Premium Deferred Annuities............................................................ 4 Fixed Annuities ............................................................................................ 4 Variable Annuities ....................................................................................... 4 Equity-Index Anuities .................................................................................. 4 ANNUITIZATION OF DEFERRED CONTRACTS.................................................. 5 PARTIES TO AN ANNUITY CONTRACT ............................................................ 5 Annuity Owner ......................................................................................... 5 Annuitant .................................................................................................. 6 Beneficiary ............................................................................................... 7 THE ANNUITY CONTRACT ............................................................................... 8 ANNUITY APPLICATION ..................................................................... 9 CHAPTER TWO: FIXED ANNUITY FEATURES .................................... 11 TAX DEFERRAL ............................................................................................... 11 Example of Tax Deferred Growth............................................................... 11 Exhibit 2. Tax Deferred Growth................................................................. 12 Probate Defined .......................................................................................... 12 FREE WITHDRAWALS ..................................................................................... 13 SURRENDER OR WITHDRAWAL CHARGES .................................................... 14 Market Value Adjustment ......................................................................... 14 CD Annuities ............................................................................................. 15 PRINCIPAL GUARANTEE ................................................................................ 15 SYSTEMATIC WITHDRAWALS ......................................................................... 17 MEDICAL OR NURSING HOME WAIVERS ...................................................... 18 OTHER SURRENDER CHARGE WAIVERS ........................................................ 19 MATURITY DATE OR MAXIMUM DEFERRAL AGE ......................................... 19 PREMIUM TAX ................................................................................................ 19 CHAPTER THREE: FIXED ANNUITY RATES ........................................ 21 THE INITIAL RATE .......................................................................................... 21 Bonus and Base Rates ................................................................................. 21 Premium or Rate Bonuses .......................................................................... 22 FACTORS IN RATE SETTING............................................................................ 22
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Competition ................................................................................................ 22 Product Features ........................................................................................ 22 Commission ................................................................................................ 23 Investments ................................................................................................ 23 Portfolio Method Of Investing ............................................................... 23 Bucket Or Banded Method Of Investing ................................................ 24 Premium Tax .............................................................................................. 24 Interest Rate Setting................................................................................... 24 Sample Interest Rate Setting Model ....................................................... 25 The “Phantom” Rate .................................................................................. 25 RENEWAL RATES ............................................................................................ 25 ADDITIONAL CONTRIBUTION RATE .............................................................. 26 BAIL OUT RATES ............................................................................................ 27 MINIMUM GUARANTEED RATE ..................................................................... 27 RATE VERSUS YIELD ....................................................................................... 27 HISTORICAL RATES ........................................................................................ 28 SETTING INTEREST RATES ON SINGLE PREMIUM IMMEDIATE ANNUITIES ... 28 CHAPTER FOUR: FIXED ANNUITY PAYMENTS ................................. 30 ANNUITY PAYMENT FEATURES AND ADVANTAGES .................................... 30 Many Income Options Available To Meet Differing Customer Needs...... 30 Guaranteed Income..................................................................................... 31 Lifetime Income .......................................................................................... 31 Convenience................................................................................................ 31 Taxation ...................................................................................................... 31 PARTIES INVOLVED IN ANNUITY PAYMENTS ................................................ 31 Owner ......................................................................................................... 31 Annuitant ................................................................................................... 32 Payee ........................................................................................................... 32 Beneficiary .................................................................................................. 32 INCOME OPTIONS ........................................................................................... 32 Life Income ................................................................................................. 32 Life and Period Certain Income .................................................................. 32 Life With Installment Refund Income ........................................................ 32 Life with Cash Refund ................................................................................ 33 Temporary Life Income ............................................................................... 33 Joint and Survivor Life Income .................................................................. 33 Joint and Specified Percentage to Survivor Life Income ............................ 33 Joint and Specified Percentage to Contingent Life Income ........................ 33
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Joint and Survivor With Period Certain Income ....................................... 33 Joint and Survivor Life With Installment Refund ..................................... 34 Joint and Survivor Life with Cash Refund ................................................. 34 Period Certain ............................................................................................ 34 CHAPTER FIVE: TAXATION OF FIXED ANNUITIES* ....................... 35 Tax Deferral................................................................................................ 35 Withdrawals ............................................................................................... 35 LIFO and FIFO Withdrawals ................................................................. 35 Pre - 59 ½ Distributions ............................................................................ 36 Multiple Contracts ..................................................................................... 37 TAX-FREE EXCHANGES .................................................................................. 37 1035 Paperwork Requirements .................................................................. 38 1035 Time Delays ....................................................................................... 39 TAXATION OF ANNUITY PAYMENTS ............................................................. 39 WHO PAYS THE TAXES?................................................................................. 40 Who Owes The Taxes On Withdrawals? ................................................... 40 Who Owes the Taxes on A Jointly Held Annuity and at Ownership Changes? .................................................................................................... 40 Who Pays The Tax At Annuitization? ...................................................... 41 TAXATION RULES AT DEATH ........................................................................ 42 Death Prior To Annuitization.................................................................... 43 Death After Annuitization ......................................................................... 43 Non-Natural Owners ................................................................................. 43 Insurance Company Application Of The Distribution At Death Rules .... 44 Distribution At Death Deferred Contract Type I .................................... 44 Distribution At Death Deferred Contract Type II .................................. 45 Distribution At Death Deferred Contract Type III ................................. 45 ESTATE TAXATION ......................................................................................... 46 Deferred Contract ....................................................................................... 46 Annuitized Contract .................................................................................. 46 OTHER TAXATION ISSUES .............................................................................. 46 Taxation of Social Security Benefits ........................................................... 46 Divorce ....................................................................................................... 47 Assignment of Annuities, or Pledging an Annuity As Collateral ............ 47 CHAPTER SIX: ADVANTAGES OF THE VARIABLE ANNUITY...... 48 TAX- DEFERRAL .............................................................................................. 48 INVESTMENT OPTIONS ................................................................................... 48 GUARANTEED DEATH BENEFITS .................................................................... 49
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VARIETY OF FLEXIBLE INCOME OPTIONS....................................................... 49 SUMMARY ....................................................................................................... 49 CHAPTER SEVEN: VARIABLE ANNUITY FUNDAMENTALS ........ 51 DEFERRED CONTRACTS .................................................................................. 51 Tax-Deferral ............................................................................................... 51 PREMIUM PAYMENTS ..................................................................................... 52 Flexible Premium Variable Annuities........................................................ 52 Single Premium Variable Annuities .......................................................... 52 THE VARIABLE ANNUITY AS A SECURITY..................................................... 52 Investment Risk .......................................................................................... 52 The Separate Account................................................................................. 53 The Sub-Account ........................................................................................ 53 VARIABLE ANNUITY ACCUMULATION UNITS............................................... 53 ANNUITIZATION ............................................................................................ 54 THE VARIABLE ANNUITY PROSPECTUS ......................................................... 54 Variable Annuity Expenses........................................................................ 55 Transaction Expenses ............................................................................. 55 Sample Deferred Sales Load Calculation ............................................... 56 Annual Expense ...................................................................................... 57 Separate Account Expenses .................................................................... 57 Performance Data ....................................................................................... 58 Definition of Terms .................................................................................... 58 Account Valuation Method ........................................................................ 58 Annuitization Options ............................................................................... 58 Contract Provisions .................................................................................... 59 Sub-Account Descriptions ......................................................................... 59 Fixed Account Description......................................................................... 59 Federal Tax Considerations ........................................................................ 60 ANNUITY APPLICATION................................................................................. 60 CHAPTER EIGHT: VARIABLE ANNUITY SUB-ACCOUNTS............ 62 TYPES OF RISK ................................................................................................ 62 Financial or Default Risk ........................................................................... 62 Bond Rating Agencies ............................................................................ 63 Market Risk ................................................................................................ 64 Interest Rate Risk ....................................................................................... 64 Interest Rate Changes and Bond Prices .................................................. 64 Interest Rate Changes and Bond Term and Quality ............................... 64 Purchasing Power Risk .............................................................................. 65
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Economic or Political Risk.......................................................................... 65 Exchange Rate Risk .................................................................................... 65 SUB-ACCOUNT OBJECTIVES ........................................................................... 66 Capital Appreciation ............................................................................... 66 Total Return ............................................................................................ 66 Income .................................................................................................... 66 Preservation of Capital ........................................................................... 66 TYPES OF SUB-ACCOUNTS.............................................................................. 67 Government Sub-Account Funds .............................................................. 67 US Government Sub-Account Funds ..................................................... 67 US Government Treasury Sub-Account Funds ...................................... 69 Corporate Bond Sub-Account Funds ......................................................... 69 High Yield Corporate Bond Sub-Account Funds ................................... 69 Corporate Bond Sub-Account Funds - High Quality ............................. 70 Corporate Bond Sub-Account Funds - General...................................... 70 World Bond Sub-Account Funds ........................................................... 70 Equity Sub-Account Funds........................................................................ 71 Aggressive Growth Sub-Account Funds ................................................ 71 Growth Sub-Account Funds ................................................................... 71 Small Cap or Small Company Sub-Account Funds ............................... 72 Growth and Income Sub-Account Funds ............................................... 72 Equity Income Sub-Account Funds........................................................ 72 World Stock Sub-Account Funds ........................................................... 73 Sector Sub-Account Funds ..................................................................... 73 Balanced Sub-Account Funds ................................................................ 73 Money Market Sub-Account Funds ....................................................... 74 CHAPTER NINE: VARIABLE ANNUITY FEATURES .......................... 75 CONTRIBUTION FEATURES ............................................................................. 75 Dollar-Cost Averaging ............................................................................... 75 Regular Investment Programs ................................................................... 76 Asset Allocation Programs ......................................................................... 76 LIQUIDITY FEATURES ..................................................................................... 77 Penalty Free Withdrawals .......................................................................... 77 Nursing Home Waivers ............................................................................. 77 Systematic Withdrawal Programs ............................................................. 78 GUARANTEED DEATH BENEFIT PROVISIONS ................................................. 79 Stepped-Up Death Benefits ........................................................................ 79 Assumed Percentage Increases in Account Value ..................................... 80 SUMMARY ....................................................................................................... 80
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CHAPTER TEN: VARIABLE ANNUITY INCOME PAYMENTS ........ 81 VARIABLE ANNUITY INCOME PAYMENT FEATURES AND ADVANTAGES .... 81 Many Income Options Available To Meet Differing Customer Needs...... 81 Guaranteed Income..................................................................................... 81 Opportunity for Growth............................................................................. 82 Lifetime Income .......................................................................................... 82 Convenience................................................................................................ 82 Taxation ...................................................................................................... 82 PARTIES INVOLVED IN ANNUITY PAYMENTS ................................................ 82 Owner ......................................................................................................... 82 Annuitant ................................................................................................... 83 Payee ........................................................................................................... 83 Beneficiary .................................................................................................. 83 INCOME OPTIONS ........................................................................................... 83 Life Income ............................................................................................ 84 Life and Period Certain Income ............................................................. 84 Life With Installment Refund Income .................................................... 84 Life with Cash Refund............................................................................ 84 Joint and Survivor Life Income .............................................................. 85 Joint and Specified Percentage to Survivor Life Income ....................... 85 Joint and Specified Percentage to Contingent Life Income ................... 85 Joint and Survivor With Period Certain Income .................................... 85 Joint and Survivor Life With Installment Refund .................................. 85 Joint and Survivor Life with Cash Refund ............................................. 85 Period Certain ......................................................................................... 86 CHAPTER ELEVEN: TAXATION OF VARIABLE ANNUITIES ......... 87 TAXATION OF ANNUITY PAYMENTS ............................................................. 87 Fixed Annuity Income Payments............................................................... 87 Variable Annuity Income Payments .......................................................... 88 CHAPTER TWELVE: ADVANTAGES OF EQUITY-INDEXED ANNUITIES..................................................................................................... 89 TAX- DEFERRAL .............................................................................................. 89 OPPORTUNITY FOR GROWTH......................................................................... 89 GUARANTEED MINIMUM RETURN ................................................................ 90 AVOIDANCE OF PROBATE .............................................................................. 90 VARIETY OF METHODS TO ACCESS ACCOUNT VALUES ................................ 90 SUMMARY ....................................................................................................... 90
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CHAPTER THIRTEEN: FEATURES OF EQUITY-INDEXED ANNUITIES..................................................................................................... 91 SECURITIES REGULATION AND EQUITY-INDEX ANNUITIES .......................... 91 INDEX-BASED PORTFOLIOS ............................................................................ 92 Why Index-Based Portfolios Are Used by Money Managers .................... 93 STANDARD & POOR’S COMMON INDEX, 1980 TO 2010 ................................ 93 Diversification ........................................................................................ 95 Equity Investing...................................................................................... 95 Low Management Fees........................................................................... 95 INDEX FUNDS VS. EQUITY-INDEX ANNUITIES ............................................... 96 IMPORTANT TERMS IN EQUITY-INDEX ANNUITIES ....................................... 96 Cap .............................................................................................................. 96 Term ........................................................................................................... 96 Participation Rate....................................................................................... 97 Floor ............................................................................................................ 97 Averaging ................................................................................................... 97 Compounding ............................................................................................. 98 Vesting ....................................................................................................... 98 INDEX BENEFIT CALCULATIONS .................................................................... 98 Annual Reset Method................................................................................. 98 High Water Mark Method.......................................................................... 99 Point-to-Point Method ............................................................................. 101 FREE WITHDRAWALS ................................................................................... 102 Ten Percent of Initial Premium................................................................ 102 Ten Percent of Accumulated Value .......................................................... 102 Ten Percent of Principal ........................................................................... 102 Ten Percent of the Minimum Guaranteed Value ..................................... 102 Nursing Home or Medical Waiver Withdrawals ..................................... 103 Impact of Withdrawals on the Annuity Value ......................................... 103 ANNUITIZATION .......................................................................................... 103 PRINCIPAL GUARANTEE .............................................................................. 103 MINIMUM INDEX RETURNS .......................................................................... 104 MINIMUM GUARANTEED RATES ................................................................. 104 DEATH BENEFIT............................................................................................ 105 HOW INSURERS PARTICIPATE IN THE EQUITY INDEX MARKET .................. 105 Types of Options....................................................................................... 105 Put Options ........................................................................................... 105 Call Options .......................................................................................... 106 Option Premium Income .......................................................................... 107
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Covered Option Writing .......................................................................... 107 Use of Options by Portfolio Managers ..................................................... 107 Increasing Yields .................................................................................. 108 Protection Against Loss ........................................................................ 108 Adding Diversification ......................................................................... 108 Index Options ........................................................................................... 108 SUMMARY ..................................................................................................... 109 CHAPTER FOURTEEN: HOW ANNUITIES MEET RETIREMENT NEEDS ............................................................................................................ 110 RETIREMENT ................................................................................................. 110 Individual Retirement Accounts .............................................................. 110 IRA Maximum Contribution Levels .................................................... 110 IRA Maximum Contribution Levels for Individuals 50 and Over ....... 111 Regular IRAs ........................................................................................ 111 The Roth IRA ....................................................................................... 111 Advantages of IRAs ............................................................................. 112 Regular IRA Eligibility ............................................................................ 113 Regular IRA Contribution Rules ............................................................. 113 IRA Investments ...................................................................................... 114 Types of Regular IRAs ............................................................................. 114 Individual Retirement Accounts ........................................................... 114 Individual Retirement Annuities .......................................................... 115 Spousal IRAs ............................................................................................ 116 Premature Distributions .......................................................................... 116 Exceptions ............................................................................................ 117 Required Minimum Distributions of the Regular IRA ........................... 118 Required Beginning Date ..................................................................... 118 Required Minimum Amount ................................................................ 119 Distribution Method Selection ............................................................. 119 Calculating Required Minimum Distributions ..................................... 120 IRA Rollovers ....................................................................................... 121 Partial Transfers And Rollovers ........................................................... 121 Rollovers and Direct Rollovers From Qualified Plans to a Regular IRA. .............................................................................................................. 121 Eligibility Rules of the Roth IRA ............................................................. 122 Frequency of Contributions ...................................................................... 123 Contributions After Age 70 ½ ................................................................. 123 Spousal Roth IRAs ................................................................................... 123 Excess Contributions................................................................................ 123
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Roth IRA Distribution Rules ................................................................ 124 Using an Annuity For IRA Funds .......................................................... 129 Tax Rules .............................................................................................. 129 Fixed Annuities Used As An IRA ........................................................ 129 Variable Annuities Used as an IRA...................................................... 131 Equity-Index Annuities Used As An IRA ............................................ 132 SEP PLANS ................................................................................................... 138 Eligibility .................................................................................................. 138 Tax-Deferral ............................................................................................. 138 Tax Deductibility ..................................................................................... 138 Investment Options .................................................................................. 139 Deductibility Limits ................................................................................. 139 Distributions ............................................................................................ 140 Advantages ............................................................................................... 140 Disadvantages of SEP Plans .................................................................... 140 Fixed Annuities as SEP Vehicles ............................................................. 140 Variable Annuities As SEP Vehicles ....................................................... 141 Equity-Index Annuities As SEP Vehicles ............................................... 141 SIMPLE PLANS ............................................................................................ 141 Eligibility .................................................................................................. 141 Tax-Deductibility ..................................................................................... 142 Contributions ........................................................................................... 142 Investment Options .................................................................................. 143 Distributions ............................................................................................ 143 Advantages of SIMPLE IRA plans .......................................................... 143 Annuities as SIMPLE Plan Vehicles ....................................................... 144 Qualified Plans for the Self-Employed ..................................................... 144 Contributions ........................................................................................ 144 Eligibility .............................................................................................. 145 Vesting .................................................................................................. 145 Investment Options ............................................................................... 145 Tax Deductibility .................................................................................. 145 Distributions ......................................................................................... 146 Advantages ........................................................................................... 147 Disadvantages ....................................................................................... 147 Life Insurance in a Self-Employed Retirement Plan ................................ 148 Summary of Using an Annuity Within a Qualified Plan ....................... 148 NON-QUALIFIED RETIREMENT VEHICLES ................................................... 148 Annuity Features and Non-Qualified Retirement Vehicles .................... 148 Premature Distributions ........................................................................ 149
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Distributions ......................................................................................... 149 Taxation at Withdrawal ........................................................................ 149 1035 Exchanges .................................................................................... 149 Using an Annuity to Supplement Qualified Retirement Plans .............. 150 CHAPTER FIFTEEN: HOW AN ANNUITY MEETS GIFTING TO MINOR NEEDS ............................................................................................ 151 GIFTING TO MINORS .................................................................................... 151 Uniform Gift To Minors Act.................................................................... 151 Uniform Transfer to Minors Act ............................................................. 151 The Custodian ....................................................................................... 152 Disadvantages of UGMA and UTMA .................................................. 153 CHAPTER SIXTEEN: HOW AN ANNUITY MEETS HOME SAVINGS NEEDS ............................................................................................................ 155 SAVING FOR A HOME PURCHASE ............................................................... 155 Important Features of Home Savings Products ....................................... 157 Allow For Additions ............................................................................. 157 Availability of Funds When Goal Is Reached ...................................... 157 Risk Appropriateness............................................................................ 157 Use of IRAs For A First-Time Home Purchase ....................................... 157 Annuity Products As Savings Tools For Home Purchase ....................... 157 CHAPTER SEVENTEEN: HOW AN ANNUITY MEETS COLLEGE SAVINGS NEEDS ........................................................................................ 159 ACCUMULATING ASSETS FOR A COLLEGE EDUCATION ............................. 159 Cost of A College Education ..................................................................... 159 College Funding Product Features........................................................... 160 Allow For Additions ............................................................................. 160 Liquidity ............................................................................................... 160 Risk Appropriateness............................................................................ 160 Gifting As A College Funding Method .................................................... 161 The Coverdell Education Savings Account .............................................. 161 Advantages of the Coverdell ESA ........................................................ 161 Contribution and Eligibility Rules of the Coverdell ESA .................... 162 Distributions From Coverdell ESAs ..................................................... 163 Naming a New Beneficiary ...................................................................... 165 Distributions Due to Death ................................................................... 166 Rollovers From A Coverdell ESA to A Coverdell ESA ...................... 166 Termination of Coverdell ESAs ........................................................... 166
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Using an Annuity as a Coverdell ESA .................................................... 166 Ownership............................................................................................. 167 Ability to Make Additions .................................................................... 167 Guaranteed Rates .................................................................................. 167 Liquidity ............................................................................................... 167 Premature Distribution Tax .................................................................. 167 Variable Annuity Sub-Accounts........................................................... 168 Variable Annuity Sub-Account Tax-Free Transfers ............................ 168 Use of An Annuity in a Coverdell ESA ............................................... 169 Using an Annuity As A College Funding Vehicle ............................... 169 CHAPTER EIGHTEEN: HOW AN ANNUITY MEETS OTHER CLIENT NEEDS ............................................................................................ 170 REDUCTION OF CURRENT TAX LIABILITY .................................................... 170 INCOME ........................................................................................................ 170 LOW RISK TOLERANCE - FIXED ANNUITIES................................................. 171 Financial Strength .................................................................................... 171 Standard & Poor’s Insurance Rating Services...................................... 171 Moody’s Investor Service Insurance Financial Strength Ratings ........ 171 Duff & Phelps Credit Rating Company, Insurance Rating Service ..... 172 State Regulations...................................................................................... 172 INCAPACITY .................................................................................................. 172 LIVING TRUSTS ............................................................................................. 173 CHAPTER NINETEEN: ANNUITY ALTERNATIVES ........................ 174 CERTIFICATES OF DEPOSIT ........................................................................... 174 Risk ........................................................................................................... 174 Uses of CDs .......................................................................................... 175 Maturities ............................................................................................. 175 Tax Considerations ............................................................................... 175 Fees....................................................................................................... 175 MUTUAL FUNDS ........................................................................................... 176 Diversification .......................................................................................... 176 Types of Mutual Fund Securities .......................................................... 177 Tax Considerations ............................................................................... 177 Objectives ............................................................................................. 177 Loads .................................................................................................... 177 Fund Families ....................................................................................... 178 Opening Requirements ......................................................................... 178 Risk ....................................................................................................... 178 MUNICIPAL BONDS ...................................................................................... 179
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Risk Characteristics of Municipal Bonds ................................................. 180 General Obligation Bonds .................................................................... 180 Special Tax Bonds ................................................................................ 180 Revenue Bonds ..................................................................................... 180 Housing Authority Bonds ..................................................................... 180 Industrial Revenue Bonds..................................................................... 181 Insured Municipal Bonds ..................................................................... 181 Uses of Municipal Bonds ......................................................................... 181 Tax Considerations ................................................................................... 181 Private Activity Bonds ......................................................................... 182 KEY DATES AFFECTING ANNUITY TAXATION .............................. 183 Prior to August 14, 1982 ...................................................................... 183 August 14, 1982 and after .................................................................... 183 January 19, 1985 and after.................................................................... 183 After February 28, 1986 ....................................................................... 183 Prior to April 23, 1987.......................................................................... 183 April 23, 1987 and after........................................................................ 183 October 22, 1988 and after ................................................................... 184 GLOSSARY ................................................................................................... 185
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INTRODUCTION Competition among life insurance companies offering annuity products has resulted in the development of annuity products with features such as nursing home waivers, systematic withdrawals, and five-year surrender schedules. These products offer much more than a promise to pay in exchange for a lump sum, the traditional definition of an annuity. The many different annuity products available mean annuities are more complex than ever before, but are also more customer-friendly than ever before. This manual will discuss the basic types of annuities available, common features, taxation of annuities, ownership considerations, annuity payment options and the pros and cons to be aware of when determining whether an annuity will best meet a client’s financial needs.
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CHAPTER ONE: ANNUITIES - AN OVERVIEW An annuity is a contract between an insurance company and the owner or owners of the annuity policy. Premium is submitted to the insurance company for the policy and the insurance company pays a specified rate of interest to the owners for the premium submitted. There are two basic types of annuities available: deferred annuities and immediate annuities. Among deferred annuities, there are fixed and variable annuities and single premium and flexible premium annuities. Immediate annuities may also be fixed or variable. This manual will concentrate on fixed annuities, but for overview purposes, a brief discussion of variable annuities will be included.
Single Premium Immediate Annuities Single Premium Immediate Annuities (SPIAs) pay income “immediately” (within twelve months of purchase). In exchange for a lump sum payment (“single premium”) the insurance company promises to make regular payments. The amount of these payments is based on the type of annuity the purchaser selects. There are a wide variety of immediate annuity options available, from payments over life to payments for a specified period, such as five, ten or fifteen years. Payment frequency may be monthly, quarterly, semi-annual or annual.
Deferred Annuities Deferred annuities are called “deferred” because the annuity payments do not begin until sometime after the first twelve months from the policy opening date. In addition, earnings on the policy are “deferred” from taxation until withdrawn. Some insurance companies refer to this type of annuity as a “retirement annuity” because tax laws favor receiving payments from a deferred annuity after age 59 ½, and therefore are often
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Flexible Premium Deferred Annuity Tax-Deferred Phase
Annuitization Phase
Flexible Premium Contributions
Annuity Payments
Accumulated Cash Values
$$
Single Premium Immediate Annuity
Single Contribution
$$
Regular Annuity Income Payments
$$
Exhibit 1.1. Flexible Premium Deferred Annuity, Single Premium Immediate Annuity
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purchased for or during retirement years. “TDA,” or tax-deferred annuity, is the most common name for this type of annuity. Flexible Premium Deferred Annuities Premium payments or contributions may be made to a flexible premium deferred annuity throughout the life of the contract, or until the contract holder begins irrevocable annuity income payments. The purchaser opens a Flexible Premium Deferred Annuity (FPDA) with a single contribution, but may make additional contributions to the policy. Single Premium Deferred Annuities The purchaser makes only one contribution to a Single Premium Deferred Annuity (SPDA). Fixed Annuities A fixed annuity is an annuity to which the insurance company credits a fixed interest rate for a specified period. The annuity contract will also guarantee a minimum rate of interest. For example, the contract may have a first year rate guarantee of 6%, and a minimum rate guarantee of 3% for all following years. Variable Annuities A variable annuity (VA) is an annuity that allows the purchaser to allocate his or her contributions to a variety of sub-accounts, which in many ways are similar to a mutual fund. Instead of paying a stated rate, the variable annuity’s return is based on the performance of the subaccounts the purchaser selects. For example, the VA’s “Growth” subaccount may return 12% over a one-year period, and the next may return -2%, depending on the performance of the growth stocks within the subaccount portfolio. Variable annuities may be either flexible or single premium products and are considered both an insurance product and a securities product.
Equity-Index Annuities Equity-index annuities are annuities that offer the advantage of growth that can exceed a fixed annuity without some of the risks associated with
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variable annuities. Equity-index annuities provide a return that is related to a stock index, most commonly the S&P 500. The insurance company offering the annuity also provides guaranteed minimum returns, which provides the purchaser with reduced exposure to market risks. Besides these unique features, equity-indexed annuities provide many of the same advantages as other annuities, such as tax-deferral and avoidance of probate.
Annuitization Of Deferred Contracts Fixed, equity-index and variable deferred annuities include an option, or in some states a requirement, to annuitize the contract. Annuitization refers to making an irrevocable option to receive periodic payments. Payments typically will commence within one month, three months, six months or one year from the annuitization start date. The deferred contract may require that the annuitization start date (also referred to as the contract maturity date, annuity start date or maximum deferral date) be no later than a certain age, e.g. age 85. The maximum annuity start date may also be governed by state law.
Parties To An Annuity Contract An annuity contract involves three different parties - the owner, the annuitant and the beneficiary. Annuity Owner The owner is the person (natural or non-natural) who owns the annuity. The annuity contract specifies certain rights of the owner, such as the ability to withdraw funds, name the annuitant and beneficiary, and determine, within contract restrictions, the annuitization date and annuitization method. Some annuity companies allow the owner to change the annuitant on a contract, or add, change or delete an owner or joint owner. The owner can change the beneficiary at any time, as long as no irrevocable beneficiary has been named. Joint Ownership Some contracts allow joint ownership. This means that the contract is owned equally by both owners, and all transactions and changes such as those listed above will require the signature of both owners. The owners may never transact on the contract independently of one another. In
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addition, most experts agree that all tax ramifications of the contract during the owners’ lifetimes are also shared equally, on a 50/50 basis. This aspect is discussed in more detail in Chapter Five. Sometimes, the intended purpose for naming a joint owner is to ensure that at one owner’s death, the other owner can remain owner of the annuity contract. However, annuity contracts may contain provisions that require that a death benefit be paid to a beneficiary at the death of one owner. In addition, the Internal Revenue Code (IRC) contains restrictions on continuation of an annuity upon an owner’s death. Therefore, joint ownership on an annuity contract does not guarantee that the surviving joint owner may continue a contract. Non-Natural Owners The owner of the contract may be a natural or non-natural person. A “non-natural” person refers to entities such as corporations or trusts. If a non-natural person owns an annuity, however, the annuity loses its tax deferral status. The exception to this loss of tax deferral is certain trusts which are considered an agent for a natural person (e.g. a revocable living trust). Some insurance companies will not open annuity contracts for non-natural persons because of the loss of tax deferral restriction. Annuitant The annuitant is generally the measuring life on the contract. Measuring life means that in many (but not all) deferred annuity contracts, the annuitant’s death ends the contract; at the annuitant’s death, a death benefit is paid to the beneficiary. (“Death benefit” for the purpose of this manual is defined as a payout of full contract value with no surrender charges applied.) If a life income option is selected, the insurance company’s actuary staff uses the annuitant’s life expectancy on an annuitized contract to determine payment levels. Life expectancy is also used to determine the length of time a deferred contract may be held for both expected profit and reserve levels. Joint annuitants are allowed on some annuity contracts. As with almost every item in an annuity contract, the ramifications of naming a joint annuitant vary, but in most cases, the contract will not pay a death benefit as long as there is a surviving annuitant.
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The annuitant cannot be a non-natural person. Chapter Five discusses in detail the different death distribution structures possible in an annuity contract. Beneficiary The beneficiary receives the annuity proceeds upon death of the annuitant and/or owner, as specified in the contract. Any person, natural or non-natural, may be named as beneficiary. Contract application forms normally contain room for naming both primary and contingent, or Class I and Class II, beneficiaries. Primary, or Class I Beneficiaries. Beneficiaries listed as primary will receive the annuity death proceeds, if living. More than one beneficiary may be named to share in the death proceeds at the primary beneficiary level. Contingent, or Class II Beneficiaries. Contingent beneficiaries receive the annuity proceeds only if all primary beneficiaries are deceased at the time of the death of the annuitant or owner. A contingent beneficiary should generally be included on a contract in case the primary beneficiary predeceases the annuity owner. Beneficiary Designations. Insurance companies normally require that the beneficiaries’ names, relationship and designation are spelled out clearly before issuing annuity contracts. The insurance company can then be certain that the death distribution is paid as quickly as possible to the appropriate beneficiaries. Potentially unclear designations such as “all children,” “estate,” “siblings,” etc. should be avoided. Instead, clear designations such as “John Smith, son of Randall Smith, and Rose Evers, daughter of Randall Smith” or “Estate of Randall Smith.” should be used. Per - Capita
Most insurance companies assume per capita distribution when more than one beneficiary is named in the same beneficiary class. For example, a per capita distribution when “John Smith, son and Rose Evers, daughter” are named would mean that John and Rose would share equally in the death distribution, if living. If only one were alive at Randall Smith’s death, that one would receive the entire distribution.
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Per Stirpes
Per stirpes is a beneficiary designation meaning that if one of the named beneficiaries within the same class is deceased at the time of distribution, that beneficiary’s share goes to his children, to his grandchildren if their children were also no longer living, or to his estate if no heirs survived. Because of the potential difficulty in locating per stirpes descendants, some insurance companies will not recognize this type of beneficiary designation. Percentage Distributions
Beneficiaries may be designated to receive a percentage of the proceeds. In this situation, should a named beneficiary pre-decease the annuitant and/or owner, the insurance company may assume a per capita distribution of the percentages allocated to a deceased beneficiary. The surviving beneficiaries would then share equally in the deceased beneficiary’s share. When complicated beneficiary designations are requested by an annuity applicant, it is wise to check with the insurance company’s legal department to determine the clearest method of describing the designation.
The Annuity Contract The annuity contract contains important information and provisions and is given to the client once the policy has been issued. The annuity owner has a certain number of days from the date the deferred contract is received to review the contract. This period of time is known as the freelook period. If the owner decides not to take the policy within this period of time, the insurance company will return the contribution in full to the owner. Contract provisions include: • • • • •
Defining the owner, annuitant and beneficiary, and the role each plays in the contract life. Disclosure of the interest rate guarantees and/or guarantee periods for the initial rate, the minimum rate and renewal rates. Explanation of income options and when these options may be selected without withdrawal charges. The withdrawal or surrender charge schedule and the circumstances under which charges are applied. Explanation of administrative charges, if any.
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• • •
Special features, such as nursing home waivers, systematic withdrawal, guarantee of principal. The actions resulting from the death of the owner, annuitant or beneficiary. Any state disclosure requirements.
ANNUITY APPLICATION Before the policy can be issued, an application must be completed and premium paid to the insurance company. The application will typically include: • • • • • • •
Name, social security number, sex, birth date and address of the owner (s). Name, birth date, sex and social security number of the annuitant (s). Name and relationship of the beneficiary(ies). Some applications require the social security number as well. Type of annuity, if the company offers more than one type. Whether this annuity is replacing another annuity. Signature of owner(s). Some applications require the signature of the annuitant(s) as well. Signature of the agent accepting the application.
Along with the application, additional forms may be required for disclosure purposes. If replacement of the annuity is involved, certain states require that additional information be taken from and given to the applicant. Once the insurance company receives the application and premium, unless information is missing or the parties on the application do not qualify under the contract parameters, the insurance company will issue a policy. The policy normally consists of the contract, a copy of the application, and any state disclosures required. Some contracts are issued in the field, and are referred to as field issue or instant issue contracts. The agent accepts the money on behalf of the insurance company, completes the application with the annuity owners, and attaches an application copy to a contract, which is given to the customer immediately. If the insurance company finds any errors or omissions in the application when it is received, it will send an
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endorsement to the contract to the agent or directly to the policy owners. The endorsement will require that correct or missing information be supplied and that all owners sign, or the contract will be invalidated. Field issue contracts are often popular with customers, who like taking a contract with them at the time of submitting premium.
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CHAPTER TWO: FIXED ANNUITY FEATURES Competition and customer demand have spawned a multitude of features in the fixed annuity marketplace. This chapter will discuss features commonly found in today’s annuities. Interest rates will be discussed separately, in Chapter Three.
Tax Deferral Deferred annuities, as noted, are tax-deferred instruments, as long as they meet requirements set forth in IRC Section 72, which defines the requirements of a tax-deferred annuity. Under these regulations, earnings from an annuity are not taxed until withdrawn. The difference between tax-deferred growth and growth on a taxable instrument can be significant, depending upon the length of time the earnings remain in the annuity, and the marginal tax bracket of the annuity owner. Example of Tax Deferred Growth Assume a customer in a 28% federal marginal tax-bracket has $7,500 to contribute to an annuity annually. Exhibit 2 compares the growth of a tax-deferred annuity for this customer paying 3.5% over twenty years to a taxable certificate of deposit, also paying 3.5% over twenty years. The annuity tax-deferred value is over $23,200 greater than a taxable account, if we assume the taxes are paid from the taxable account accumulations. [Note: This comparison is for illustration purposes within this manual only. Any illustration shown to a customer must include disclosures, such as minimum rate guarantees, and surrender charges. Numbers are rounded.] The effect of tax-deferral prior to withdrawal is significant. To determine if an annuity compares favorably to a taxable account over the entire life of the annuity, factors such as whether the contract will be annuitized, if and when withdrawals will be made, and the anticipated tax bracket of the client when withdrawals or annuity payments are taken must be considered.
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Exhibit 2. Tax Deferred Growth Comparison of Tax-Deferred Growth to Growth In A Taxable Account
The effect of tax-deferral prior to withdrawal is dramatic. To determine if an annuity compares favorably to a taxable account over the entire life of the annuity, factors such as whether the contract will be annuitized, if and when withdrawals will be made, and the anticipated tax bracket of the client when withdrawals or annuity payments are taken must be considered.
Probate Avoidance
Annuities, as life insurance products, can avoid probate: the death benefit can be paid directly to the beneficiary. If the estate of the deceased is named as beneficiary, the annuity proceeds will be probated before distribution to heirs of the estate. Probate Defined Probate is the process of ensuring property bequeathed through a will or via intestacy laws is free from creditor claims. (Intestacy laws are state statutes dictating how property is dispersed when no valid will exists at a property owner’s death.) Probate is a lengthy process involving
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ensuring the validity of the will, appraising all property, notifying potential creditors of the death of the property owner through public notices, identifying all heirs, paying all applicable taxes, giving creditors a period of time in which to come forward with claims, and finally distributing the remaining property as the will or intestacy law directs. Many people desire to avoid probate because of the publicity, delay and expense involved: Publicity: Each asset and debt, along with its value or liability, is listed as part of public record. Delay: Probate often takes eighteen months to two years to complete. During the time that the estate is being probated, the assets of the estate cannot be accessed by the heirs. Expense: Commonly, five or more percent of the estate’s value will be assessed in probate related legal fees. Life insurance is not the only vehicle that avoids probate. Other methods include placing property in joint tenancy, in a revocable living trust, in “pay-on-death’ bank accounts, in “transfer on death” brokerage accounts and making lifetime gifts to remove property from the estate.
Free Withdrawals Most annuity contracts allow a certain amount to be withdrawn from the contract value without a withdrawal or surrender charge applied. This feature is commonly known as the penalty-free withdrawal feature. Common penalty-free amount options found in annuity products are: •
10% of the accumulated value.
•
10% of premium.
•
An amount equal to all interest earned.
•
A cumulative free withdrawal, e.g. 10% in year one, 20% in year two if the prior year’s free withdrawal was not taken, and so on.
Normally, surrender charges are applied to withdrawal amounts greater than the penalty free amount. Annuity contracts with rate guarantees that extend for more than one year may have more restrictions on free withdrawal provisions than those with one year rate guarantee periods.
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Surrender Or Withdrawal Charges Annuities normally include an initial surrender charge period. A charge is applied for withdrawals greater than the penalty free amount for a specified period of time. For example, a contract may have a surrender charge for the first six years of the contract wherein the first year a charge of 6% is assessed on the amount withdrawn (above the free amount), the second year 5%, the third 4% and so on until after the sixth year the charge is zero. Surrender charges may be based on the accumulated value, less the free withdrawal amount, or premiums contributed, less the free withdrawal amount. The length of the surrender charge period may be the same as the rate guarantee period on the annuity. For example, a contract with a 5 year guaranteed rate may have a five year surrender charge period. The surrender period may be based upon the date of initial contribution, policy issue date, or there may be a surrender period for each contribution. Under the first method, if a contract is opened on 1/2/05 and has a six-year surrender period, regardless of how many and when additional contributions are made, the surrender charge period will be over by 1/2/2011 (six years). Under the second method, the initial contribution would have a six-year surrender period, and each additional contribution would have its own six-year surrender period, beginning on the date the insurance company credits the additional contribution to the policy. Surrender charges do not apply if a contract is surrendered, or canceled, during the free look period. The free look period is the period of time an annuity owner has to review the policy and cancel without penalty. The free look period length can vary based on state regulation. Some states require a ten day free look period, others a free look period as long as thirty days. If a contract is surrendered during the free look period, the amount returned is principle only. The insurance company does not generally pay interest to the owner on a contract surrendered during the free look period. Market Value Adjustment Some surrender schedules incorporate a Market Value Adjustment or MVA. If current, new money rates are lower than the rate the annuity is
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paying at surrender, the annuity will be given a positive cash value adjustment, resulting in a higher surrender value than if no MVA was calculated. If current, new money rates are higher than the rate the annuity is paying at surrender, a negative adjustment to cash value will be made, resulting in a lower surrender value than if the MVA was not calculated. The idea behind an MVA is that the insurance company will have to pay less to replace moneys surrendered in a decreasing rate environment, so the contract value is given a positive MVA. In an increasing rate environment, the cost of new money is higher for the insurance company, so there is a negative MVA applied to the surrendered policy. CD Annuities Annuities referred to as CD annuities may not allow any withdrawals whatsoever during the rate guarantee period for that annuity. There is no surrender charge, per se. CD annuities are often “bare bones” annuities, with a one-, three-, five- or seven-year rate guarantee period and no free withdrawals, no nursing home waivers, and no additions allowed.
Principal Guarantee Principal guarantee means that if the annuity owner makes a full surrender, he will never receive less than his principal. Two important points regarding most guarantee of principal features: 1) Surrender charges apply to withdrawals or partial surrenders which are greater than the free withdrawal amount, but less than a full surrender. 2) When partial surrenders are made, for the purposes of calculating guarantee of principal, the insurance company reduces principal by the amount withdrawn plus applicable surrender charges. Assume a $20,000 annuity is purchased which is earning 4.5%, with a five year surrender schedule of 10%, 9%, 8%, 7%, 6%, a 10% free withdrawal feature, and a guarantee of principal feature. 1) If the customer withdrew $5000 in year one, a 10% surrender charge would apply to the amount withdrawn exceeding the free amount. Assume the policy is worth $20,450 at the time of
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withdrawal. $2045 of the $5000 withdrawal would be the penalty free withdrawal, and $2955 would be subject to a 10% surrender charge of $295.50. Principal, in terms of the guarantee of principal feature, is now $14,704.50 -- $20,000 premium, less the $5,000 withdrawal and the $295.50 surrender charge. 2) Assume the customer then surrendered in the second year and the annuity value was $15,350. The penalty free amount of $1535 would have no charge applied, but the remaining $13,815 would be subject to a 9% surrender charge of $1243.35 resulting in a net surrender value of $12,571.65. The guaranteed principal is now $13,169 ($14,704 less $1535). Since this principal amount is more than the net surrender amount calculated at $12,571.65, the full surrender charge will not apply, and the customer will receive $13,169. The annuity owner received $5000 in year one, $1535 (free amount) and $13,169 in year two for a total of $19,704. He was charged $295.50 in surrender charges. If the owner had surrendered the contract in one lump sum, with no prior withdrawals, he would have received a minimum of $20,000 regardless of the calculated surrender charges, since the principal was contractually guaranteed at full surrender. Year One: $20,450.00 - 5000.00 -295.50 $14,704.50
$20,000 original principal Value at time of withdrawal $2045 penalty free and $2955 subject to penalty surrender charge penalty Principal remaining
Year Two: $15,350.00 -1535.00 $13,815.00 -1243.35 $12,571.65
Value at time of surrender penalty free amount Amount to apply surrender charge surrender charge penalty Net Surrender Value
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Principle Guarantee Calculation: $20,000.00 -5,000.00 -295.50 14,704.50 -1535.00 $13169.50
Original Contribution Withdrawal Year One Surrender Charge Year One Principle Remaining (Guaranteed) Free Withdrawal Year Two Principle Remaining (Guaranteed)
$13,169.50
Amount Received at Surrender
Note that the IRS regulations would treat the withdrawals as being comprised first of any interest in the contract even though the insurance contract treats the withdrawals as principal first for the purposes of principal guarantee provisions.
Systematic Withdrawals Systematic withdrawals allow regular income to be withdrawn from an annuity, without locking the client into a payout schedule, as annuitization does. Systematic withdrawals are paid on a monthly, quarterly, semi-annual or annual basis, as the respective annuity product allows, on an automatic basis. The contract may allow the withdrawals to be based on a percentage of the contract value, a specific dollar amount, or an amount equal to interest earned. If the withdrawals exceed the penalty-free withdrawal amount, normal surrender charges generally apply. Systematic withdrawals occur during the deferral stage; systematic withdrawal payments are not annuity payments. Systematic withdrawal payments may be stopped and started and withdrawal amounts may be changed. Systematic withdrawals can be mailed directly to the payee, and may often be deposited directly to a bank account through electronic funds transfer. The check may also be mailed from the insurance company to the customer’s bank for deposit. Some annuity contracts place restrictions on the free withdrawal privilege if systematic withdrawals are taken. For example, some
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contracts allow systematic withdrawal of amounts equal to interest or a single withdrawal up to the free withdrawal amount without surrender charges. But, if systematic withdrawals are being taken and a random withdrawal is made, surrender charges apply. Other annuity products allow an annual random withdrawal along with systematic withdrawals, as long as the total withdrawn does not exceed the free withdrawal amount. Since the IRC states that withdrawals from annuities are comprised of interest first, monthly withdrawals can effectively remove the taxdeferral feature of an annuity. And, systematic withdrawals taken more frequently than annually will also reduce the yield on the annuity, since earnings will not be compounding upon earnings. The calculation of annuity yields is discussed further in Chapter Three.
Medical Or Nursing Home Waivers Annuities may contain a Medical Waiver or Nursing Home Waiver. This feature allows withdrawing from or taking a full surrender with normally applied surrender charges waived for nursing home, Hospice or Hospital stays. The conditions to qualify under a nursing home waiver vary, but generally, a stay of a specific length, e.g. thirty, sixty or ninety days, in a qualified facility as defined by the contract, is required. The contract may apply the waiver based on the annuitant and/or owner’s medical stay, and in some cases the medical stay of the spouse of the annuitant or owner may also be included in the provisions of the waiver. Most waivers are careful to specify that the confinement begin after the policy opening date, but a few available do not preclude the application of the waiver to persons in a nursing home at the time of purchase. State regulation may govern what type of facility is considered a qualified facility, the length of time required to stay in the facility before the waiver applies, and other provisions in the waiver. Another variance in the nursing home waiver feature is whether or not the insurance company allows multiple withdrawals to be taken once the required confinement period has been met, or if a one-time only withdrawal or surrender may be made.
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Other Surrender Charge Waivers A few annuity products include a waiver of surrender charges based on disability of the owner and/or annuitant. Another item for which surrender charges are waived in some cases is the situation when required minimum distributions from qualified annuities exceed the penalty free amount allowed in the annuity contract.
Maturity Date Or Maximum Deferral Age The maximum deferral age, also referred to as the annuitization date or maturity date, is the date when annuitization or liquidation of the contract must commence. Some states require that annuities mature by a certain age, e.g. 85. Other states allow deferral through age 100. This feature is important because some clients would like to pass the entire value of their annuities directly on to their beneficiaries. If the maximum deferral age is high enough, chances are the client will be able to do so. The maximum deferral age also impacts the maximum annuitant or owner age allowed to open the contract. For example, if a contract has a maximum deferral age of 85, and a ten-year surrender schedule, the maximum age to open the contract will likely be age 75. Some annuity products may specify a certain maximum maturity date, but, if state laws allow, the insurance company may operationally allow the holder to continue deferral of the contract to some higher age.
Premium Tax Premium tax is not exactly an annuity feature, but the way in which the annuity company charges the customer for premium tax affects the desirability of a product, just as features do. Premium tax is charged by some states on annuity premium. Some states charge a front-end tax, meaning it must be paid to the state at the time the annuity contract is opened. Other states charge a back-end tax, meaning at annuitization, and in some cases, at death and surrender as well. Many companies pay for the premium tax which is due up-front, and only charge the customer at annuitization or surrender. Other companies reduce the rate of return on their products in states with high front-end tax.
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CHAPTER THREE: FIXED ANNUITY RATES
Fixed annuity products have several rates important to the customer: the initial rate, the rate on additional contributions (if the product is a flexible premium product), the renewal rate, the bail out rate, and the minimum guaranteed rate.
The Initial Rate The initial rate is the rate earned on the initial or opening contribution to the annuity. The initial rate may be guaranteed for a wide variety of periods, depending on the annuity contract offered by the insurance company. This period may be as short as a three-month period and as long as ten or twenty years. The annuity contract itself is the best source to verify the initial rate guarantee period for any particular product. Bonus and Base Rates The initial rate may be declared as a bonus rate or as a non-bonus or base rate by the insurance company. A bonus rate is one inflated for a period of time, and is higher than the base rate the insurance company calculates would be paid as interest on the product. A typical bonus rate would be one percentage point higher than the base rate, but some products may have a one-half, two, three percent or higher bonus rate. Sometimes, to qualify for the bonus rate, certain specifications must be met. This is particularly common for products with high bonus rates. For example, the contract may have to be held for a certain length of time for the bonus rate to apply. Or, the contract may have to be distributed in a certain manner, e.g. as an annuity of at least five years. If the conditions are not met, the bonus will not be credited to the account value.
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Premium or Rate Bonuses Bonus rates may be either premium or rate bonuses. In the case of a premium bonus, a certain percentage of additional premium is credited to a contribution, and a stated interest rate is applied to the sum of the contribution and additional premium. For example, if a product has a one percent premium bonus and $10,000 is contributed, the stated base rate of, say, four percent would be credited to $10,100 of premium. In the case of a one percent interest rate bonus with the same base rate of four percent and $10,000 contribution, a five percent rate would be applied for the first year.
Factors In Rate Setting To further understand the difference between a bonus rate and a base rate, a basic understanding of the factors influencing what rate an insurance company will pay on a product is important. Many factors come into play in determining rates, and, very likely, no two insurance companies determine crediting rates identically. But certain commonalities may be found in the elements of rate setting. Competition Insurance companies often track rates other insurance companies are paying on competing products, especially products distributed to similar markets as their own. For example, some annuity companies focus on distribution through captive agents, some through independent agents, some through agents in financial institutions, others through agents in stock brokerage firms. The insurance company may either focus on a particular distribution market, or may design products differently for these distribution streams and the different customer bases they reach. The rate of an annuity is affected by what rate the competitive annuity products within its distribution market are paying. Product Features Product features affect the probability of certain profit margins being reached by the insurance company. For example, the length of the surrender schedule, along with the percentage charged in each year of the schedule affects the length of time an annuity is held by a client, and how much money the insurance company can count on to retain should the client surrender prior to the end of the surrender schedule. An annuity with a long surrender schedule with relatively high percentage
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charges each year will likely pay a higher interest rate than one with a short surrender schedule with relatively low surrender charge percentages, particularly if both products are issued by the same company. Withdrawal features also affect interest rates. The annual amount free, nursing home waivers, systematic withdrawal availability, and how soon after policy issue the product may be annuitized without penalty all factor into the equations insurance companies use to determine the rate paid. Principal guarantee, the inclusion or exclusion of administrative charges, and the length of the initial rate guarantee are also factors in rate setting. Commission Commission rate paid the agent and/or agency is another element in the interest rate setting decision. Lower commission products may have higher rates and/or features like short surrender schedules and flexible withdrawal features. Lower commission does not always mean higher rates, just as higher commission does not always mean lower rates, since the combination of features, administrative charges, and commission chargebacks all impact rates. Investments The insurance company places the moneys received through the purchase of its products in a variety of instruments, including, but not limited to, bonds, mortgages, stocks, real estate and short-term instruments. Each company will invest its moneys differently among its mix of suitable instruments, and of course, each company’s investments will have a different return. Portfolio Method Of Investing In establishing interest rates paid, some insurance companies use a return on a portfolio which consists of all moneys received from the purchases of a particular type of annuity product. For example, moneys received in 2008 for the purchase of a company’s FPDA annuity and used to purchase bonds yielding 4% is mixed with moneys received in 2009 and used to purchase bonds yielding 5%. The resulting calculated investment return to the insurance company is a blend of these
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investment returns and it is this portfolio rate of return that is used to determine new money and renewal interest rates. This is commonly known as the portfolio method of investing and interest rate crediting. Bucket Or Banded Method Of Investing Other insurance companies use the bucket or banded method of determining a return on investment and resultant interest rate crediting. This means that moneys that are received during a particular time period are segregated in terms of investment return tracking. Money used to purchase an FPDA annuity in 2008 and invested by the company in 4% bonds would be tracked separately for interest rate crediting purposes than moneys from annuities purchased in 2009. The initial rates and subsequent rates would be all based on the return and performance of the investments purchased with each band of time (allowing for turnover and management of these investments in subsequent years). Premium Tax If front-end premium tax is charged to the purchaser of the annuity, the return on the annuity will be affected. For example, if the front-end tax were one percent, an insurance company passing that tax onto the customer may reduce the premium by one percent, and apply the full stated rate to the remaining account value. Other companies have a lower crediting rate in states with premium tax. For example, in most states a product may pay 4.5%, but in a premium tax state, may pay 4.0%. Interest Rate Setting To bring all these components together, the example below illustrates how an insurance company might calculate an interest rate. In this example, it is assumed the insurance company has determined the cost in rate for each feature. E.g. a systematic withdrawal feature costs 5 basis points (.05%) in rate, a principal guarantee feature costs 2.5 basis points (.025%), etc. This insurance company also has an internal policy to match its competitive survey rate average for this annuity product. The example below is for explanatory purposes only. Insurance companies are as different as the people that run them, and the rate setting process varies. However, this method of calculation provides a good example of the components of the rate setting process:
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Sample Interest Rate Setting Model Return on portfolio:
7.500%
Less: Spread (profit to insurance company):
2.000%
Cost of 5 year surrender schedule:
1.000%
Principal guarantee:
.025%
Commission paid:
.500%
Cumulative withdrawal feature:
.150%
Calculated Rate: Competition survey rate average:
3.825% 4.000%
Base Rate Set:
4.000%
Bonus (1 year) Rate Set:
5.000%
The “Phantom” Rate In many ways, from the customer’s perspective, the base rate on a bonus product may be somewhat of a “phantom” rate. Since the following years’ rates may be subject to the performance of the portfolio or bucket at that time, the current base rate on a bonus product may never be credited to a customer’s annuity. Unless the contract specifically guarantees future rates (other than the minimum rate) after the bonus rate period has expired, the agent must be careful not to give the customer the expectation that the rate after the bonus rate has expired will be equal to the base rate in effect at purchase.
Renewal Rates Renewal rates are the rates paid after the initial rate guarantee period has expired. To establish renewal rates, insurance companies use either the portfolio or the bucket method. Generally, they will take a look at the return on the portfolio or bucket, make adjustments for current “experience” (incidence of surrenders, deaths, withdrawals and cancellations), assess competition, and then set the renewal rate. Renewal rates, like initial rates, may be guaranteed for a day, a quarter, a month, twelve months, a calendar year, or any other time length the
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insurance company determines. Some companies quote administrative policies regarding the expected renewal rates, even though this rate is not contractually guaranteed. For example, a company may have the administrative policy of renewing products within twenty basis point of the initial rate. Since this rate is not contractually guaranteed the principle of caveat emptor (let the buyer beware) applies. Reasons companies operate under administrative policies rather than guarantees for a product may be because guarantees must be backed by reserves, or because the company wants to retain the flexibility to respond to dramatic changes in the interest rate environment.
Additional Contribution Rate Flexible premium annuities pay a stated interest rate for additional contributions. Many pay the new money rate. Most contracts using this method consider the new money rate in effect for initial contributions and any additional contributions made during the same rate period. For example, assume that the rate on an FPDA for new money in the month of April is 4%. All new annuities opened and any additions added during this month to existing policies will receive 4% for a one-year period. Another additional contribution rate method is to credit additions with the rate in effect at the time the annuity was opened for the first contract year, and the renewal rate in years following. Assume a contract was opened on April 1, 2008 for 4%. All additions through March 2009 will also receive 4%. On April 1, 2009, all new additions and the existing account value will be credited the renewal rate at the time: 4.25%. This latter method is often used by companies using the portfolio method of interest rate crediting, since all moneys will eventually earn the same rate, once the initial crediting period is over. Another variable in addition rate crediting occurs when a bonus rate is involved. Some companies pay additions the initial bonus rate in effect at the time the addition is made, and guarantee that rate for the normal bonus rate period (e.g. one year). Others will pay the bonus rate only on initial premium, not on additions.
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Bail Out Rates Some annuities offer a feature that allows the owner to surrender the annuity, or bail out of the annuity, if the rate ever falls below a certain percentage point. This point is known as the floor or the bail out rate. The amount of difference between the initial rate credited and the floor varies from product to product. The bail out rate may be stated as a specified percentage: The owner may surrender the contract in full with no surrender charges applied if the stated rate ever falls below 3.75%, or as a percentage difference from the initial rate: The owner may surrender the contract in full with no surrender charges applied if the stated rate ever falls more than 1.5% below the initial rate. Certain conditions normally have to be met to invoke the bail out feature. For example, the owner may have to request the surrender within thirty days of the rate change. Or the owner may have to invoke the bail out the first time the rate falls to the bail out level. If the owner waits until the second time (e.g. the following renewal period), the bail out feature may not apply.
Minimum Guaranteed Rate The minimum guaranteed rate is the rate the insurance company contractually guarantees to pay after the initial rate guarantee period has ended. This rate is normally stated as a percentage: 3.0%, but may be indexed: the greater of 3.0% or the one year T-bill rate. The minimum guaranteed rate may also be tiered: 3.5% in years 2 - 5, 4% in years 6 - 10, 3.0% thereafter. Certain state insurance commissioners prefer a stated, non-tiered rate, or will not allow a company to lower a product’s minimum rate. Minimum rate guarantees can therefore vary for the same product from state to state.
Rate Versus Yield The insurance industry commonly uses the term rate to denote what other members of the financial industry, for example banks, term yield. The quoted rate on an annuity is not a simple, non-compounded rate. It is the yield, after 360, 365, or 366 days of compounding, based usually on a daily interest rate factor. Methods of calculating the yield vary among insurance companies, but the general principal is the same: Bank customers are accustomed to the word rate meaning simple interest rate,
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and yield meaning return on compounded simple interest rate. The insurance industry often uses the word rate to mean annual return on compounded simple interest rate, or annual return on compounded daily interest rate factor. For example, a customer walks into a bank. The rate board sits in the middle of the bank and states 1 year CD: 2.50% rate, 2.75% yield. The bank customer knows the 1 year CD is actually going to pay them 2.75% for the 1 year term. This same customer, is speaking to an insurance agent, is told: the annuity rate is 3.50%. This customer may erroneously believe the yield will be something higher, e.g. 3.75%. This issue is especially pertinent when monthly systematic withdrawal payments equal to interest are taken from an annuity. Since money is withdrawn monthly, there is less money to compound, so the return on the annuity, instead of being 3.50% as in our example above, would be close to 3.30%. Many insurance companies have designed materials to more clearly specify that the interest rate quoted is more correctly termed yield and to include the effect of systematic withdrawals on the yield as well.
Historical Rates The issue of interest rates is many faceted, as this chapter has demonstrated. The historical crediting of new money and renewal rates on an annuity product can therefore be a valuable tool to determine the way in which the changing interest rate environment has impacted interest rate crediting on a particular product. Even if a product is new, if an insurance company is using an interest crediting model like the one discussed earlier under the heading Interest Rate Setting, a model renewal rate history may be available on the new product. The insurance company calculates what the rate would have been over the past years using the model and based on the features of the new product.
Setting Interest Rates On Single Premium Immediate Annuities An immediate annuity has different elements from a fixed annuity that are involved in the determination of its interest rate. These elements are: • return on investment • premium tax, if applicable
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• • • •
mortality risk for life income options administrative expense (for the processing of monthly checks or electronic funds transfer of payments) spread or profit margin commission paid
Since the value of an immediate annuity is steadily decreasing, the rate paid on the immediate annuity principal is expressed as an internal rate of return. Many insurance carriers do not disclose the internal rate of return, and suggest the client compare payout amount to payout amount when determining the best immediate annuity among competing products.
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CHAPTER FOUR: FIXED ANNUITY PAYMENTS This chapter will discuss receiving annuity payments through the purchase of a Single Premium Immediate Annuity (SPIA), or through annuitizing a deferred annuity. A SPIA is an annuity that will begin irrevocable periodic payments within twelve months of purchase. Annuitization of a deferred annuity refers to the commencement of irrevocable periodic payments sometime after twelve months from purchase. Annuity payments from a SPIA and an annuitized deferred contract fall under the same taxation rules in IRC section 72. Generally, the same income options are available under a SPIA contract and when a deferred contract is annuitized. The selection of an annuity option is virtually irrevocable. In other words, once payments have commenced, the contract owner cannot change to some other payment method, nor stop the payments. Some states allow a free look period for SPIAs, wherein the contract could be canceled. But a SPIA or annuitized deferred contract cannot be surrendered after this free look period as a deferred contract could be prior to annuitization.
Annuity Payment Features And Advantages There are several advantageous features to annuity payments. They include the following: Many Income Options Available To Meet Differing Customer Needs A variety of annuity income options are available, including income based on a single life, joint lives, or on a certain period of time. Some insurance companies offer payout options that will increase payments annually on a specified percentage basis, to adjust for inflation or as a cost-of-living-adjustment.
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Guaranteed Income At annuitization commencement, the insurance company guarantees to make payments of a specific amount, and these payments will not change. The customer does not have to worry about interest rate or dividend fluctuation as he or she would with many other incomeproducing products. The customer selects the mode of payment. Payment mode frequencies are usually monthly, quarterly, semi-annual or annual. The owner can often decide even what day of the month payments will be processed as well. Lifetime Income If a life option is selected, payments are guaranteed to continue for life. Payments can continue to beneficiaries under some life options as well. Convenience Along with being able to select how frequently and what day of the month payments are processed, many companies can directly deposit payments to a bank account. Taxation Unlike withdrawals from deferred annuities, which are currently taxed as being comprised of interest before principal, annuity payments are considered part interest and part principal. Therefore, taxation is spread over the payment period, rather than being levied up-front.
Parties Involved In Annuity Payments When annuity payments begin, four parties may be involved: the owner, annuitant, payee and beneficiary. Owner The owner of the annuity is the person who purchases the annuity. As discussed in Chapter One, the owner of a deferred contract has several rights during the deferral stage, including the right to withdraw funds, change the beneficiary, and in some cases to add or change the annuitant. Once annuitization commences on a deferred or immediate annuity, the owner’s rights are normally limited to changing the beneficiary. As noted, annuitization is irrevocable, so the owner cannot
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withdraw funds (aside from the annuity payments), make additional contributions, or change annuitants. Annuitant The annuitant is the measuring life on the contract. If an annuity income option is to be paid over life, it is the annuitant’s, and in some cases also the joint annuitant’s, life expectancy that is used to determine payment amounts. It is also the annuitant’s death that causes payments to cease, or to transfer to a beneficiary. Payee Some annuity contracts allow annuity payments to be made to a payee, someone other than the owner or annuitant. The tax issues surrounding the naming of a non-owner payee are discussed in Chapter Five. Beneficiary The beneficiary receives annuity payments, or in some cases, a lump sum, upon the death of the annuitant.
Income Options Life Income The life income annuity is sometimes referred to as a straight life option or life only option. Payments under a life income annuity are guaranteed for the annuitant’s lifetime and will cease at the annuitant’s death. Life and Period Certain Income Life and period certain payments are guaranteed for the annuitant’s lifetime, or for a certain period of time, whichever is greater. For example, if a life and ten year period certain annuity is purchased, payments will be paid for ten years, and will continue if the annuitant is still living at the end of the ten-year period. If the annuitant dies during the ten-year period, payments will continue to the beneficiary until the ten-year period expires. Life With Installment Refund Income Payments are guaranteed during the life of the annuitant and, if at the annuitant’s death the sum of all payments made are less than the
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principal paid to purchase the annuity, the beneficiary will continue to receive payments until the principal has been depleted. Life with Cash Refund Payments are guaranteed during the life of the annuitant and, if at the annuitant’s death, the sum of all payments made is less than the principal paid to purchase the annuity, the beneficiary will receive a lump sum equal to the remaining principal amount. Temporary Life Income Under a temporary life income annuity, payments are guaranteed for the annuitant’s lifetime, or for a certain period of time, whichever is shorter. For example, if a temporary life and ten year certain annuity is selected, and the annuitant dies in the fifth year, payments would cease in the fifth year. If the annuitant is still living at the end of the tenth year, the payments would cease at the end of the ten year period. Joint and Survivor Life Income Joint and survivor annuities are also referred to as last survivor annuities. Payments are guaranteed during the lives of both annuitants. Payments cease upon the death of the last surviving annuitant. Joint and Specified Percentage to Survivor Life Income Payments are guaranteed during the life of the first to die. After the first death, payments reduce by a specified percentage, e.g. 50%, and are paid until the death of the second to die. Joint and Specified Percentage to Contingent Life Income Payments are guaranteed during the life of the primary annuitant under a joint and specified percentage to contingent life income. After the primary annuitant’s death, payments reduce by a specified percentage, e.g. 50%, and are paid until the death of the joint annuitant. This option may also be available with installment or cash refund at the death of the joint annuitant. Joint and Survivor With Period Certain Income Under joint and survivor with period certain income annuities, payments are guaranteed for a specified period or the lives of joint annuitants, whichever is greater. If there is a surviving annuitant after
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the period certain time frame expires, payments continue until the death of the last annuitant. If both annuitants die prior to the period certain time frame expiration, the beneficiary will continue to receive payments until the certain period is over. Joint and Survivor Life With Installment Refund Payments under joint and survivor life with installment refund annuities are guaranteed during the lives of joint annuitants, and if at the last annuitant’s death the sum of all payments made are less than the principal paid to open the annuity, the beneficiary will continue to receive payments until the principal has been depleted. Joint and Survivor Life with Cash Refund Payments under joint and survivor life with cash refund annuities are guaranteed during the lives of joint annuitants, and if at the last annuitant’s death the sum of all payments made are less than the principal paid to open the annuity, the beneficiary will receive a lump sum equal to the remaining principal. Period Certain Under period certain annuities, payments are guaranteed for a certain period of time. If the annuitant dies during that time, payments will continue to the beneficiary until the specified period of time expires.
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CHAPTER FIVE: ANNUITIES*
TAXATION
OF
FIXED
Tax Deferral Earnings on annuities are not taxed until withdrawn, as long as the owner of the annuity is a natural person, or if the annuity is owned by a trust or an agent for a natural person. A common example of a trust that qualifies for tax deferral as owner of an annuity is a revocable living trust. The property within a living trust is generally taxed just as though it were titled under the name of the property owner. Most living trusts use the social security number of the property owner or owners, or the grantors of the trust for all tax reporting purposes. Withdrawals LIFO and FIFO Withdrawals Withdrawals from contracts opened after August 13, 1982 are considered to be made up of all interest in the contract before any principal or cost basis is withdrawn. The last money in (interest earned), is considered to be the first money out. This is known as LIFO: Last-In, First-Out. For example, assume a contract opened several months ago for $10,000 now has a value of $10,700. The owner withdraws $1000. Seven hundred of the one thousand dollar withdrawal is considered interest by the tax code, and is taxable. The remaining three hundred dollars is considered return of principal, and is not taxable. Contributions and earnings attributable to contributions made to contracts prior to August 14, 1982, are withdrawn as principal first, *Note: Although great effort has been made to ensure this publication contains accurate, timely information, it is provided with the understanding that the author and publisher are not engaged in rendering legal, accounting, tax, or other professional
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service. If professional advice is required, the services of a competent legal advisor should be sought.
interest last. The first money in, the premium or cost-basis, is withdrawn first. This taxation flow is known as FIFO: First-In, First-Out. Contributions and earnings attributable to contributions made after August 13, 1982, made to a contract opened prior to August 14, 1982, are withdrawn based on the LIFO distribution rules. But contributions and attributable earnings made prior to August 14, 1982 in this same contract retain their FIFO treatment. The IRS approved order of withdrawals and applicable taxation is as follows: • Withdrawn First: Pre-August 14, 1982, Cost Basis - Non-Taxable • Withdrawn Secondly: Earnings on Pre-August 14, 1982 Contributions - Taxable. • Withdrawn Thirdly: Earnings on Post-August 13, 1982 Contributions - Taxable • Withdrawn Last: Post-August 13, 1982, Cost Basis - Non-Taxable. If a contract purchased prior to August 14, 1982, is exchanged for a contract opened after August 13, 1982, the tax treatment (FIFO) is retained or grandfathered for contributions and earnings made prior to August 14, 1982. Pre - 59 ½ Distributions Regulations surrounding annuities are meant to encourage long-term retirement savings. As such, the IRS code includes an additional ten percent tax on the earnings withdrawn prior to the owner’s age 59 ½. The most common exception to this premature distribution tax are: 1) Withdrawals attributable to the owner’s disability. 2) Withdrawals of pre - August 14, 1982 contributions and earnings. 3) Distributions due to death. 4) Annuity payments made from an immediate annuity. Any income option, life or period certain is exempt from the premature distribution tax. However, if a client purchases a deferred annuity, holds it for longer than twelve months, then exchanges it for an immediate annuity, this exception to the premature distribution tax will not apply. The original
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opening date of the deferred contract will be used as the contract start date, so the annuity payments would not be deemed as immediate annuity payments by the IRS. 5) Payments based on the life or life expectancy of the contract holder or the joint life expectancies of the contract holder and beneficiary. These payments may not be modified for five years or until age 59 ½, whichever period of time is greater. If they are modified, the 10% tax will be due on all earnings distributed that would have been taxed if this exception did not apply. [Note: The IRS has issued a private-letter ruling which disallowed using systematic withdrawal payments based on life expectancy to meet this exception (Letter Ruling 9115041). The reasoning used was that the owner had the right to change or stop the systematic withdrawal payments. In contrast, any sort of life annuity option excluding temporary life would comply.] Multiple Contracts Another set of tax regulations affecting the treatment of interest and withdrawals came into effect on October 21, 1988. These regulations stated that if multiple deferred annuity contracts are entered into after October 21, 1988, with the same insurance company in any twelve-month period, the contracts will be viewed as one for purposes of determining interest earned and taxable withdrawal amounts. For example, three annuity contracts of $20,000 each are purchased through ABC insurance company on 1/2/09. Each contract earns $800 in interest in 2009. On 1/2/10, the owner requests a $2000 withdrawal from one of the three contracts. Since a total of $2400 in interest has been earned in the three contracts purchased in the same twelve-month period, the withdrawal is considered 100% interest and therefore 100% taxable.
Tax-Free Exchanges An annuity contract may be exchanged for another annuity contract without tax consequences under certain conditions. The Internal Revenue Code Section 1035 contains the regulations regarding the taxfree exchange of life insurance policies, so these exchanges are often referred to as 1035 exchanges.
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The conditions required for a non-taxable exchange of annuities are: 1) The exchange must be made directly from the surrendering insurance company to the receiving insurance company. The policy owner may not cash in a policy, receive the money, and then buy another annuity under tax-free exchange provisions. If the exchange is not made directly from insurance company to insurance company, the distribution will be taxed like any other distribution, including any applicable pre-59 ½ premature distribution tax. 2) The new contract must be payable to the same person (or persons) as the surrendered contract. Most insurance companies interpret this portion of the 1035 code to mean that the same owner, annuitant and beneficiary designations must be made on the new contract as were in place on the old contract. This issue may get sticky if the surrendering company allowed joint annuitants or joint owners and the new company does not. Often, the receiving company’s legal department can review the surrendering company’s contractual provisions regarding the roles and rights of the joint owner or joint annuitant to determine if the new contract can be structured to address these same roles and rights. In other words, if the new contract ownership can be constructed to meet the same objectives, payouts, and tax ramifications as the old, most insurance companies will accept the business as a taxfree exchange. 3) Life insurance and endowment contracts may also be exchanged for annuities on a tax-free basis, but annuities may not be exchanged tax-free for a life insurance or an endowment contract. 1035 Paperwork Requirements To exchange a policy, the policy owner completes surrender paperwork for the old policy. The receiving company normally has Absolute Assignment Forms or 1035 Exchange Forms that serve as a surrender request to the old company. The applicant completes and signs a new application for the new annuity contract, returns the old policy, and in many states, signs and completes required replacement forms. This paperwork is sent to the receiving insurance company. The receiving insurance company sends appropriate copies of the signed forms and the old policy to the surrendering insurance company. The surrendering
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insurance company calculates cost basis in the old contract and the amounts that are attributable to pre-August 14, 1982 contributions and reports these figures to the new company for future tax reporting purposes. The surrendering carrier calculates the surrender check and sends it to the receiving carrier, who then issues the new policy. 1035 Time Delays The time period to complete an exchange is commonly thirty to sixty days. The surrendering company often has conservation procedures such as notifying the original writing agent of the surrender, writing letters to the policy owner, etc., in an attempt to keep the business. The process of calculating cost basis, surrender value and issuing a check also adds to the turn-around time on an exchange. And, realistically, since the surrendering insurance company is losing business, they may prioritize existing customers transactions before to 1035 exchange transactions. Because of this delay, many companies offer a rate lock on 1035 business they receive, so that the client is guaranteed a rate for thirty to sixty days.
Taxation Of Annuity Payments As noted, earnings are taxed as withdrawn from deferred contracts, but once a contract is annuitized, or if a contract is an immediate annuity, different tax rules apply. Annuity payments are taxed as part principal, part interest. The IRS has specific rules regarding the calculation of the taxable and non-taxable portions of an annuity payment. The IRS calculation determines the exclusion ratio, the ratio used to calculate the portion of each payment that is non-taxable. Since the IRS calculation for a period certain annuity is the simplest, it will be illustrated to provide a general explanation of the calculation of the exclusion ratio: The exclusion ratio is the ratio of the investment in the contract to the expected return in the contract, and is the ratio of each payment which is not taxable. Exclusion Ratio = Investment in the Contract / Expected Return in the Contract Exclusion Ratio x Annuity Payment = Non-Taxable Amount of Payment
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Assume a ten year period certain annuity, purchased with $50,000 and paying $500.00 a month for ten years. Exclusion Ratio = $50,000 Investment in the Contract / [($500 x 12 mos.) x 10 yr.] Expected Return $50,000 $60,000
= 83.33% exclusion ratio
83.33% x $500 payment = $416.65, the non-taxable portion of each payment.
Who Pays The Taxes? Because of the different parties involved in an annuity, it is important to discuss which party has the tax liability at ownership changes, at annuitization, and at death. Who Owes The Taxes On Withdrawals? The owner of the contract has all rights to the contract and is considered by the IRS to have the responsibility for taxes due on withdrawals of interest and premature (pre 59 ½) withdrawals of interest. Who Owes the Taxes on A Jointly Held Annuity and at Ownership Changes? If joint owners are involved, it is generally held that the IRS views the annuity to be owned on a 50/50 basis. Therefore, each owner is liable for fifty percent of the income tax due on any withdrawal, and if one owner is over 59 ½ and the other is under, half of the interest paid out will be subject to the premature distribution tax. Another ramification of joint ownership is potential gifting. If the property used to purchase the annuity was not jointly held prior to purchasing the annuity, in other words if it was owned solely by one of the owners, for all contracts issued after April 22, 1987 a gift of 50% of the property is made at the time the joint owner is named on the annuity contract. The donor must report to the IRS gifts of over $13,000 made in one year to a donee, and gift tax may be due. And if the joint owner is added or if ownership is changed during the life of the contract, there
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may also be income tax ramifications, as described in the following example: Assume Joan Smith owns a deferred annuity. She opened the contract with $30,000 and the annuity is now valued at $35,000. She wants to reduce the value of her estate, so is considering gifting the annuity to her son, James. The gift would be accomplished by removing herself as owner and naming James as the owner. Since her contract was purchased after April 22, 1987, if she gifts this property, she will be making a completed gift to James of $35,000. She will have to file an annual gift tax return and may have a gift tax liability. In addition, Joan would also be responsible for the income tax due on the gain in the contract at the time of the gift. (The insurance company is required to report to the IRS the earnings of the contract at the time of the ownership change.) Depending on Joan’s specific situation, non-tax deferred property may be a more appropriate gift, since the income tax ramifications would not be so significant. If Joan were contemplating gifting a contract purchased prior to April 23, 1987, the completed gift will not be considered to be made until James cashes-in or surrenders the policy. At that time, the gain in the contract at the time of the gift will be Joan’s tax liability, and the gain in the contract after the gift will be James’ responsibility. Because of the potential complications regarding gifting, change of ownership and joint ownership, many insurance companies only allow ownership changes between spouses or to a living trust, and limit joint ownership to spouses. Who Pays The Tax At Annuitization? An assumption often erroneously made regarding annuity policies is that the owner is responsible for taxes during the deferred stage, and the annuitant is responsible during the annuitization stage. Generally, however, regardless of the property type, tax liability is the responsibility of the owner of the property. Therefore, at annuitization, the key question is: Who owns the property?
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If the owner and annuitant are the same person, obviously there is no question as to ownership, nor as to tax liability. But if an annuitant is named on an annuity contract that is not the owner, and the contract is annuitized, the tax liability question is pertinent. A second question must then be asked: Who receives the annuity payments? If annuity payments are made to the owner on the contract, the tax liability is still clear: the annuitant is solely the measuring life, and the owner as the property owner, receives payments and is taxed on those payments. But, some insurance companies pay the annuitant the annuity payments, and send the IRS the tax information under the annuitant’s social security number. Under this scenario, the insurance company must be viewing the naming of a non-owner annuitant as an intended gift. For contracts issued after April 22, 1987, gain in the contract is taxable to the owner at the time of the gift, so a gift at annuitization would mean the owner would be paying tax on the gain so far, so the taxation on the annuity payments may be comparatively minimal. The IRS has not clarified the taxation of annuity payments where an annuity purchased prior to April 23, 1987, was gifted. Only the situation of surrendering a policy, as discussed in the situation with Joan above, has been specifically addressed. By far, most annuity companies make annuity payments to the owner. Or, should an alternate payee be designated by the owner, the insurance company reports the taxable earnings under the owner’s social security number to the IRS (which should not be assumed to remove the owner’s legal responsibility of reporting any applicable gifts to the IRS). As can be seen, if the annuity insurance carrier makes annuity payments to the annuitant, and reports the taxable portion of the payments to the IRS under the annuitant’s social security number, the owner should be directed to his or her own legal expert counsel to determine when and if a gift has been made, and how income should be reported for tax purposes.
Taxation Rules At Death Any contract issued after January 18, 1985 (including contracts issued via 1035 exchange after this date) must follow certain distribution rules upon the death of a contract owner. The purpose of the death
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distribution rules is to ensure that annuity contracts cannot continue into perpetuity and therefore defer taxes into perpetuity. Death Prior To Annuitization If the owner dies prior to annuitization start, the contract must be distributed within five years of the owner’s death, or if begun within one year of the date of the owner’s death, as an annuity not to exceed the life expectancy of the beneficiary. The latter option (annuitization) must be selected within 60 days of the owner’s death. The annuity payments are taxed like any other annuity payments (spread over the life of the annuity). However, if the annuity election is not made within sixty days of the owner’s death, the IRC regulations treat the distribution as though it were received in the year of death, and it is taxed like a lump sum withdrawal - interest taxed as withdrawn. If a spouse is named as the owner’s beneficiary, the spouse can elect to continue the contract upon the owner’s death. Only a spouse named as beneficiary can continue a contract upon an owner’s death. The beneficiary treats taxable earnings received as unearned income, and is taxed at his or her own tax bracket, not that of the deceased owner. Death After Annuitization There are no mandatory distribution rules for an annuitized contract at death. The terms of the annuity income option dictate what happens to the proceeds of the policy at death. If the beneficiary receives any payment that includes a taxable portion, based on the exclusion ratio in place at the annuitant’s death, the beneficiary must pay taxes on that gain at his or her income tax bracket. Non-Natural Owners The IRS has clarified taxation rules for annuities owned by non-natural owners and distributions due to death from such contracts that occur after January 1985. The IRS explained that for contracts issued after April 22, 1987, the death distribution rules treat the annuitant as though the annuitant were the owner if a non-natural person is named as owner. In addition, if a primary annuitant is changed on a contract with a nonnatural owner, the distribution-at-death rules apply to the contract as though the owner had died.
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Insurance Company Application Of The Distribution At Death Rules The January 18, 1985, distribution rules pose an interesting dilemma for the insurance company. Traditionally many insurance companies considered the annuitant as the measuring life on a deferred contract, i.e., at the annuitant’s death, a death benefit (annuity contract value without surrender charges) was payable to the beneficiary. But the IRS distribution rules state that the owner’s death forces a payout. Although there are no hard and fast rules regarding how an insurance company may handle this issue, generally there are three death-atdistribution contract types into which a deferred annuity will fall. These are discussed below: Distribution At Death Deferred Contract Type I This contract structure pays a death benefit at the annuitant’s death and surrender value at a non-annuitant owner’s death. This contract type views the annuitant as the measuring life. At the annuitant’s death, full contract value, with no surrender charges, is paid to the annuitant’s beneficiary. This payout must be taken as a lump sum within one year of the annuitant’s death, or, if elected within sixty days, as an annuity not to exceed the life expectancy of the beneficiary. If a non-annuitant owner is named, and the owner pre-deceases the annuitant, the owner’s beneficiary must follow IRS requirements and take distribution within five years, or as an annuity. If the owner’s beneficiary is a spouse, the surviving spouse can continue the contract rather than take a forced distribution. If, at the time the distribution takes place any surrender charges are in force, they will be applied to the distribution value. If a non-spouse is the beneficiary on a contract structured in this manner, many insurance companies will allow the beneficiary to keep the contract in force for the five-year period so that the surrender charge period is passed or the charges decreased. Contracts of this sort often call the owner’s beneficiary the contingent owner, or the contract may state that the surviving joint owner is considered the owner’s beneficiary upon the owner’s death.
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Sometimes, contracts with this structure have a high maximum age for the owner and a lower maximum age for the annuitant. This is because the risk to the insurance company at the owner’s death is mitigated by surrender charges. Distribution At Death Deferred Contract Type II This type of contract pays a death benefit at the owner’s death and takes no action at the annuitant’s death. This contract type goes against the typical logic of annuitant as the measuring life of the policy. Instead, it is in sync with the IRS requirements, making the owner the trigger for distribution at death. More and more new product contracts are constructed in this manner. Basically, the annuitant is nothing more than a name in the annuitant space on the application. At the annuitant’s death, the owner names a new annuitant. It is upon the owner’s death that the death benefit is paid. The exception under this type of contract structure occurs when the owner is a non-natural person. As pointed out earlier, under that scenario, the annuitant’s death is considered the owner’s death for IRS distribution purposes and these contracts will treat the annuitant as owner when a non-natural owner is named. Distribution At Death Deferred Contract Type III This contract structure pays a death benefit at either the owner’s or the annuitant’s death. This contract type certainly can be the easiest to set up for a client without any unsuspected consequences to the owner or beneficiary. Under this type of contract, if either the annuitant or owner dies, the full annuity value is paid to the beneficiary. If the owner dies, the IRS distribution rules apply - a spousal beneficiary may continue the contract or the distribution must be taken with five years or as an annuity not to exceed the life expectancy of the beneficiary. If the annuitant dies, the payment must be made within one year or as an annuity not to exceed the life expectancy of the beneficiary.
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The three contract type descriptions above are very general and have been simplified for explanatory purposes. Joint ownership, joint annuitants, restrictions regarding spousal joint owners, and specific contract terms can alter the resultant distribution. One principle, however, is clear: naming the same person as owner and annuitant on an annuity contract can greatly simplify annuity distribution at death.
Estate Taxation Deferred Contract The contract value of a deferred annuity at the death of the owner is included in the owner’s estate. If a contract is jointly owned, generally only 50% of the value is included in the deceased owner’s estate. If the annuity proceeds are payable to a spouse upon the owner’s death, generally, the unlimited marital estate tax deduction applies. Annuitized Contract The type of annuity income selected by the owner impacts estate valuation. If a non-refund life annuity is purchased, no value will be included in the deceased annuity owner’s estate. If payment or payments continue after death to the deceased’s estate, the value of these payments are included in his or her estate. If payable to a beneficiary, the amount included in the deceased’s estate is based on his or her incidence of ownership in the contract. If the contract was jointly owned, 50% of the payment values are included in his or her estate. If solely owned by the deceased, 100% of the payment values are includable in the deceased’s estate.
Other Taxation Issues Taxation of Social Security Benefits Deferred annuity earnings (not withdrawn) are not included in the calculation used to determine the taxation of social security benefits. However, the taxable portion of annuity payments or withdrawals are considered part of unearned income, and as such, are part of the taxation of social security benefits calculation.
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Divorce Unlike qualified plans, the 10% premature distribution tax is not waived for distribution of annuities required under a qualified domestic relations order. However, annuities may be transferred due to divorce. Most carriers will accommodate such transfers, such as splitting a jointly held contract into two separate contracts. Assignment of Annuities, or Pledging an Annuity As Collateral The portion of an annuity assigned or pledged as collateral for a loan is viewed as a distribution, meaning earnings will generally be taxable. Premature distribution tax, if the annuity owner is under 59 ½, will also generally apply.
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CHAPTER SIX: ADVANTAGES OF THE VARIABLE ANNUITY
Flexible Income
Variable annuities offer several advantages as long-term investment vehicles. The two Investment Options foremost advantages are tax-deferral and the Tax - Deferral opportunity to choose among many different investment options. Other advantages include guaranteed death benefits and flexible annuity income options. Guaranteed Death Benefit
Tax- Deferral A variable annuity is both a securities and an insurance product. As an insurance product, the build up of account values is free from taxation until withdrawn. Tax deferral can provide a significant impact on growth when compared to growth in a taxable product, as was discussed in Chapter Two.
Investment Options Variable annuities include a number of different investment options called sub-accounts. Each sub-account has a specific investment objective, such as growth, total return, income or capital appreciation. The variable annuity purchaser may select the sub-accounts which best meet his or her investment objectives. As investment goals change, or market conditions warrant, account values may be redistributed within the variable annuity sub-accounts. An added advantage is that when moneys are moved from one subaccount to another, no current tax ramifications occur. This is different than transfers from mutual fund to mutual fund, even within the same fund family. Transfers among mutual funds, other than those within a qualified retirement plan or IRA, may cause current income and capital gains taxation.
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Investing in equity sub-accounts can act as a hedge against inflation. Historically, common stocks have generally risen as consumer price indices have risen. Inflation can reduce purchasing power significantly - remember when bread was a quarter a loaf and gasoline under a dollar per gallon? (If not, ask your parents.)
Guaranteed Death Benefits Many variable annuities include a guaranteed death benefit. Although the provisions vary, typically the minimum death benefit guarantee is a guarantee of the greater of the value of the contract at time of death or all premiums paid, less any withdrawals. Some variable annuities also include a stepped-up death benefit, wherein the contract values are frozen every certain number of years for the purposes of calculating the death benefit. The death benefit guarantee in this case is typically the greater of the stepped-up value, the current value at the time of death or the total of all premiums paid. A guaranteed death benefit is very attractive to those concerned about the value of the assets left to beneficiaries.
Variety of Flexible Income Options Variable annuities contain several income options to meet the varying income needs of the contract holder. Annuity income or annuitization options include income for life as well as income for specified periods of time. Income can normally be received every month, every quarter, or once a year, as the customer desires. Income from a variable annuity can often be taken as regular, systematic withdrawals as an alternative to, or prior to, annuitization payments. These payments can be started and stopped as necessary and can also generally be received on a monthly, quarterly or annual basis.
Summary Variable annuities mix the advantages of insurance and securities. The insurance benefits of tax-deferral, death benefit guarantees and annuity income options are combined with the benefits of self-directed investing
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and numerous investment options normally associated with securities products. Because of these advantages, more and more variable annuities are being purchased to meet long-term investing and retirement needs.
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CHAPTER SEVEN: VARIABLE ANNUITY FUNDAMENTALS A variable annuity is a contract between the annuity owner and an insurance company. It is a tax-deferred product that allows the purchaser to allocate contributions to one or more sub-accounts. A sub-account is a pool of securities invested to meet a specified objective. A variable annuity also includes the option to receive annuity income payments at a specified date in the future. The variable annuity is so-named because the return on the annuity is variable. Returns vary based on the performance of the sub-accounts selected by the purchaser. Fixed annuities are another type of annuity contract issued by insurance companies. Fixed annuities pay a fixed rate of interest, established by the insurance company. Fixed rate annuities typically guarantee the rate of interest paid on their contracts for contiguous one year periods.
Deferred Contracts Most variable annuities are considered deferred because annuity income payments do not begin until sometime after the first twelve months from the policy opening date. In addition, earnings on the policy are deferred from taxation until withdrawn. If annuity income payments begin within twelve months of purchase, the IRS considers the contract an immediate income annuity. Purchases of variable immediate income annuities are less common than fixed immediate income annuities since typically the variable annuity purchaser is a longer-term investor, looking for growth. This subject is covered in more detail in a later chapter. Tax-Deferral Since a variable annuity includes the characteristics of an insurance product, the earnings within the variable annuity are not subject to
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taxation until withdrawn. Annuities include this tax-deferred advantage based on Internal Revenue Code Section 72. The effect of tax-deferral on an annuity’s return can be quite significant, depending on the length of time the earnings remain in the annuity, and the marginal tax bracket of the annuity owner, as was illustrated in Chapter Two.
Premium Payments Two types of variable annuities are available: flexible premium and single premium. Flexible Premium Variable Annuities The purchaser opens a flexible premium annuity with a single contribution, but may make additional contributions to the policy. The contributions may normally be made at anytime during the life of the policy. Single Premium Variable Annuities The purchaser makes only one opening contribution to a single premium annuity.
The Variable Annuity As A Security Variable annuities are regulated as both an insurance product and a securities product. To sell a variable annuity, both an insurance and Series 6 securities license are required. States may require either a life insurance license or a special variable annuity insurance license to sell variable annuities. Investment Risk Variable annuities are regulated as a security because the variable annuity policyowner bears investment risk: the policyowner chooses where his purchases are allocated among the sub-accounts. Fixed annuities, on the other hand, are not considered securities because the insurance company assumes the investment risk. The insurance company takes the risk that it will be able to meet the obligations of a fixed annuity contract - the initial rate guarantee, the minimum rate guarantee, and any other guarantees of the contract. Even though a
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variable annuity may include guarantees that equate to an insurance company risk, the preponderance of risk is assumed by the policyholder. The Separate Account The separate account is used by the insurer to hold the sub-account assets of the variable annuity. Under federal securities law, the separate account is considered a separate legal entity from the insurance company issuing the variable annuity. The separate account must be registered as an investment company under the Investment Company Act of 1940. This is the same act which governs the registration of investment companies issuing mutual funds and sets forth the requirements relating to promotion, reporting requirements, pricing of securities for sale to the public and allocation of investments within a portfolio. The separate account may be managed by a firm outside of the insurance company. It is not uncommon for a variable annuity to have more than one separate account affiliated with the annuity, and for each separate account to be managed by a different group of advisors. Typically, the separate account managers, if from outside the insurance company, are from mutual fund companies or institutional investment firms. The Sub-Account The sub-accounts within the separate account are pools of securities, such as stocks, bonds and money market instruments. Each sub-account is managed according to an objective such as growth, aggressive growth, high yield bond or growth and income. The objective, the types of securities invested in, and risks of the sub-account as an investment are described in the variable annuity prospectus. Chapter Eight discusses the various investment objectives, risks and portfolio composition found in the most common variable annuity subaccount types.
Variable Annuity Accumulation Units The return of a variable annuity is based on the value of the subaccounts. The total value of a variable annuity’s sub-account is calculated by multiplying the number of accumulation units held by an annuity owner by the value of each unit in the sub-account. For example, if Mr. Smith owns 2025 units of the ABC Annuity Special
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Growth Account, and each unit is worth $1.45, his account value is $2,936.25 (2025 x $1.45). The value of the separate account is calculated each day the New York stock exchange is open for trading, at the end of each trading day.
Annuitization Variable annuities include an option, or in some states, a requirement, to annuitize the contract. Annuitization is an irrevocable decision to receive periodic annuity income payments. Payments will commence within one month, three months, six months or one year from the annuitization start date. The variable annuity contract may require that the annuitization start date (also referred to as the contract maturity date, annuity start date or maximum deferral date) be no later than a certain age, e.g. age 85. The maximum annuity start date may also be governed by state law.
The Variable Annuity Prospectus Since the variable annuity is a security, a variable annuity prospectus must follow the requirements set forth in the Investment Company Act of 1940 and the Securities Act of 1933. The prospectus must, among other information, state the specific investment objectives of the subaccounts, provide expense information, and a financial statement, as well as company information. The prospectus contains important information and provisions regarding the variable annuity product. Common information found in the prospectus includes: • summary of expenses • performance data • definition of terms • account valuation method • annuity income, or annuitization options • contract provisions, such as purchase provisions, calculation of death benefit, exchanging units, and the free look period • a description of each sub-account, including objective, investment policy, and associated risks
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• •
a definition of the fixed account, if any, including initial and renewal rate guarantees federal tax considerations
Variable Annuity Expenses Expenses in a variable annuity include transaction expenses, annual expense, separate account expenses and sub-account expenses. Transaction Expenses Transaction expenses are fees levied for certain transactions made by the annuity owner. Fees may be charged based on the purchase of subaccount units (making a contribution to a sub-account), the withdrawal of sub-account units, and/or the exchange of units between subaccounts. Purchase of Sub-Account Units Most variable annuities today do not charge a fee, or sales load, at the time of unit purchases. Those that do, however, commonly charge a level percentage fee. For example ABC Variable Annuity may charge a three percent sales load for each purchase. If $10,000 were contributed to the variable annuity, $300 would be charged as a sales load, leaving $9700 to purchase units. Withdrawal of Sub-Account Units Commonly, variable annuities include a deferred sales load. For a certain period of time, for instance five years from purchase, a sales load will be charged at the time units are surrendered, or a withdrawal is made. Typically, sales load percentages decline over time. For example, the deferred sales load schedule may be six percent in the first year from purchase, five percent in the second year from purchase, four percent in year three, and so on. Level deferred sales load schedules are also found in variable annuities, for example, five percent for withdrawals made the first five years from purchase. Most variable annuities apply the sales load to each purchase made. For example, if a purchase is made at the time of opening, the deferred sales load schedule is applied to the units purchased at that time. If a second purchase is made the following year, the deferred sales load schedule is
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applied to this purchase separately. When withdrawals are made, the sales load is applied on a first-in, first-out basis. Sample Deferred Sales Load Calculation Assume a variable annuity has a five year deferred sales load schedule, starting at five percent in the first 12 months from purchase, and decreasing by one percentage point each subsequent year. Deferred Sales Load Schedule Contract Year 0 1 2 3 4 5
Sales Load Percentage 5% 4% 3% 2% 1% 0%
A purchase of $10,000 is made to open the contract and additional contributions of $10,000 are made in contract years one and two. A withdrawal of $12,000 is made in year three. Contract Year 0 1 2 3
Purchase (Withdrawal) Amount $10,000 $10,000 $10,000 ($12,000)
The sales load would be applied as follows: Amount Withdrawn: $12,000 ($10,000) ($ 2,000)
Number or Contract Years From Purchase 3 2
Sales Load Percent 2% 3%
The first $10,000 of the $12,000 withdrawal was contributed three contract years prior to the time of withdrawal and is charged a 2% sales load. The next $2,000 is charged a 3% sales load, since the purchase of these units was made two contract years prior to the withdrawal. Exchange of Units Variable annuities may charge a fee for the exchange of units from one sub-account to another. Typically, this charge is not assessed until a
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certain number of exchanges or transfers have occurred, if the fee is charged at all. Exchange or transfer privileges may include certain limitations, such as the dollar amount that may be exchanged, the frequency of transfers or exchanges, and the number of times exchanges can occur within a contract year. Annual Expense An annual contract fee is charged to each variable annuity contract holder. This fee is normally $30 - $35. This fee covers account maintenance, transaction processing, clerical services, etc., related to each contract. Separate Account Expenses Separate account expenses include mortality and expense risk charges and administration and maintenance fees. Separate account expenses are charged to all contract holders, regardless of the sub-accounts held. Mortality and Expense Risk Charges The variable annuity issuer assumes certain risks when issuing contracts, and for that, a percentage charge is assessed against the separate account daily. The mortality risk assumed by the provider is based on the promise to pay lifetime annuity income payments, regardless of how long an annuitant might live and the payment of a minimum death benefit. The expense risk is the risk that the sales load and administration fees may not be sufficient to cover the expenses related to maintaining the variable annuity contracts prior to annuitization. Administration and Maintenance Fees Some variable annuities products include a fee charged to the separate account for administration and maintenance in addition to the annual contract fee. This fee pays for issuing statements, processing transactions, calculation and monitoring of daily sub-account values, and the creation of separate account annual reports. Some variable annuity providers consider some of these charges as sub-account fees and charge a percentage to the various sub-accounts rather than to the separate account.
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Sub-Account Expenses Sub-account expenses are those charged to each sub-account. The amount of the expenses is related to the expense of managing the subaccount. The percentage charged varies, therefore, depending on the investment strategies and types of securities in the sub-account. Subaccounts with higher risk objectives, such as a foreign stock sub-account normally have higher expense charges than a lower risk sub-account such as a US Government securities sub-account. The management of these higher risk sub-accounts is considered more demanding than most lower risk sub-accounts. Performance Data The prospectus includes a variety of sub-account performance data. The change in unit values at the beginning and end of the current and previous years along with the percentage change and subsequent total return is included. The size of the sub-accounts, number of units in each account and actual expense ratios are also included. Comprehensive financial data, beyond that found in the prospectus, is available from the annuity issuer, or designated accounting firm, in the “Statement of Additional Information.” Definition of Terms The prospectus includes the definitions for such items as accumulation units, the owner, the annuitant, the beneficiary, the contract value, the death benefit, and other terms needing explanation. Account Valuation Method The method and timing of account valuation is described in the variable annuity’s prospectus. Basically, accounts are valued each day the New York Stock Exchange is open. The valuation is performed at the close of the exchange. A sub-account’s unit value is set at some par value at inception, and recalculated each business day thereafter. Annuitization Options The prospectus explains annuity income and annuitization options. These options are discussed in Chapter Five.
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Contract Provisions Although many variable annuity contracts contain the same type of provisions, the specifications of those provisions vary, resulting in very different features and benefits. For example, most contracts allow a free withdrawal. This is a withdrawal meeting certain criteria within the contract and therefore not incurring a sales load. The terms of these withdrawals can be relatively liberal or quite restrictive. For example, two different variable annuities may each have a provision titled 10% free withdrawal. One allows a withdrawal of up to 10% of the contract value with no sales load charge as soon as the annuity is opened. In addition, if the 10% free withdrawal is not taken during a contract year, it accumulates so that in contract year two, 20% may be withdrawn, in year three, 30% and so on. The other annuity allows a 10% free withdrawal only after the first year, and then only within thirty days of the contract anniversary. If the withdrawal is not taken, it does not accumulate. Reading the prospectus carefully is critical to ensure this and other provisions are properly understood. Sub-Account Descriptions Each sub-account is described in the prospectus. The description includes the investment objectives, the investment practices, and the types of securities that may be purchased and managed. The associated risks of the securities and investment practices are also fully explained. Fixed Account Description Many variable annuities include a fixed account option. A fixed account is not a sub-account within the variable annuity separate account. It is not registered under the Securities Act of 1933, nor the Investment Company Act of 1940. Rather, it is an account that is part of the general assets of the insurance company. The fixed account offers a guaranteed rate for a specified time period and a minimum guaranteed rate. The fixed account guarantees are an obligation of the issuing insurance company. Often exchanges or transfers from the fixed account are limited when compared to the frequency of transfers allowed from the sub-accounts. Since the insurance company guarantees rates of return for specified periods of time, withdrawals may be limited to ensure there are
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sufficient invested assets to meet rate guarantees. In addition, since the fixed account is an obligation of the issuing company, reserves must be set aside to meet all contract obligations and withdrawal privileges impact the amount of reserves required. Some variable annuity contracts incorporate a Market Value Adjustment, or MVA, for withdrawals from the fixed account. If current, new money rates are lower than the rate the fixed account is paying at surrender or withdrawal, the annuity will be given a positive cash value adjustment, resulting in a higher surrender value than if no MVA was calculated. If current, new money rates are higher than the rate the fixed annuity is paying at surrender or withdrawal, a negative adjustment to cash value will be made, resulting in a lower surrender value than if the MVA was not calculated. The idea behind an MVA is that the insurance company will have to pay less to replace moneys surrendered in a decreasing rate environment, so the policy is given a positive MVA. In an increasing rate environment, the cost of new money is higher for the insurance company, so there is a negative MVA applied to the surrendered policy. Federal Tax Considerations The variable annuity prospectus contains a description of the federal tax ramifications of purchasing a variable annuity. The tax issues related to the separate account and general annuity taxation rules are discussed. The customer should contact his or her own tax professional for advice for his or her specific situation.
Annuity Application Before the policy can be issued, an application must be completed and premium paid to the insurance company. The variable annuity application is similar to a fixed annuity application, but has some differences. The application will include: • Name, social security number, sex, birthdate and address of the owner(s) • Name, birthdate, sex and social security number of the annuitant(s) • Name and relationship of the beneficiary(ies). Some applications require the social security number as well • Type of annuity, if the company offers more than one type (flexible premium, single premium, IRA or qualified plan) • Allocation of purchase payments among the sub-accounts
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• • • •
Special programs such as dollar cost averaging, asset allocation, or investment by bank draft Whether the variable annuity is replacing another annuity Signature of owner(s). Some applications require the signature of the annuitant(s) as well Signature of the agent accepting the application
Along with the application, additional forms may be required for disclosure purposes, or if replacement of the annuity is involved, certain states require that additional information be taken from and given to the applicant.
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CHAPTER EIGHT: VARIABLE ANNUITY SUBACCOUNTS Central to the variable annuity are the subaccounts. The sub-accounts are the vehicles through which the purchaser can meet his or her financial objectives. Selecting sub-accounts that properly reflect a customer’s objectives and risk tolerance is the variable annuity representative’s most important challenge in the sale of a variable annuity. As mentioned previously, each sub-account has an objective and investment policy. Each objective and investment policy has associated risks. This chapter will review the common types of sub-accounts found in variable annuities, beginning with the common risks and objectives that are associated with the sub-account types.
Types of Risk Generally, types of risks related to securities include Financial or Default Risk, Market Risk, Interest Rate Risk, and Purchasing Power Risk. Economic or Political Risk and Exchange Rate Risk are risks most often associated with international securities. Financial or Default Risk Financial risk is the risk that the underlying corporation or issuing entity will be financially unable to meet the obligations of the security. In the case of stocks, the financial risks include the risk that the corporation will be unable to pay dividends and/or will reduce or eliminate dividend payments. Financial difficulties within the corporation can also cause the value of the stock to fall, just as financial strength can drive share values up. The financial or default risk of a bond is the risk that the issuing entity, whether a corporation, a state or local government, or the federal government, will be unable to meet the obligations of the bond issue.
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The relative risk of default of a bond is based on the creditworthiness of the issuer. Therefore, the risk of default of a bond issued by the US government is considered to be virtually nonexistent whereas the risk of default of a small, undercapitalized corporation, or a large corporation newly reorganized to avoid bankruptcy will be considered to be quite high. Bond Rating Agencies Bond rating agencies perform credit analysis and assign ratings to bond issues. The two best known agencies are Moody’s Investor Services and Standard & Poor’s Corporation. Other bond rating agencies include Duff & Phelps, McCarthy, Crisanti and Maffei, and Fitch Investors Service. The focus of the evaluation of rating agencies is the relative ability of the issuer to meet the specific obligations of the bond. Moody’s and S&P assign letter ratings to the different risk levels, or grades. The higher the rating, the lower the risk of default. The different rating agencies use different descriptions for the letter grades assigned, but the industry has general terms applied to the different bond grades, as shown in the table below. General Industry Description
Moody’s
S&P
Prime
Aaa
AAA
High Quality
Aa
AA
Upper Medium Grade
A
A
Medium Grade
Baa
BBB
Moderately Speculative
Ba
BB
Speculative
B
B
Highly Speculative
Caa
CCC
Lowest Quality
C
C,D
Investment Grade
Below Investment Grade
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Market Risk Market risk refers to the risk of price fluctuation of a particular security, securities of a particular industry group, e.g. all airlines or all pharmaceutical companies, or for the entire securities market. Financial difficulties within an industry can impact price, as can competition, regulations, public perception, political upheaval, etc. Some professionals refer to components of market risk as event risk rather than market risk to emphasize the inability to predict a risk such as the impact of a massive oil spill, a series of airplane accidents, the discovery of (another) cancer causing element found in a popular food item, etc. Interest Rate Risk When interest rates change, equities may be affected due to the relative attractiveness of competing securities. For example, if rates in long-term, prime bonds have been relatively low, a certain portion of risk averse investors may accept the additional risk for the expected additional return found in high quality stock. Once bond rates rise, these investors may return to the long-term bonds they feel more comfortable with. Interest Rate Changes and Bond Prices Bond prices are impacted by changes in interest rates. When interest rates move up or down, generally the bond price moves in the opposite direction. For example, if a bond with a fixed rate of 7% were purchased, and rates fell to 5%, the price of the bond will rise, because investors will be willing to pay more for the 7% rate. If rates rise, the bond’s price will fall because investors will pay less for the 5% rate. Interest Rate Changes and Bond Term and Quality The longer the term of the bond, or the greater the number of years to the bond’s maturity, the more sensitive the bond price to interest rate changes. Since there are a greater number of years for the bond to be impacted by the rate change, the relative impact on price is greater. In addition, the higher the bond quality, the greater the relative impact of interest rates on the bond’s price. Since high quality bonds have low default risk, the high quality bond’s price is based primarily on its interest rate. Low quality bond, or junk bond, prices are impacted by the acceptance of default risk by the investor. Therefore, if interest rates change, the impact on a high quality bond will be relatively greater than the impact on a low quality, or junk bond. The sensitivity to rate
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changes are also impacted by the options of a bond, such as whether the bond is callable, and whether the rate paid, or the coupon, is a fixed rate or floating rate based on an index. Purchasing Power Risk Purchasing power risk is the risk that a security will not increase in value to keep pace with inflation, or the reduced purchasing power of currency. If a stock or bond returns 5% and the inflation rate is 6% during the same period, the security will be generating returns that result in the reduction of purchasing power. Fixed coupon bonds have a greater susceptibility to purchasing power risk than a bond with a floating coupon bond. Equities are generally considered as a hedge against inflation, since generally common stock prices have moved upward as inflation indices, such as the Consumer Price Index, have risen. Economic or Political Risk The economic and political climate of the country from which a security is issued can impact the volatility of that security. War, uprisings, or a change in government will obviously impact the economy and stability of a country and the assets within it. Trade agreements, embargoes, and multi-nation treaties can all impact the financial health of businesses within a country. Therefore, some foreign securities can include relatively high levels of economic and/or political risk. Exchange Rate Risk Exchange rate risk is a risk found only in bond sub-accounts holding bonds from outside the US. Exchange rate risk is the risk that the currency in a foreign country will decrease in value relative to other currencies, such as the dollar. If so, the bonds issued from that country will be worth less to investors from countries with stronger currency, or with currency that is relatively higher in value. Not only will the bond price be worth less if the currency decreases, but the relative value of the coupon payments, reinvested income and capital gains will also decrease to the foreign investor. Exchange rate risk can be hedged against by foreign exchange futures and options. Or, a fund manager may choose to diversify among many countries to reduce exchange rate risk, while also reducing overall default and interest rate risks.
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Sub-Account Objectives The common objectives found in sub-accounts include capital appreciation or growth, current income, total return and stability of principal or preservation of capital. The sub-account managers must adhere to the subaccount’s objective as stated in the prospectus. Since variable annuities are long-term investments, the objectives of most variable annuity subaccounts reflect a long-term financial horizon of a minimum of five years. Capital Appreciation Capital appreciation is growth in the share value of the sub-account portfolio. A sub-account with capital appreciation as its objective will be comprised largely of equities. If the sub-account fulfills its objective, as the individual equity securities in the sub-account increase in value, the sub-account’s value will rise, and each unit will increase in price. Capital appreciation may be expressed as an objective of long-term capital appreciation. Typically, the inclusion of long-term implies investment in common stocks of established corporations in contrast to the objective of growth or capital appreciation which can imply investment in companies with potential for significant short or intermediate term growth, such as small company stocks. Total Return Total return refers to the percentage of growth in a sub-account from both capital appreciation and dividend income. A sub-account with the objective of total return will typically invest in dividend paying securities that also have capital appreciation potential, or will seek a balance of investments to generate both income and capital appreciation. Income Income can come from dividends from common stocks, or government and corporate bonds. An objective of high current income would indicate that the sub-account is more aggressive than a sub-account seeking simply current income. Preservation of Capital This objective is never the sole objective of a sub-account. Instead it will accompany an objective of income or growth. It is an indication that the
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sub-account intends to follow its objective of growth or income only to the extent that it will not cause loss of capital.
Types of Sub-Accounts Generally, types of sub-accounts exist which share common investment objectives. For example, a US Government sub-account fund, or series as the variable annuity companies often call them, will generally have the objective of current income and will be comprised primarily of US Government securities. The more common sub-account fund types are described below, along with common associated risks. Government Sub-Account Funds Government bond sub-account funds invest primarily in bonds and other securities issued by the US government or government agencies. Issuing departments or agencies of the US government include the US Treasury, the Federal Home Loan Bank, the Federal National Mortgage Association (Fanny Mae), the Government National Mortgage Association (Ginnie Mae), the World Bank or International Bank for Reconstruction and Development, the Federal Intermediate Credit Banks, the District Banks for Cooperatives, the Federal Land Banks and the Inter-American Development Bank. The risk of default on government issued securities is considered to be zero. Government securities are considered the safest investment in terms of default or financial risk. However, as bonds and bond-like securities, government issued securities are still subject to interest rate, market and purchasing power risks. Depending upon the structure of the security, these risks may be minimal, as in a Treasury bond held to maturity, or very high, as in an inverse floater CMO tranch. The objective of government sub-accounts is generally current income with relatively low fluctuation in unit value. However, the objective and share volatility varies from sub-account to sub-account. Some subaccounts are 100% invested in treasury securities, others use options, futures, CMOs and CMO derivatives. The relative risks and volatility in these different sub-accounts will obviously be quite different. US Government Sub-Account Funds US Government sub-accounts funds typically have the objective of current income, and many include the objective of capital preservation as
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well. Typically, US Government sub-accounts seeking current income will only allow investment in options and futures to a greater degree than those US Government sub-accounts with the objective of capital preservation. Government sub-accounts may be comprised largely of short-term, intermediate or long-term bonds, or may have portfolios of securities with a variety of maturities. The average maturity of the portfolio impacts the return and volatility of the sub-account. Generally, the shorter the maturity, the lower the volatility and return of the subaccount. However, certain short-term government securities, such as adjustable rate mortgage securities, can be volatile in sharply increasing or decreasing interest rate markets. Government securities sub-accounts may include GNMA (or Ginnie Mae) securities. Ginnie Mae securities are generally pass-through, or participation, securities. Pass-throughs are pools of mortgages wherein the investor (in this case the sub-account) owns an interest. The principal and interest payments made on the mortgages are passed through to those with a share in the pool. Mortgage securities can provide a higher rate of return than many other government issued securities, but carry the risk that the mortgagees may pay off their mortgages early, e.g. in a decreasing rate environment. This risk is known as “pre-payment” risk. When mortgages are paid off “early,” which can mean either before the terms of the mortgage agreement or before the expected pay off date, principal is returned to the investors and the interest payments cease. New mortgages purchased in the lower rate environment will pay lower interest to the pool participants. A method of reducing prepayment risk is investment in CMOs, or collateralized mortgage obligations. A CMO is a security backed by a pool of pass-throughs, actual loans, or stripped mortgage backed securities. Basically, a CMO is structured so that the underlying mortgages are placed into several classes, or tranches of bonds with varying stated maturities. The prepayment risk of the pool is spread among the bond tranches, with some tranches having less prepayment risk than the overall pool and other tranches having more. The yield on
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the higher risk tranches is higher than those of the lower risk tranches. A sub-account manager may purchase CMOs with the intent of reducing prepayment risk on the overall sub-account portfolio. Other mortgage securities may be found in a government sub-account portfolio to increase yields as well as hedge against interest rate risks. Derivatives such as IOS and POs, PACs and Inverse Floaters range from moderate to high risk methods of yield enhancement. The prospectus of the variable annuity should be read thoroughly to ascertain the amount of risk a sub-account is assuming by its use of derivatives. US Government Treasury Sub-Account Funds US Treasury sub-account funds hold assets comprised solely or primarily of debt issued by the US Treasury. These sub-accounts too may be short-term, intermediate or long-term. The long-term subaccounts have the greatest volatility, and show the greatest return when interest rates fall. Because Treasury sub-accounts either limit or do without mortgage-backed securities, the risks related to prepayment as found in a Ginnie Mae sub-account are not normally found in a Treasury sub-account. And since government backed securities are considered to have no risk of default, the major risk found in a Treasury sub-account is interest rate risk. Corporate Bond Sub-Account Funds Corporate Bond sub-account Funds, as the name suggests, invest mainly in corporate bonds. A number of different types of corporate bond subaccounts are available. High Yield Corporate Bond Sub-Account Funds High yield corporate bond sub-account funds are often the most aggressive of the corporate bond sub-accounts. They are generally invested in corporate bonds issued by financially trouble companies. The bonds have a higher coupon rate than those of more financially stable corporations. Therefore the risk of default in a high yield portfolio is reflected in the potential for higher returns. Whether the return is ample enough for the default risk is up to the sub-account managers to determine. The sub-accounts often allow, by prospectus, a percentage of the fund assets to be in common or preferred stock as well. Some funds
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also invest in futures and options. Again the overall portfolio composition affects the overall risk of the sub-account. Corporate Bond Sub-Account Funds - High Quality High quality corporate bond sub-account funds generally invest in investment grade corporate debt along with treasuries, and government agency securities. The risk of default in high quality corporate bond funds is low, but the funds retain the interest rate risk of all bond funds. Like government funds, corporate bond funds can be found with portfolios comprised of short term, intermediate term or long-term bonds. The average maturity of the portfolio will impact the relative interest rate risk of the sub-account since short term bonds are generally less sensitive to interest rate risk than long-term bonds. Corporate Bond Sub-Account Funds - General Corporate bond sub-account funds which are not comprised of highyield or high-quality bonds have a wide variety of objectives. Generally, corporate bond sub-accounts invest primarily in investment-grade domestic corporate debt. Other investments can include US government securities, stock, foreign securities and small percentages of less than investment grade bonds. Generally, the risk levels and return of a corporate bond sub-account fund should fall somewhere between high quality and high yield corporate bond funds. However, the return, interest rate and default risks are dependent on the specific portfolio of the sub-account. World Bond Sub-Account Funds World bond sub-account funds include sub-accounts that invest solely in bonds from outside the US (also known as International bond funds) and those which also include US corporate bonds in their portfolios (also known as Global bond funds). The risks of the political and economic environment varies from country to country or region to region in the world markets. Issues such as trade agreements and embargoes, multi-nation treaties, such as NAFTA and GATT, and wars or uprisings can all have an impact on the default risk of a world bond sub-account. Because this risk is related to political events, it is known as political risk. Some countries are very stable, such as many western European nations and others have
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highly volatile economies and political environments, such as some eastern European nations. World bond sub-accounts are generally considered aggressive funds. However, some sub-accounts are invested in a great deal of US bonds, only venturing into foreign markets when the risk and return trade off is ascertained to be a prudent risk by the sub-account manager. These portfolios may be considered “low risk” within the world bond sunaccount arena. Others are highly speculative, entering newly emerging foreign markets with highly volatile political and economic environments. Equity Sub-Account Funds Equity sub-account funds are largely comprised of common stocks. The universe of equity sub-accounts is even more diverse in objective and portfolio composition than bond funds. Aggressive Growth Sub-Account Funds The primary objective of an aggressive growth sub-account fund is capital appreciation. Portfolios normally hold large amounts of small and midsize companies, with good (as defined by the sub-account managers) potential for growth. Options and futures may also be heavily utilized in aggressive growth portfolios. As the name implies, aggressive growth sub-account funds generally provide excellent opportunity for growth, but can also be highly volatile. This sub-account type is for the long-term investor able to ride out the potentially extreme fluctuations in return. Growth Sub-Account Funds The objective of a growth sub-account fund is growth of capital, or capital appreciation. The portfolio mix ranges from stocks of a wide variety of large corporations to stocks solely from established corporations in certain sectors of the marketplace, such as technology or health care. Growth portfolios are less volatile, generally, than aggressive growth funds due to their more conservative, higher quality stock portfolios. Those with portfolios with a high concentration in a particular sector are
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subject to more market risk than those with a more diversified portfolio. Investment in foreign stocks can also increase risk and volatility in a growth fund. Small Cap or Small Company Sub-Account Funds Small Cap stock sub-account funds invest in stocks of small to midsize companies. Generally, the objective of these sub-accounts is capital appreciation. Small company sub-account funds may seek appreciation through a values approach - the fund managers seek out securities which they determine are undervalued in price given their potential for growth - or by focusing on growth potential by picking stocks from companies which show strong earnings and revenue growth. The amount of diversification in a small cap sub-account impacts its subjectivity to market risk -- some small cap sub-accounts are heavily invested in certain sectors. Recently, technology firms have been one such sector. Sector swings will impact sub-accounts so invested more greatly than more diversified small cap sub-accounts. Small cap sub-account funds vary in overall risk and portfolio quality, so may be appropriate for the moderate to aggressive investor, with a longterm investment horizon to ride out the market’s potential volatility. Growth and Income Sub-Account Funds The objective of growth and income sub-account funds is current income and capital appreciation. Generally, portfolios are comprised of high dividend stocks and convertibles. Portfolios may also include some small-cap stocks and bonds. Growth and income sub-accounts are generally considered less risky than growth sub-accounts, because of the former’s emphasis on stocks from large, established corporations with histories of healthy returns and dividend payments. The short-term volatility of a growth and income sub-account makes them suitable for the long-term investor. Equity Income Sub-Account Funds Equity income sub-account funds are generally considered the most conservative of the equity sub-account portfolios. Generally, an equity income sub-account fund’s objective is current income and capital
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appreciation. Portfolios generally consist of high quality, high-dividend stock and convertibles, as well as bonds. Equity income sub-accounts generally return lower yields than a corporate bond sub-account, but over the long-term have the potential for greater total return than a corporate bond portfolio due to the capital appreciation of the stocks within the portfolio. Short-term volatility is an issue, as with all equity funds. World Stock Sub-Account Funds World stock sub-account funds include both sub-account types that invest solely in stocks issued by companies outside the US (also known as International stock funds) and those which invest in stocks from companies both inside and outside the US (also known as Global stock funds). The risks and portfolio composition is similar to those of world bond funds, except of course world stock funds invest in stocks. Sector Sub-Account Funds Sector sub-account funds are funds that invest in stocks within certain sectors, such as financial, retail, services, utilities, etc. Depending on the sector invested in, the fund may have the objective of capital appreciation or current income. For example, utility sub-accounts have the objective of current income, while precious metals sub-accounts have the objective of capital appreciation. Sector sub-account funds are generally used as hedging instruments against purchasing power risk, against interest rate risk, or against general market risks. Sector sub-account funds as a whole tend to be volatile, since their exposure to sector swings is high. Sector funds are best used as a part of a diversified investment portfolio, for the long term investor. Balanced Sub-Account Funds Balanced sub-account funds are comprised of both bonds and equities. A balanced portfolio includes a mixture of preferred stocks, common stocks, and bonds. The objective of a balanced sub-account fund is generally to achieve long-term growth or capital appreciation and earn current income while conserving principal. Balanced sub-accounts generally have less opportunity for growth than an equity fund, but have
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the advantage of less volatility due to the bonds and preferred stocks in the portfolio. Through the diversification of its portfolios, default risk, market risk, interest rate risk and purchasing power risk can all potentially be reduced through a balanced sub-account fund. However, as with all general sub-account fund categories, each sub-account termed a balanced fund is different. Some balanced portfolios emphasize capital appreciation through the investment in a high percentage of growth stocks. Others seek current income and invest in conservative, high quality bonds and income-oriented stock. The investment emphasis in the portfolio will impact the types and degree of risks in the sub-account. Money Market Sub-Account Funds Money market sub-account funds are generally considered as cash equivalents: very liquid with stable unit value. However, as securities products, there is no guarantee that unit values will remain stable in a money market. If a sub-account manager were to make bad investments, it is possible that share values could drop below the $1 par unit value normally set for money market portfolio. Money market sub-account funds typically invest in short term liquid vehicles, such as short-term commercial instruments like CDs, bankers’ acceptances and commercial paper, short-term government securities, and short-term municipal securities. Some money market portfolios include short-term securities issued around the world, to enhance yield. Although as mentioned, there is some risk of principal in a money market sub-account, they are generally the most conservative, least risky sub-account available. If a variable annuity includes a mutual fund subaccount, it typically will not have a fixed account.
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CHAPTER NINE: VARIABLE ANNUITY FEATURES When variable annuities were first introduced, available features were pretty basic. The ability to participate in subaccounts made up of securities and enjoy tax-deferred growth was seen as such an advantage by the product providers that little need was seen to offer many “bells and whistles.” As more providers entered the variable annuity marketplace, however, more features were added. Features such as dollar-cost averaging, asset allocation programs, systematic withdrawals and nursing home waivers are now common features of variable annuities. Now Playing: Variable Annuities
Contribution Features Besides writing a check and mailing it to the variable annuity company (or broker-dealer) with sub-account investment instructions, three other methods are available through variable annuities to manage contribution payments. These methods are dollar-cost averaging, regular investment programs through bank drafts, and asset allocation. Dollar-Cost Averaging Dollar-cost averaging is the process of making regular contributions of a fixed amount to a sub-account or sub-accounts. When unit prices are high, the amount contributed will purchase fewer units than when prices are low. Over time, this method often results in a lower average price per unit than if all units were purchased at once, or were purchased randomly over a period of time. Dollar-cost averaging features automate regular investing in the variable annuity. The dollar cost averaging programs in variable annuities generally work as follows: on a regular basis, a fixed amount is transferred from one sub-account to one or more different sub-accounts. The owner determines how frequently dollar-cost averaging transfers will occur, the sub-accounts from which the dollar-cost averaging
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payments will be made, and the sub-accounts to which the dollar-cost averaging payments will be made. Some variable annuities limit the sub-accounts from which dollar cost averaging transfers may be made to a money market or guaranteed rate account. A minimum balance is normally required for the sub-account from which the transfers are made, e.g. $2000 to $5000. Regular Investment Programs Another method of dollar-cost averaging is to make regular contributions through bank drafts to a variable annuity. The owner authorizes his or her bank to make automatic monthly drafts to the variable annuity. The owner designates on the contract application or special form in which sub-accounts the draft amount will be invested. Besides the benefit of dollar-cost averaging, these programs often offer the smaller investment customer an opportunity to participate in a variable annuity. Bank draft programs often require minimum monthly contributions of only $25 to $50. Asset Allocation Programs Asset allocation is a term referring to the way in which assets are divided, or allocated, among different investment options. The goal of asset allocation is to provide the best return while reflecting a customer’s risk tolerance and investment objectives. The benefit of an asset allocation program is that the customer is able to rely on the management experience of the sub-account managers to review market changes and make asset allocation decisions for them. Many variable annuities offer an asset allocation program wherein dollars will be allocated in a method determined by sub-account managers or by a computerized asset allocation model. Usually the allocation vehicles include an equity sub-account, a bond sub-account and a money-market sub-account. Or one sub-account may be used which contains equities, bonds and money-market instruments. On a regular basis, the percentage invested in the asset allocation subaccounts is reviewed and assets are reallocated as determined by the managers or computer model. An asset allocation program within a variable annuity should not be confused with an overall asset allocation strategy for a particular client.
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These programs should be used within the overall financial objectives of a client, and may be found to be a suitable component of a portfolio through the customer profiling process.
Liquidity Features Variable annuities include a number of withdrawal methods. A penalty free withdrawal feature is available in virtually every variable annuity (outside of variable annuities within certain qualified plans). Systematic withdrawal programs and nursing home waiver features are available in many variable annuities. Annuitization is also available on all variable annuities. Penalty Free Withdrawals As mentioned in a previous chapter, variable annuities include withdrawal features that are not subject to deferred sales loads. The terms of these withdrawal features vary. A common free withdrawal provision allows up to ten percent of the accumulated value to be withdrawn once each contract year without any sales loads or surrender penalties charged. Another common provision is the withdrawal of all interest each contract year. Some variable annuities allow penalty free withdrawals from contract start date, and others require a one-contractyear waiting period. Some may allow more than ten percent to be withdrawn, and may allow the withdrawal percentage to accumulate each year if it is not used. It is prudent to carefully check the prospectus to ensure accurate understanding of any free withdrawal provision. Although a free withdrawal is free from any charges from the variable annuity, taxation of earnings will still occur. Once earnings are withdrawn, they are taxable as current income. The IRS views withdrawals from annuities as being comprised of earnings before any principal can be withdrawn. Nursing Home Waivers Nursing home or medical waivers are another form of penalty free withdrawal feature found in annuities. Under this type of waiver, if a contract owner (or annuitant, depending on the stipulations of the waiver), is put into a hospital, nursing home, or other qualified, as defined by the waiver, health care facility, a withdrawal or surrender of the contract can be made without normally applicable sales loads being
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charged. Some nursing home waivers allow multiple withdrawals, others one only. Typically, to be eligible for this waiver, the stay in the qualified facility must be from thirty to one hundred and eighty days, and the withdrawals or surrender request based on the waiver must be made within thirty to sixty days from the time eligibility is established, or from the date of discharge from the facility. Again, check the waiver language in the prospectus or contract endorsement to verify the specific terms of the waiver. Not all states allow nursing home waivers, so a variable annuity contract may have this provision in some states, but not all. Systematic Withdrawal Programs Many variable annuities offer the owner the ability to withdraw a specific dollar amount on a regular basis, or as a systematic withdrawal, from the variable annuity. Systematic withdrawal payments may be started and stopped at the owner’s discretion, unlike annuitization or annuity income payments which generally may not be stopped once they commence. Two issues regarding systematic withdrawals are important to remember: 1. If the amount of the systematic withdrawal exceeds the penalty free amount available, surrender charges or deferred sales load charges will apply. 2. Systematic withdrawals can exceed or fall within current returns. Assume a systematic withdrawal program was begun upon a variable annuity’s inception and the withdrawal amount requested was $500 per month. If in any month the variable annuity earns less than $500, the withdrawal will eat into either earnings from prior months, or into the principal in the annuity. This is especially important for the customer who is used to taking income from a CD to understand. The CD customer is used to receiving interest income only from a CD. The CD balance remains constant after each withdrawal. Of course, some variable annuities offer “earnings only” systematic withdrawal programs.
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Systematic withdrawals are also often used as a means to satisfy required minimum distribution from a qualified retirement plan or IRA. Many variable annuity issuers have the capacity to calculate and distribute required minimum distributions based on the variable annuity values. This capability can be a big benefit to a customer needing required minimum distributions, since the necessary calculations can be confusing to the average taxpayer.
Guaranteed Death Benefit Provisions Guaranteed death benefit provisions vary from annuity to annuity and may include stepped-up valuations, assumed percentage increases in total account valuation, or other calculations. Regardless of the specific terms of the provision, many customers find guaranteed death benefits an attractive feature of a variable annuity because they are able to protect assets for their beneficiaries. The death benefit is the amount paid upon the death of the contract owner and/or annuitant. Variable annuity contracts vary regarding when a death benefit is paid. Some contracts pay surrender value upon a nonannuitant owner’s death. The surrender value of the annuity is the amount payable if the variable annuity were liquidated in full, with all applicable deferred sales loads applied. Other contracts pay a death benefit upon either the annuitant or owner’s death. Again, the prospectus should be carefully reviewed to determine under what circumstances the death benefit is paid, and how the prospectus defines the calculation of the death benefit. Stepped-Up Death Benefits Stepped-up guaranteed death benefits are more and more commonly found in variable annuities. A stepped-up death benefit effectively “freezes” the value of the contract for the purposes of calculating the death benefit. When a variable annuity includes a stepped-up death benefit, the calculation of the death benefit is calculated by incorporating a comparison of values to derive the death benefit payable, such as: 1. the total account values on the date of death, 2. the total premiums paid, less withdrawals and surrender charges,
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3. the surrender value on the date of death, or 4. the stepped-up death benefit. The stepped-up death benefit is the account value fixed at certain intervals during the contract life. For example, the interval may be every five years. Assume a contract which used the calculation described in the previous paragraph to determine the death benefit and was opened in January 2003 with a premium payment of $10,000. No other contributions are made. The account value on the fifth year contract anniversary in January 2008 was $15,500. The annuitant dies, causing a death benefit payout, in March 2009, when the account value was $14,900. Total premiums less withdrawals totaled $10,000. The death benefit amount payable would be $15,500: the “stepped-up” value as of the fifth year anniversary. Assumed Percentage Increases in Account Value Some variable annuities include in the death benefit calculation an assumed increase in the account value on an annual basis. For example, the death benefit paid is based on the greater of: 1. the account value at the date of death, 2. the surrender value payable at the date of death, or 3. the total premiums paid, less withdrawals, assuming the premiums accrued interest of a certain percentage annually.
Summary The variable annuity has many flexible options for making contributions and withdrawals, and contains guarantees, such as death benefit guarantees and the fixed account guarantees discussed in Chapter Two. Although long-term sub-account performance is the factor which typically leads to choosing a particular variable annuity, the availability of certain features among possible annuity choices can lead to the best fit for the financial goals of the customer.
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CHAPTER TEN: VARIABLE ANNUITY INCOME PAYMENTS This chapter will discuss receiving annuity payments by purchasing a single premium variable immediate annuity, or annuitizing a deferred variable annuity. As discussed earlier, an immediate annuity is an annuity which will begin irrevocable periodic payments within twelve months of purchase. Annuitization of a deferred annuity refers to the commencement of irrevocable periodic payments sometime after twelve months from purchase. Annuity payments from an immediate annuity and an annuitized deferred contract fall under the same taxation rules in IRC Section 72 and the same income options under an immediate annuity or at annuitization are generally available, based on the specific contract provisions.
Variable Annuity Advantages
Income
Payment
Features
And
There are several advantageous features to annuity income payments. They include the following: Many Income Options Available To Meet Differing Customer Needs A variety of annuity income options are available, including income based on a single life, joint lives, or on a certain period of time. Annuity payments may be fixed or variable. Guaranteed Income Variable income payment options offer a guarantee that income will continue for a certain period. Fixed annuity income options guarantee the amount of each payment as well as the payment period. The owner selects the mode of payment. Frequency of payment modes are usually monthly, quarterly, semi-annual or annual. The owner can often decide even what day of the month payments will be processed.
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Opportunity for Growth Variable income options provide an opportunity for growth of income payments. The value of the annuity units which make up the amount of each payment may increase over time, providing a potential hedge against inflation. Many variable annuities allow the transfer of units from one sub-account to another during annuitization, leaving the ability to self-direct investments intact for the policyowner. Lifetime Income If a life option is selected, payments are guaranteed to continue for life. Payments can continue to beneficiaries under some life options as well. Convenience Along with being able to select how frequently and what day of the month payments are processed, many companies can directly deposit payments to a bank account. Taxation Unlike withdrawals from deferred annuities, which are currently taxed as being comprised of interest before principal, annuity payments are considered part interest and part principal. Therefore, taxation is spread over the payment period, rather than being all up-front as is the case with random withdrawals and surrenders.
Parties Involved In Annuity Payments When annuity payments begin, four parties may be involved: the owner, annuitant, payee and beneficiary. Owner The owner of the annuity is the person who purchases the annuity. As discussed in Chapter Two, the owner of the annuity has several rights during the deferral stage, including the right to withdraw, change the beneficiary, and in some cases to add or change the annuitant. Once annuitization commences on a deferred or immediate annuity, the owner's rights are normally limited to changing the beneficiary and authorizing the transfer of units among sub-accounts. As noted, annuitization is irrevocable, so the owner cannot make random withdrawals, make additional contributions, or change annuitants.
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Annuitant As with fixed annuities, the annuitant is the measuring life on a variable annuity contract. If an annuity income option is to be paid over "life,” it is the annuitant's, and in some cases also the joint annuitant's, life expectancy that is used to determine payment amounts. It is also the annuitant's death which normally causes payments to cease, or to transfer to a beneficiary or joint annuitant. Payee Some annuity contracts allow annuity payments to be made to a "payee,” someone other than the owner or annuitant. Beneficiary The beneficiary receives annuity payments, or in some cases, a lump sum, upon the death of the annuitant.
Income Options Variable annuities offer both fixed and variable annuity income options. The income options under a variable annuity are similar to those under a fixed annuity, however, the payment stream from a variable income option differs from a fixed income option, because the unit values of a variable annuity fluctuate over time. Fixed income options pay a fixed amount for a specified period. Generally, if a fixed option is selected, the value at the variable annuity income start date is used to purchase an annuity income plan payable based on annuity income rates in effect at the time of purchase. In essence, the units used to purchase the fixed annuity income are no longer in a variable annuity contract, but are exchanged for a new, fixed income contract. If a variable income option is selected at annuitization, the number of income units is fixed per payment, but the payment amount will vary. The units remain invested in a sub-account or sub-accounts, and therefore change in value as frequently as every business day. For example, assume a 10 year (120 month) certain variable annuity income option is selected. The owner uses 12,000 units to purchase this variable annuity income option. Each month for 120 months, 100 units will comprise the annuity income payment. The first month, each unit is
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worth $10.00 on the annuity income payment date, resulting in a $1000 payment. Month two each unit is worth $9.98, resulting in a $998 payment. The third month, each unit is worth $10.25, resulting in a $1025 payment. As can be seen, the variable annuity income option allows the ability to continue to participate in the performance of the sub-accounts. Generally, the owner can select both fixed and variable income options. Annuitization from a fixed account, however, would be limited to fixed options. Life Income The life income annuity is sometimes referred to as a "straight life" option or "life only" option. Payments are guaranteed for the annuitant's lifetime and will cease at the annuitant's death. Life and Period Certain Income Life and Period Certain payments are guaranteed for the annuitant's lifetime, or for a certain period of time, whichever is greater. For example, if a life and ten year period certain annuity is purchased, payments will be paid for ten years, and will continue if the annuitant is still living at the end of the ten year period. If the annuitant dies during the ten year period, payments will continue to the beneficiary until the ten year period expires. Life With Installment Refund Income Payments are guaranteed during the life of the annuitant and, if at the annuitant's death, the sum of all payments made are less than the units paid for the annuity, the beneficiary will continue to receive payments until the principal has been depleted. Life with Cash Refund Payments are guaranteed during the life of the annuitant and, if at the annuitant's death, the sum of all payments made are less than the units paid for the annuity, the beneficiary will receive a lump sum equal to the remaining principal amount.
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Joint and Survivor Life Income Joint and Survivor annuities are also referred to as "Last Survivor" annuities. Payments are guaranteed during the lives of both annuitants. Payments cease upon the death of the last surviving annuitant. Joint and Specified Percentage to Survivor Life Income Payments are guaranteed during the life of the first to die. After the first death, payments reduce by a specified percentage, e.g. 50%, and are paid until the death of the second to die. Joint and Specified Percentage to Contingent Life Income Payments are guaranteed during the life of the primary annuitant. After the primary annuitant's death, payments reduce by a specified percentage, e.g. 50%, and are paid until the death of the joint annuitant. This option may also be available with installment or cash refund at the death of the joint annuitant. Joint and Survivor With Period Certain Income Payments are guaranteed for a specified period or the lives of joint annuitants, whichever is greater. If there is a surviving annuitant after the period certain time frame expires, payments continue until the death of the last annuitant. If both annuitants die prior to the period certain time frame expiration, the beneficiary will continue to receive payments until the certain period is over. Joint and Survivor Life With Installment Refund Payments are guaranteed during the lives of joint annuitants, and, if at the last annuitant's death, the sum of all payments made are less than the units paid for the annuity, the beneficiary will continue to receive payments until the principal has been depleted. Joint and Survivor Life with Cash Refund Payments are guaranteed during the lives of joint annuitants, and, if at the last annuitant's death, the sum of all payments made are less than the units paid for the annuity, the beneficiary will receive a lump sum equal to the remaining principal.
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Period Certain Payments are guaranteed for a certain period of time. If the annuitant dies during that time, payments will continue to the beneficiary until the specified period of time expires.
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CHAPTER ELEVEN: TAXATION OF VARIABLE ANNUITIES The taxation rules applying to variable annuities are similar to those which apply to fixed annuities. The area in which variable annuities are taxed differently than fixed annuities is in the taxation of annuity payments.
Taxation Of Annuity Payments As noted, earnings are taxed as withdrawn from deferred contracts, but once a contract is annuitized, or if a contract is an immediate annuity, different tax rules apply. Annuity payments are taxed as part principal, part interest. The IRS has specific rules regarding the calculation of the taxable and non-taxable portions of an annuity payment. Fixed Annuity Income Payments The amount of the non-taxable portion of a fixed annuity income payments is calculated using an exclusion ratio. Since the period certain IRS calculation is the simplest, it will be illustrated to provide a general explanation of the calculation of the exclusion ratio. The exclusion ratio is the ratio of the investment in the contract to the expected return in the contract, and is the ratio of each payment that is not taxable, or is "excluded" from taxation.
Exclusion Ratio = Investment in the Contract Expected Return in the Contract Exclusion Ratio x Annuity Payment = Non-Taxable Amount of Payment Assume a ten year period certain annuity, purchased with $50,000 and paying $500.00 a month for ten years.
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Exclusion Ratio = $50,000 Investment in the Contract [($500 x 12 mos.) x 10 yr.] Expected Return $50,000
= 83.33% exclusion ratio $60,000
83.33% x $500 payment = $416.65 is the non-taxable portion of each payment. Variable Annuity Income Payments The expected return of the variable income annuity is unknown. Therefore, rather than using the same exclusion ratio to calculate the non-taxable portion of variable annuity income payments, the ratio used is Investment in the Contract / Number of Years Annuity Payments Will Be Made. If a life annuity is chosen, the number of years is determined by using IRS life expectancy tables. For a period certain, the certain number of years is used. Using again a 10 year period certain annuity to illustrate the calculation of the non-taxable portion of a variable annuity: $50,000 Investment in the Contract 10 Years of Annuity Payments = $5000 annual excludable amount Each year, $5000 in payments are excludable from taxation. If a variable annuity income option includes a refund option, the calculation is more complex. Since variable annuity income payments fluctuate, it is possible that the annual amount received could be less than the calculated excluded amount. If the income payments received are less than the excludable amount, the amount of the excludable amount not received may be carried over the remaining years of the annuity. For example, using the 10 year certain example above, if only $4000 in income payments were received in the fifth year, the $1000 excludable portion not received would be carried over the remaining five years. The excludable portion would then be $5200 annually rather than $5000 for the duration of the annuity.
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CHAPTER TWELVE: ADVANTAGES OF EQUITYINDEXED ANNUITIES Equity-indexed annuities are annuities that offer the advantage of growth that can exceed a fixed annuity without some of the risks associated with variable annuities. Equityindex annuities provide a return that is related to a stock index, most commonly the S&P 500. The insurance company offering the annuity also provides guaranteed minimum returns, which provides the purchaser with reduced exposure to market risks. Besides these unique features, equity-indexed annuities provide many of the same advantages as other annuities, such as tax-deferral and avoidance of probate.
Tax- Deferral Equity-index annuities offer tax-deferred growth on accumulations while earnings remain in the contract.
Opportunity For Growth Like variable annuities, an equity-index annuity contract has the potential to earn a return greater than a fixed annuity. Because the return is tied to an index, the return may be significantly higher than the return of a fixed annuity. In addition, as mentioned in the discussion of equities in Chapter 8, equities have commonly outpaced the inflation rate, so an equity-index annuity can have the benefit of a return that acts as a hedge against inflation. The equity-index annuity pays a return based on changes in the index to which the annuity is linked. The insurer promises to pay this return based on the index benefit formula provided for in the contract. Unlike a variable annuity, which pays a return based directly on the performance of sub-accounts, the return on most equity-index annuities is based on the returns in the insurer’s general account. Unless an equity-index
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annuity is registered with the Securities and Exchange Commission as an investment product, the insurer uses the general account portfolio as its underlying portfolio to generate the annuity’s return, not a separate account composed of sub-accounts as is used in variable annuities.
Guaranteed Minimum Return Non-registered equity-index annuities include a guaranteed minimum rate of return. They also include a minimum index return. Variable annuities often have a minimum death benefit guarantee (as do some equity-index annuities), but the variable sub-accounts do not include a minimum rate of return. The guarantee features can make the equityindex annuity attractive to those who would like the opportunity to participate in equity return, but who do not want to take on the risk of negative return found in equity variable sub-accounts.
Avoidance of Probate Equity-index annuities, like other annuities, avoid probate. The purchaser may name a beneficiary and the insurer will pay the beneficiary directly upon the termination of the contract due to death.
Variety of Methods to Access Account Values Equity-index annuities include options such as penalty-free withdrawals, systematic withdrawals and annuitization, just as the fixed and variable annuities do. Some also provide nursing home or medical waivers.
Summary Equity-index annuities are unique products that mix the advantages of both fixed and variable annuities. The customer who is looking for an opportunity to participate in equity growth without assuming the level of market risk of sub-account investing may find the equity-index annuity to be the right product choice.
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CHAPTER THIRTEEN: FEATURES OF EQUITYINDEXED ANNUITIES Just as the equity-index annuity has many of the advantages of other annuity types, it has many of the same features. However, it includes unique provisions, features and terms. This chapter will discuss these provisions, features and terms.
Securities Regulation and Equity-Index Annuities As has been discussed, variable annuities are regulated as both securities products and insurance products. However, up until recently most equity-index annuities have not been considered securities products, and insurers have considered them exempt from securities regulations, such as the requirement for a prospectus, and also exempt from any securities licensing requirements for any agent selling them. The reason most equity-index products have not been considered securities products is based on the premise that the purchaser does not assume the product’s investment risk. The return on the annuity is not based on sub-accounts chosen by the purchaser, but is based on returns from the insurer’s general account. In addition, the insurer guarantees a minimum return, and the interest credited is not modified more than annually. These conditions have been seen as having placed equity-index annuities under an exemption from SEC regulation for annuity contracts. Variable annuity values are based on the value of units purchased within a sub-account that is part of an account that is not part of the insurer’s general account, the separate account. In sub-account investing, the purchaser assumes the investment risk. The insurer does not provide a minimum guaranteed rate on variable sub-accounts.
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Some equity-index annuities currently on the market are structured as securities products and have been registered as security products, as variable annuities are. In order to sell such products, the agent offering them must comply with the NASD and any state regulations related to selling securities products, including licensing requirements. A prospectus must also be provided. Securities products must also be registered as investment products with the SEC. Among the equity-index annuities currently on the market that are registered as investment products are those which include several index options from which the customer can choose. For example, one product has four different equity-index options based on the S&P 500. Customers can transfer among registered equity-index annuity options, as they can between variable annuity sub-accounts. It is easy to see why equity-index annuities that allow the purchaser to decide in which portfolio to invest would be considered securities products: the purchaser is assuming the investment risk. Registered equity-index annuities may also include a market value adjustment, and some allow the purchaser to select the method under which the insurer will calculate the change in the S&P and the resultant index benefit.
Index-Based Portfolios Most equity-index annuities use the S&P 500 Composite Stock Price Index as the index on which to base returns. The S&P 500 is an index created and maintained by Standard & Poor’s. It currently includes stock prices from 500 companies traded on the New York Stock Exchange, the American Stock Exchange, and the NASDAQ. These 500 companies represent 90 different industry groups. The four major industry groups within the index are Industrial, Utilities, Financial and Transportation. The companies within the index may be the largest in their industry, or may be smaller companies which are industry leaders. The S&P 500 is considered an index which is a reflection of the performance of the U.S. stock market. It is used by many equity index mutual fund and sub-account managers as the index on which to model their portfolios. It is also used by the U.S. Commerce Department as a leading indicator when measuring the economic health of the various sectors of the U.S. economy.
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Why Index-Based Portfolios Are Used by Money Managers As mentioned, the S&P 500 represents the overall U.S. stock market’s performance, and includes industry leaders and large companies. By investing in the companies which make up the index, in the proportions in which the companies are represented within the index, one is investing in a diversified portfolio of companies in all the various industry sectors of the U.S. economy. Over time, financial analysts have determined that the equities of the companies which make up the S&P 500 have generally outperformed other managed equity portfolios. One explanation for the superior performance of funds or sub-accounts modeled on the S&P 500 over the last 10 years compared to most other equity funds is found in the efficient market theory. This theory states that the markets tend to operate in a highly efficient manner – the prices of the stocks in the market are the result of the knowledge and expectations of the marketplace. Since the stocks’ prices are the result of this efficiency, it is difficult, if not impossible, to consistently outperform the market by picking stocks using financial analyses tools. According to the efficient market theory, for best performance, invest in stocks represented by overall stock market indices, such as the S&P 500. As can be imagined, especially now that the market is in such turmoil and has recently lost so much of its value, there is a great deal of dissent within the financial community as to whether this theory is true, and whether this theory explains why index funds had performed well when measured over the last ten years. Some opponents of the efficient market theory suggest that the exceptionally strong stock market performance of the last several years as the reason index fund returns were healthy. Others point out that certain sector funds (found in the financial services, technology, health care and communications sectors) have consistently outperformed index funds, thereby “proving” that professional financial analysis can indeed result in returns that outperform the market. Whether one holds to the tenets of the efficient market theory or not, a case can be made using several sound financial principals that index
Standard & Poor’s Common Index, 1980 to 2010
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As reported in the Statistical Abstract of the United States, 1996, 1997,1999, 2000, 2006, 2009, 2011, 2012 U.S. Department of Commerce (Annual averages of daily figure)
Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Index Value 118.7 128.0 119.7 160.4 160.5 186.8 236.3 268.8 265.9 323.1 330.2 376.2 415.7 466.5 459.3 615.9 740.7 970.4 1,229.2 1,469.3 1320.3 1148.1 879.8 1111.9 1211.9 1248 1418 1468 903 1115 1257
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investing makes sense. These principals include diversification, equity investing, and using savings products that have low management fees. Diversification As has been stated, the S&P 500 is composed of 500 different stocks. Twenty-six different industries are represented. Investing in a portfolio of so many different companies and industry sectors definitely qualifies such a portfolio as diversified. Diversification helps to protect against the reduction of return in a portfolio caused by a poor economic performance of a particular company or a particular industry sector. Stocks from many companies and sectors are held in a diversified portfolio so that some stocks will be experiencing positive returns when other stocks are experiencing negative returns. Even now, with the stock market experiencing significant downturns, this diversification is seen by many experts as important for those investing in the market for the longterm, as most annuity purchasers should be. Equity Investing As was mentioned in the discussion of variable annuity sub-accounts, equities provide opportunity for growth, and are viewed as a hedge against inflation. Equities are considered an important part of a balanced investment strategy. Index funds based on the S&P 500 are generally considered to be largecap funds, meaning they are composed of equities from large companies. Small-cap funds are those made up of smaller, growth companies. Smallcap portfolios are generally considered more aggressive, or more risky, than are large-cap portfolios. Investing in index-based portfolios is generally considered to be a less risky method of participating in equity growth than is investing in a small-cap portfolio. Of course, portfolio risk depends on more than just the type of equity within the portfolio. Use of tools such as options and other derivative securities affect the overall risk of a portfolio, for example. Low Management Fees Portfolios created and maintained based on the financial analyses and other expertise of portfolio managers are considered actively managed portfolios. Actively managed portfolios generally include higher management fees than do most index funds. This is because, in effect,
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the index creator, such as Standard and Poors, is doing an important piece of a portfolio manager’s duties: S&P is determining which stocks are within the index (and therefore the portfolio) and is determining each stock’s relative proportion within the index. An advantage of a fund not actively managed is its generally lower management fees reduce the likelihood that such fees will erode the overall return of the portfolio.
Index Funds vs. Equity-Index Annuities An obvious risk in index portfolio investing is market downturn. If the S&P 500 has a negative return, so generally will the portfolio based upon it. Equity-index annuities protect against this risk through a variety of guarantees made by the insurer: principal guarantees, minimum guaranteed index returns and minimum guaranteed rates. These equityindex annuity features help to make the equity-index annuity a more conservative product than an index fund. In addition, equity-index annuity returns are not based solely in a portfolio based on an index. Rather, the insurer participates in index portfolios through the use of options. This facet of equity-index annuities will be discussed later.
Important Terms in Equity-Index Annuities Before discussing the index benefit calculation methods available in equity-index annuities, there are several terms that need to be explained. Cap Some equity-index annuities include a cap. The cap is a limit on the percentage increase resulting from the index benefit calculation. For example, if the contract had a 7% cap, and the index return calculation resulted in a 7.25% increase, the contract would be credited with the cap rate of 7%. Not all equity-index annuity contracts include a cap. Term The term of an equity-index annuity is generally the length of time surrender charges are applied. The term may range from 5 years to 15 years, depending on the contract. Some contracts apply surrender charges to each new premium, meaning that each contribution would have its own term.
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A contract’s language may also use term in conjunction with a period of time. For example, a contract may state that when the policy is opened, it is in its ten-year term. Surrender charges apply if withdrawals are taken or the policy is surrendered during the ten-year term. After the ten-year term is over, the policy can be renewed for a one-year term. The contract then might state that no surrender charges apply if withdrawals are taken or the policy is surrendered during a one-year term. A close reading of the contract is necessary to ensure an understanding of conditions surrounding the period or term of an equity-index annuity contract. Participation Rate The participation rate is the percentage of the change in the index that will be used to calculate the annuity’s return. For example, if the index benefit calculation resulted in an increase of 10% and the participation rate was 90%, the return on the annuity for that period would be 9%. An annuity contract may allow the insurance company to name a new participation rate at the beginning of each new period, e.g. annually. Some annuities offer an initial participation rate that is greater than 100%. This is similar to a bonus rate on a fixed annuity – for the first year (or possibly, some longer period), the insurer will pay a return greater than it promises to in subsequent years, assuming the same return environment. Floor Fixed annuities use the term floor to mean the lowest rate a contract may fall to before a contract holder may bail out. But, under equity-index annuity contracts, the term floor has a different meaning. The floor is the minimum index-linked return the contract will pay. Under most equityindex contracts, the floor is 0%. This is important because the index and the calculated index benefit may result in a negative number. A floor of 0% means that no negative return will be applied to the equity-index annuity. Not all equity-index annuities have a floor, but most that are not registered investment products do include this provision. Averaging Some index return calculations used in equity-index annuities average the index’s value over a period of time. Some average the index daily, some monthly and others may average it over its entire period, such as
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12 months. Averaging the return helps to reduce the skewing that a sharp fluctuation in the index return at the end of a period, for instance just at the time of calculation, could cause. Compounding Another variation in the index benefit calculation in equity-index annuities is whether or not interest is compounded during the calculation period. All equity-index annuities compound interest from period to period, or term to term, but not all calculate and credit and compound index based returns to account values throughout the term. Vesting Under some equity-index contracts, if a surrender or withdrawal is made during the term, the amount of the index benefit is not credited in whole. Some contracts refer to this process as “vesting,” others apply a surrender charge to withdrawals or surrenders during the term. Regardless of the wording, the amount of the calculated index return may not be available in full until the end of the term under some equityindex annuities. Under such contracts, the accumulated amount available at withdrawal or surrender generally increases, until the full, accumulated value is available at the end of the term.
Index Benefit Calculations There are three common indexing methods available in equity-index annuity contracts, the annual reset method, the high water mark method and the point-to-point method. Annual Reset Method Under the annual reset method, the index value at the end of the contract year is compared to the index value at the beginning of the contract year. Often, the value at the end of the contract year is based on an average value over that year.
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For example, assume that at the beginning of the contract year, the S&P 500 is valued at 500. Each month, the average S&P 500 is calculated. At the end of the year, the averages are totaled and divided by 12, and result in a value of 625. Assume that the contract has a participation rate of 90%. The increase in the index value is calculated as: 625-500 = 25% x 90% participation rate 500 = 22.5% interest applied High Water Mark Method Under the high water mark method, the value of the index is measured at specified times during the term, such as at each anniversary date. The index value is compared to the starting value at the anniversary date, and if it is higher, the index benefit is calculated and interest credited. This higher index value then becomes the new high water mark. At subsequent anniversary dates, the current index value is compared to the high water mark. If the current index is higher, the index benefit is calculated and interest credited. If the current index is equal to or less than the last high water mark, the account value remains unchanged. Some contracts do not actually credit the interest to the accumulated value until the end of the term. Or in others the more common method of a vesting schedule is utilized. Since under the high water mark method interest is not credited until the end of the term, if the policy is surrendered during the term, some contracts require the uncredited interest to be forfeited. Other contracts will use the highest index value between the start date and the time the surrender is made in order to determine the interest accrued up to the point of surrender. High water mark products often have a participation cap, and may have a lower participation rate than products using other index return calculation methods. To illustrate the high-water mark method, assume a $5,000 annuity is purchased with an 8 year long term. At the start of the contract, assume the S&P 500 is at 525. Also assume the contract allows for compounding of gain during the term. The tables below illustrate the index value and account value at each contract anniversary within the term:
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End of Year 1 2 3 4 5 6 7 8
End of Year 1 2
3
4
5 6
7
8
Index Value 550 525 595 513 580 555 550 595
Return 550-525 = 4.76% 525 Lower than previous high water mark, so no return is applied Lower than previous high water mark, so no return is applied Lower than previous high water mark, so no return is applied 580-525 = 10.48% 525 Lower than previous high water mark, so no return is applied Lower than previous high water mark, so no return is applied 595-525 = 13.33% 525
Account Value $5238.10 $5238.10
$5238.10
$5238.10
$5787.05 $5787.05
$5787.05
$6558.46
Notice that if the change in the index is less than zero, no negative return is applied.
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If the contract also includes a vesting schedule, the total account value would not be available at the end of each year. Rather, the total account value would be available at the end of the term, assuming no withdrawals were made within the term. If the contract had a participation rate, the return would be calculated by taking the change in the index, and multiplying it by the participation rate. If the contract has a cap, the maximum return that could be applied to the account values would be limited by the cap percentage rate. Point-to-Point Method Under the point-to-point method, the value of the index at the end of the term is compared to the value at the beginning of the term and the difference is credited as interest. If the contract has a participation rate, the index increase would be multiplied by the participation rate, and the resulting percentage would be applied to the contract. Using the same illustration as was used for the high-water mark method, the point-topoint method would calculate the return as follows: End of Year 1 2 3 4 5 6 7 8 End of Year 1 2 3 4 5 6 7 8
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Index Value 550 525 595 513 580 555 550 595 Return Not calculated until the end of the term
595-525 = 13.33% 525
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Account Value $5000 $5000 $5000 $5000 $5000 $5000 $5000 $5666.50
If the contract uses a participation rate, the change in the index would be multiplied by the participation rate and the resulting percentage would be applied to the contract. If the contract includes a cap rate, no return higher than this rate would be applied to the contract values. Contracts using the point-to-point method may not credit any interest prior to the end of the term, even if a surrender is taken. Some contracts may offer a guaranteed minimum index return, and will calculate account values based on this guaranteed minimum should a surrender occur prior to the end of the term, and would pay this minimum return if the index benefit calculation was less than the guaranteed minimum index return.
Free Withdrawals Equity-index annuities generally provide free withdrawal provisions. However, a free withdrawal feature of an equity-index annuity can be different from those of a fixed annuity. Ten Percent of Initial Premium One of the variations of equity-index annuity penalty-free withdrawal provisions is to allow 10% of the initial premium to be taken annually without any applicable surrender charges applied. Ten Percent of Accumulated Value Another variation of the free withdrawal provision of an equity-index annuity is to allow 10% of the accumulated value to be withdrawn annually. Often, the accumulated value as of the last anniversary date is used when calculating the free withdrawal amount available. Ten Percent of Principal If an equity-index annuity offers a free withdrawal of 10% of the principal, the calculation will include the initial premium, plus any additional contributions, but will not include any interest. Again, principal as of the last anniversary date is normally used for determining this free amount. Ten Percent of the Minimum Guaranteed Value Another free withdrawal provision found in equity-index annuities is 10% of the minimum guaranteed value. The guaranteed rate of many
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equity-index annuities is 3% applied to a percentage of premium which varies from 75% to 100%. Commonly, states approve a minimum guaranteed value of 87.5% of payments, accumulated with a rate of 1% to 3%. Nursing Home or Medical Waiver Withdrawals Equity-index annuities may include nursing home or medical waivers. The conditions of the waivers vary by contract and by the state in which the contract is issued, just as they do for fixed annuities. Impact of Withdrawals on the Annuity Value As has been discussed, equity-index annuities use various methods to determine the index benefit to be applied to the annuity. Generally, all the methods measure the change in the index from one point in time to a later point in time, and apply a percentage of that change (anywhere from 60% to 125%) to determine the rate to apply to the account value. Under most of the methods, the calculation is done annually, and interest is applied annually. If withdrawals are made during the calculation period, the calculation may not include the amount withdrawn, regardless of when during the period the withdrawal was made. For example, if a withdrawal is made halfway between the end of the second and third contract years from an annual reset equity-index annuity, the index benefit calculation at the end of the third year may exclude the value of the withdrawal during the entire third contract year. It is important that the agent read the contract provisions carefully to determine the impact of withdrawals on the return in the contract. For example, if a customer can wait for a withdrawal until after the end of the calculation period, the maximum amount of return may be applied to the contract for that calculation period.
Annuitization Besides withdrawals, annuity values may be accessed through annuity income or annuitization options. Equity-index annuities generally provide the same annuity options fixed annuities provide. Registered equity-index annuities may include variable annuitization options.
Principal Guarantee Equity-index annuities can include principle guarantee provisions. Principle guarantee provisions typically state that no less than the
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premium contributed to the contract will be returned at the end of the annuity term.
Minimum Index Returns In addition to principal guarantee, equity-index annuities may include a minimum index return. This return is either a guaranteed percentage over a period of time that coincides with the surrender charge period, or is a guarantee related to a base rate in effect for a specified period that coincides with the surrender charge period. For example, a contract may guarantee a minimum index return at the end of 8 years of 114% of premium contributed. In such a contract, if the index return calculation at the end of the 8-year term resulted in a return of less than 114% of premium, the accumulated value at the end of the term would be equivalent to 114% of premium contributed.
Minimum Guaranteed Rates Equity-index annuities include a guaranteed minimum rate. Based on the National Association of Insurance Commissioners Non-Forfeiture Obligation regulation, most states require a minimum rate of 1% to 3% on 87.5% of the premium within the annuity. The minimum guaranteed rate comes into play when a surrender is made prior to the end of the term, or when a death benefit is paid, if a contract also includes a minimum index return. In such a contract, the minimum index return functions as the lowest amount that will be received at the end of the term. For example, assume $10,000 is contributed to a contract with a 5 year term, a minimum guarantee of 3% on 87.5% of premium, and a minimum index return of 114% at the end of the 5 year term. If the contract is surrendered at the end of the second year, the surrender value will be no less than $9283 (87.5% of $10,000 = $8750, accruing 3% interest annually). If the contract is not surrendered during the term, but is kept in force until the end of the term, and the index return results in an index benefit of 1%, the minimum index return will be applied, since it is greater than the 1% calculated index benefit. In such a case, the accumulated value at the end of the term would be $11,140 (114% of premium contributed).
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Death Benefit Equity-index annuities generally have a death benefit guarantee which is the greater of the accumulated value based on the index benefit calculation, or 87.5% of the premium, less any prior withdrawals, earning interest of 3% annually.
How Insurers Participate in the Equity Index Market As mentioned, unless an equity-index annuity is registered with the SEC as an investment product, the return on the annuity is based on the general account of the insurer. The method used by the insurer to participate in the index, typically the S&P 500, is by the use of options on the index. The general account of the insurer is a portfolio of stocks and bonds and other securities. The insurer earns a return on this portfolio, which is used to pay the returns on fixed annuities and the fixed accounts of variable annuities. It is also used to pay the minimum guaranteed returns on the equity-index annuity. However, in order to provide a return based on the index, the insurer enhances the return on the portfolio, and hedges the risk of declining returns, through the use of options. In order to understand how this can be accomplished, a short discussion of option basics follows. Options are securities which give the purchaser the right to buy or sell a security at a specified price within a specified period of time. They are used by individual investors and investment professionals, such as mutual fund and other portfolio managers to earn income and protect or hedge a portfolio against loss. Types of Options Put Options An option to sell a security at a specific price is called a put option. The put gives the option buyer the right to sell 100 shares of a security at a specified price. The specified price in the option contract is called the exercise price or contract price. An option contract is always for 100 shares, so each 100 shares is known as one contract.
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A put option is profitable to the buyer if the stock or index to which the put applies drops in price. For example, assume XYZ stock is selling for $40 a share. Three put contracts (300 shares) are purchased for $4 a share, with an exercise price of $40. The option contracts, not including commission, cost $1200. The option contract expires in six months. The stock goes down in price to $30 during the contract period and the put option is exercised. The option holder purchases 300 shares of stock at the current price of $30 ($9000) and then “puts” them to the option seller who must pay $40 a share ($12,000) according to the contract. The option buyer makes a profit of $1800, not counting commission charges: $12,000 less $1200 paid for the option contracts and $9000 paid for the 300 shares of stock. If the stock had gone up in price rather than down, the put would have been worthless and the buyer would have been out $1200 plus commission. The put seller would have earned the premium of $1200, less commission. In the case of index options, a put purchased at the current price of the index becomes more valuable if the index drops. The put can then be sold, generating income for the seller. If the market goes up, assuming the purchaser of the put holds a well-diversified portfolio, the put will be worthless, but the return on the portfolio will generally rise. As can be seen, the strategy of selling puts can enhance income and protect a portfolio against a market downturn. Call Options A call option is the option to buy a security at a specified price within a specified time frame. The purchaser of a call option makes a profit if the stock price or index rises. Assume ABC stock is selling for $30 a share. Four call contracts are purchased for $4 a share ($1600 plus commission). The contracts have an exercise price of $30 and expire in nine months. The stock moves up to $40 a share. The option buyer exercises the call, buys 400 shares of ABC at $30 from the call seller ($12,000) and sells them at $40 a share ($16,000). The profit, again not including commissions, is $2400. However, if the stock did not rise during the next nine months, or did
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not rise enough to cover the cost of the option contracts, the option is worthless. In the case of index options, if a call option at the current index price is sold, the seller earns the option premium. If the market then rises, the purchaser of the call will require the seller to settle the option at a price that reflects the new, higher index value. The seller, however, if holding a diversified portfolio, can expect that the return on the portfolio will rise. If the market drops, the seller retains the premium earned on the call sale, and the purchaser will allow the option to expire. Option Premium Income Besides exercising options, income can be made by trading options. The seller or writer of an option earns the premium, less commission, paid for the option. As the stock price or the index on which an option is based moves up and down, the related option prices will move up and down as well. Option prices can be quite volatile, depending on the movement of the related stock or index, the length of time of the options contract, and the exercise price. Covered Option Writing If the seller of a call owns the security on which the option is written, the seller is said to be writing a covered call. If the securities are not owned by the writer, he or she is writing a naked call. Covered calls are not subject to the large losses of a naked call. If the call option is exercised and the writer must sell securities at the strike price, the writer delivers the shares owned. He or she is not forced to go into the market and purchase securities in order to meet the call. Use of Options by Portfolio Managers Portfolio managers use options to increase yields, to protect against loss, and to add diversification to a portfolio without the expense of buying more securities. Two methods that may be used to accomplish these objectives have been examined, the method of buying index puts and selling index calls. Other index option strategies may be used by the managers of the insurer’s general account, each strategy typically having as it’s goal at least one of these three objectives.
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Increasing Yields Selling options provides income to the seller. Yields on a portfolio can be enhanced by earning premium income by selling options. Depending on the amount of option writing, the portfolio manager may minimally or significantly impact the portfolio’s income (and its risk level) by this activity. Protection Against Loss Like individual investors, portfolio managers may buy puts as “insurance” on a portfolio. Or, they may use much more sophisticated option methods. “Spread” options are one such method. A spread option is the purchase of one option and the sale of another option on the same security or index. A spread option can be used to hedge against risks which exist in a portfolio. Spread options include yield curve spreads, money market spreads, and spreads on various indexes. Adding Diversification Buying options can have the effect of leveling returns, which is one of the outcomes of diversification. Diversification levels out returns since different securities have different levels of return at any given time. Buying individual stock options or index options can provide this same benefit without the outlay involved in actually buying the securities. Index Options The price of index options that are based on overall market indices move up and down with that market, so provide the portfolio manager with a method of participating in market returns. Besides enhancing return, index options are used to help hedge a well-diversified portfolio against a market downturn. It would be difficult for a manager of a welldiversified portfolio to purchase options on every single security within the portfolio in order to hedge against a downturn. Index options can serve as a hedge for a well-diversified portfolio without the manager having to buy options on every single security in the portfolio. If an equity-index annuity is a registered investment, the annuity prospectus will give details regarding the amount and use of index options and other security derivatives used in the portfolio. No such disclosure is required to the customer of a non-registered equity-index annuity. However, the individual states and the NAIC receive many
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financial reports which include the general account investments. Many of these reports are available to the public. The type and quantity of various securities, including options, used within the general account of the insurer is subject to regulation by the individual states. While staying within the boundaries of these regulations, the manager of the insurer’s general account manages the portfolio investments and uses options to meet the responsibilities of paying the guaranteed minimum rate, paying any guaranteed minimum index return, and achieving a return competitive with other nonregistered equity-index annuities.
Summary Equity-index annuities are products that have experienced a significant increase in sales volume since they were introduced in the 1990’s. According to the SEC in the published Rule 151A, equity-index sales in 2007 reached 123 billion. The purchaser has the advantages shared by purchasers of fixed annuities: tax-deferred growth, avoidance of probate, and many withdrawal options. Equity-index annuities also provide the opportunity for growth that can exceed a fixed annuity, along with guarantees not available in variable annuities. There are potential disadvantages of equity-index annuities, including penalties or loss of interest if withdrawals are made prior to the end of the term, and fluctuating returns. However, the risks and potential disadvantages of equity-index annuities are seen by many customers as well worth the opportunity of increased returns that may be found in these annuities.
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CHAPTER FOURTEEN: HOW ANNUITIES MEET RETIREMENT NEEDS Retirement Annuities can be used within retirement plans, whether regular IRA plans, Roth IRA plans, or SIMPLE, SEP, KEOGH and other qualified retirement plans. As a nonqualified annuity, they can be used to supplement qualified retirement savings. This chapter will discuss various retirement plans, and how annuities may be used to fund them. Individual Retirement Accounts An Individual Retirement Account, or IRA, is a retirement plan available to every compensation earner. All people earning compensation may contribute to IRAs. Under EGTRRA of 2001, the maximum contribution that may be made to traditional IRAs is increased from the pre-2001 Act level of $2000. The maximum contribution limit is referred to as the “deductible amount” under the 2001 Act. The increase in the contribution limit or deductible amount will take affect according to the following schedule: IRA Maximum Contribution Levels For taxable years beginning in: 2002 through 2004 2005 through 2007 2008 and thereafter
The deductible amount is: $3000 $4000 $5000
The 2001 Act also allows older Americans to “catch up” their retirement contributions and has created a higher “applicable amount” that applies to individuals age 50 and over. These individuals may make a maximum IRA contribution according to the following schedule:
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IRA Maximum Contribution Levels for Individuals 50 and Over For taxable years beginning in: 2002 through 2004 2005 2006 and 2007 2008 and thereafter
The deductible amount is: $3500 $4500 $5000 $6000
Regular IRAs The regular IRA allows annual contributions to be made by individuals to individually held accounts or plans. The earnings in these plans are not taxed annually; rather, earnings are taxed when they are withdrawn. Earnings in an IRA are therefore tax-deferred. The impact of tax-deferral on earnings can be significant. The impact on return increases the more money is contributed to the tax-deferred plan and the longer the money remains tax-deferred. A contribution to traditional IRAs may be taxdeductible in the year the contribution is made as well. These legislated tax advantages are meant to encourage individuals to save for retirement. Withdrawals from regular IRAs must be made beginning no later than April 15 of the year following the year in which the IRA holder reaches age 70 ½. An additional 10% tax applies to most withdrawals of earnings prior to age 59 ½. The Roth IRA The key differences between a Roth IRA and a regular IRA is that contributions to a Roth IRA are never tax-deductible and withdrawals are generally free from income taxation. Contributions may also continue to be made after age 70 ½ to a Roth IRA if the individual is still working. Distributions do not have to be made beginning after age 70 ½ as they do in a traditional IRA. The Roth IRA is a streamlined version of the regular IRA, without many of the cumbersome rules associated with the traditional IRA.
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Advantages of IRAs Availability Many workers are not offered a way by their employers to save for retirement through a qualified retirement plan. However, anyone earning compensation, and his or her spouse, may contribute to an IRA. Tax-Deferral Moneys contributed to an IRA grow tax-deferred. Pre-tax contributions and earnings accumulated in an IRA are not taxed until withdrawn. Tax deferral means increased growth when compared to a taxable investment, as was discussed in Section One. Regular IRA Tax Deductibility Despite recent tax law changes, up to 87% of working Americans may take a partial or total income tax deduction for regular IRA contributions. Deducting IRA contributions reduces the amount of income tax due for the tax year the contribution was made. For example, assume a single individual has taxable income of $25,000 and is in a 15% federal tax bracket. If he or she contributes $5000 to a regular IRA his or her tax liability will be reduced by $750 ($5000 contribution multiplied by 15% marginal tax bracket). Roth IRA Tax-Free Withdrawals Qualified distributions from Roth IRAs are free from taxation. This is a tremendous advantage over non-tax advantaged savings vehicles. For example, if a person who is in a 25% tax bracket places $4000 annually in a Roth IRA for ten years and earns a 10% return over that time, a qualified distribution which would have caused a tax liability of over $7500 in a taxable savings vehicle will yield a tax liability of zero. Flexibility Contributions to an IRA are flexible. Once an IRA is opened, annual contributions do not have to continue, but may be made as the owner decides. Investment options are flexible as well. IRA moneys may be placed in bank certificates of deposit, fixed and variable annuities, mutual funds, individual securities - just about anything other than life insurance and certain collectibles.
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Easy to Combine or Transfer IRA funds may be moved via trustee-to-trustee transfers at any time, or once every twelve months via an IRA rollover and retain tax-deferral. Qualified pension plan distributions may also be rolled directly into a regular IRA and retain tax-deferral. Many clients approaching retirement want to combine IRA and pension plan distributions so that they may enjoy the ease of receiving one statement and one income check. Ease of transfer is also important as investment needs change. A younger IRA contributor may place IRA moneys in an aggressive stock fund today with the plan to move the funds to more conservative instruments as retirement approaches. Probate Avoidance An IRA may be structured to avoid probate. If a beneficiary is named for the IRA, death distributions will be made directly to that beneficiary without going through the publicity, delay and expense of probate. Regular IRA Eligibility Any individual may contribute to a regular IRA who: a) has not reached age seventy and one-half during the tax year for which the contribution is made, and b) has compensation. Compensation includes wages, salaries, tips, commissions, fees, bonuses, and taxable alimony and separate maintenance payments. Compensation does not include deferred compensation received nor social security or railroad retirement income. Disability income is also not included in compensation for the purpose of calculating IRA contribution eligibility. Other items not included in compensation are rental income, interest income, dividend income, pension or annuity income, and foreign earned income. Regular IRA Contribution Rules An individual may generally contribute up to $5000 (year 2012) or one hundred percent of compensation earned in a tax year, whichever is smaller, to an IRA.
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For example, if 45-year old Mr. Johnson earned $25,000 in compensation for the year, he could contribute up to $5000 to an IRA for the current tax year. If eighteen year old Ms. Daniels earned $1700 in compensation for the year, her maximum IRA contribution would be $1700, one hundred percent of her compensation. Once an IRA is established, there is no requirement that future contributions be made. Contributions may be made each tax year, monthly during the tax year, every other year, or never again. Additional Individual Retirement Accounts may be opened and maintained as well. There is no requirement that only one IRA may exist per IRA owner. IRA Investments Collectibles. In 1982, legislation included in the Tax Equity Fiscal Responsibility Act, or TEFRA, mandated that collectibles could not be purchased through an IRA. Collectibles include items such as art, rugs, antiques, gems, stamps and coins. The Tax Reform Act of 1986, TRA ‘86, modified this legislation to state that certain US gold and silver coins could be purchased in a traditional IRA. The Taxpayer Relief Act of 1997 added platinum coins and gold, silver, platinum and palladium bullion meeting certain specifications to the list of acceptable collectibles. None of these coins or types of bullion are now prohibited from use as an IRA investment. Life Insurance. Life insurance cannot be purchased through a traditional IRA. This prohibition does not include tax-deferred annuities, however, whether fixed or variable. Types of Regular IRAs Two types of IRA plans are currently allowed under IRS regulations: an Individual Retirement Account and an Individual Retirement Annuity. Individual Retirement Accounts An Individual Retirement Account must be an account opened through a written trust or a custodial account. The IRS allows banks, federally insured credit unions, other financial institutions and other corporations to act as trustee or custodian for IRA agreements, assuming the
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institutions meet IRS requirements. These requirements include continuity of life, established location, fiduciary experience, fitness to handle retirement funds, ability to administer fiduciary powers and adequate net worth. The Individual Retirement Account administered by these entities must meet the following requirements: a) The trustee cannot accept contributions, other than rollover contributions, of over $5000 (2012) for a tax year. b) Contributions, other than rollover contributions, must be in cash. c) The IRA holder must have a nonforfeitable right to the amount in the account at all times. d) The account cannot invest in life insurance nor most collectibles. e) Distributions must generally be made by April 1 of the year following the year in which the IRA holder reaches age seventy and one-half. f) The assets in the account cannot be commingled with other property, except in a common trust fund or common investment fund. Contributions to IRAs must be in cash. Once established as an IRA, the IRA moneys may be used to purchase any of a variety of investments, such as mutual funds, certificates of deposit, individual stocks or bonds, real estate, annuities, or any other investment other than life insurance and most collectibles. Individual Retirement Annuities An Individual Retirement Annuity is an annuity contract issued through a life insurance company. The annuity must meet the following requirements: a) The IRA holder must be named as owner and only the IRA holder or beneficiary or beneficiaries may receive payments or benefits from the annuity. b) The annuity cannot be transferable. c) Contracts issued after November 6, 1978, cannot require a fixed premium payment.
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d) Contributions, other than rollover contributions, cannot exceed $5000 for a tax year. e) Distributions must generally begin by April 1 of the year following the year in which the IRA holder reaches age seventy and one-half. Spousal IRAs A deductible contribution may be made by an individual under special IRA rules even if the individual has not earned compensation during the tax year. The requirements of this rule are: a) the amount of compensation, if any, includible in the individual’s gross income is less than the amount of compensation includible in the gross income of the individual’s spouse, and b) the individual files a joint return for the taxable year. As long as these requirements are met, the maximum contribution which may be made for this individual is the lesser of: • $5000 (2012), or • the sum of the compensation includible in the individual’s gross income for the tax year, plus the compensation includible in the gross income of the individual’s spouse for the tax year reduced by the amount allowed as a deduction to the spouse for a contribution to the spouse’s own IRA for that tax year. For example, Mr. Smith, age 66, has retired and has no compensation. His wife, Mrs. Smith, age 62, is working and earned $35,000 in includible compensation. A maximum of $5000 can be contributed to each of the Smith’s IRAs. Although this IRA funding structure is commonly called a “Spousal IRA,” each IRA is individually owned. Premature Distributions IRA moneys distributed prior to the IRA holder’s age 59 ½ are considered premature distributions. Generally, premature distributions
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are subject to an additional IRS tax of 10% applied to the entire distribution. Exceptions There are exceptions to the tax on premature distributions. exceptions are:
The
a) Disability. Disability is strictly defined by the IRS. Generally, a physician must determine that an IRA holder has a condition that will last for a contiguous period of at least twelve months under which he or she cannot do any substantial gainful activity because of his or her physical or mental condition. b) Death IRA distributions made to beneficiaries due to the death of the IRA holder are not subject to the additional 10% tax. c) Payments which are part of a series of substantially equal payments which are made over the IRA holder’s lifetime. These payments may also be made over the IRA holder and a designated beneficiary’s lifetime. At least one payment must be made annually. The payments may not be modified until the IRA holder reaches age 59 ½ , or at least five years from the first payment, whichever is greater. If the payments are modified prior to this time period, the entire amount distributed will become subject to the additional 10% tax, unless the modification in payments was due to disability or death of the IRA holder. d) Distributions for certain medical expenses. Distributions less than or equal to the amount allowable as a medical deduction for income tax purposes for amounts paid during the year for medical care. Currently the allowable medical deduction amount are amounts in excess of 7 ½% of adjusted gross income. e) Distributions to unemployed individuals for health insurance premiums. To qualify under this exception to the premature distribution tax, the IRA holder must have separated from employment and must have received unemployment compensation for twelve consecutive weeks, or, if self-employed, compensation if he or she were not self-employed. The distribution must be made either during the tax year the participant received the unemployment compensation or in the succeeding tax year. If the distribution is made after the IRA holder has been re-employed for at least sixty days, it will not qualify under this exception. f) Distributions for certain higher education expenses.
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Distributions that do not exceed “qualified higher education expenses” of the taxpayer are not subject to premature distribution tax. Qualified higher education expenses “means qualified higher education expenses… for education furnished to – (i)the taxpayer (ii)the taxpayer’s spouse, or (iii) any child or grandchild of the taxpayer or the taxpayer’s spouse, at an eligible education institution…” (IRC Section 72(t)(7)) g) Distributions for certain first-time homebuyer expenses. Distributions which are made by the IRA holder for “qualified acquisition costs” for a principal residence of a first-time homebuyer for the IRA holder, the IRA holder’s spouse, or the child, grandchild or ancestor of the IRA holder or the IRA holder’s spouse. The portion of a premature distribution attributable to non-deductible contributions is not subject to the tax on premature distributions. For example, assume an IRA holder is 45 and has made $2000 in nondeductible contributions to his IRA now worth $10,000. He takes a full, lump-sum distribution of his IRA funds. Eight thousand dollars of the distribution would be subject to the 10% premature distribution tax and $2000 would not be taxed as a premature distribution. Required Minimum Distributions of the Regular IRA If an IRA is held until the owner reaches age 70 ½, the IRA is subject to distribution rules. Regulations require that the distributions must meet certain minimum amount requirements and must be made within certain time frames. The rules surrounding these distributions are known as the required minimum distribution rules Required Beginning Date Required minimum distributions must begin by April 1 of the year following the year in which the IRA holder reaches age 70 ½. This date is the required beginning date for required minimum distributions. The regulations give the IRA holder a little extra time, three months and one day, to make his or her first distribution. All distributions following must be made by December 31.
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If an IRA holder opts to wait until April 1 of the year following the year in which he or she reaches seventy and one-half to make the first distribution, a second distribution must be made by December 31 of that same year. The first distribution is the distribution required because the owner has reached age seventy and one-half, the second is the distribution required for the calendar year following age seventy and one-half. The calculation is based on the balance in the IRA as of December 31 of the year prior to the year in which the distribution is made. For example, Mrs. Anderson reaches age seventy and one-half in August 2011. On April 1, 2012, she takes her first distribution. The distribution is calculated based on the value in her IRA as of December 31, 2010. On December 31, 2012, she takes her second distribution, based on the IRA value on December 31, 2011. Each year following, she must take a distribution by December 31 of that year, based on the IRA value on December 31 of the prior year. Required Minimum Amount Each distribution must meet a required minimum amount. Generally, the amount in the IRA must be distributed, at a maximum, over the life expectancy of the IRA owner, or the joint life expectancies of the IRA owner and designated beneficiary. The required minimum amount is calculated based on the total in all IRAs owned by the IRA holder. The distribution may be made from any one, or a combination of the IRAs, as long as the minimum amount is distributed. Distribution Method Selection Under the rules in effect for 2001 and forward, the IRA holder calculates required minimum distributions based on a distribution period using the IRA holder’s age and an IRS life expectancy table. The life expectancy table used by all IRA holder’s, except those who have a spousal beneficiary more than ten years younger than the IRA holder, assumes that the IRA holder has a beneficiary who is exactly ten years younger than the IRA holder. This table is called the “Table for Determining Applicable Divisor for MDIB (Minimum Distribution Incidental Benefit).” The table used if a spousal beneficiary is over ten years
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younger than the IRA holder is called “Table II, Joint and Last Survivor Expectancy.” When amounts greater than the minimum distribution are taken, no “credit” is given toward future years’ distributions. For example, assume Mr. Johnston’s required distribution is $3600. He decides to take $5000. He cannot use the additional $1400 distributed this year as a credit against next year’s distribution. He must take at least the required minimum each year. Annuity Method The new rules surrounding minimum distributions allow the use of an annuity payment method to meet the RMD rules. The annuity must meet the RMD rules, use the appropriate life expectancy tables, and must extend over the joint life expectancy of the IRA holder and a designated beneficiary. Generally, the purchase of an annuity wherein payments are at least equal to those based on a reasonable interest rate and a reasonable life expectancy table met the RMD rules. As long as the insurance company issuing the contract follows IRS standards for reasonable rates and mortality tables, the purchase of most life annuities and some period certain annuities will satisfy RMD rules. Calculating Required Minimum Distributions Even though the calculation of required minimum distributions has been greatly simplified, the IRA owner should seek professional tax advice for assistance in this calculation. The tax advisor may work with the IRA plan trustee to ensure the IRA owner’s distributions are calculated correctly. Some trustees or custodians will “guarantee” the calculation of distributions in certain circumstances. Common restrictions to these guarantees include items such as the IRA must be placed with that trustee prior to or at the time of the first distribution and the spouse must be named as beneficiary.
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IRA Rollovers Rollovers occur when IRA funds are distributed to the IRA owner, who then places the funds into another IRA plan or into another eligible retirement plan. The ability to roll IRA plan funds to an eligible retirement plan was created under EGTRRA of 2001. An eligible retirement plan is an IRA plan, an IRA Annuity, a qualified plan (such as a 401(k) plan), a Section 403(b) plan and a Section 457 plan. Prior to 2002, regular IRAs could only be rolled into qualified plans under limited circumstances. In order to avoid taxation on a rollover distribution, the rollover must be done in a manner which conforms to certain rules: Sixty-Day Rule A rollover must be completed by the sixtieth day from the date the distribution was received. This means that the new plan trustee must record the IRA moneys as received by the sixtieth day. One-Year Rule Only one rollover may be made from an IRA to another IRA (or IRAs) within a one-year period. Note this one-year period is not a calendar year, but twelve months from the date the distribution was received. Partial Transfers And Rollovers The IRA holder may rollover or transfer a partial distribution from an IRA. Any amount distributed from an IRA but not rolled over or transferred is subject to taxation, including any applicable tax on premature distributions or excess distributions. The IRA holder may also rollover or transfer the proceeds from one IRA into one or more IRAs or other eligible retirement plans. Rollovers and Direct Rollovers From Qualified Plans to a Regular IRA. Taxable distributions from a qualified plan may be rolled over into a regular IRA. Excluded from the amount of a taxable distribution which may be rolled over are required distributions, payments which are a series of substantially equal payments over the life or life expectancies of the IRA holder, and payments which are a part of a specified distribution of ten years or more.
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Eligibility Rules of the Roth IRA Roth IRAs are a newer form of IRA, which became available in 1998. Contributions to a Roth IRA are not deductible, but withdrawals from a Roth IRA may not be taxable. Any individual who earns compensation may generally contribute to a Roth IRA. Compensation is defined as wages, tips, salaries, commissions, fees, bonuses, and taxable alimony and separate maintenance payments. Deferred compensation received, social security or railroad retirement income, disability income and other unearned income is not considered compensation for the purposes of determining eligibility to contribute to a Roth IRA. Eligibility to contribute to a Roth IRA phases out for persons with adjusted gross income over a certain level. Eligibility phases out for joint filers with adjusted gross income between $173,000 and $183,000 and for individuals with adjusted gross income between $110,000 and $125,000. Contribution Rules of the Roth IRA Individuals may generally make contributions up to $5000 (2012) or 100% of compensation, whichever is smaller, on an annual basis to a Roth IRA. Persons age 50 or older may contribute up to $6000 (2012). The total of all IRA contributions may not exceed this limit. If an individual has made an IRA contribution to a traditional IRA for a tax year, his or her allowable Roth IRA contribution is reduced by the amount of such IRA contributions. For example, Mrs. Perez, a 40-year old earning $35,000 in 2012, makes a $2000 deductible traditional IRA contribution in May 2012. The maximum Roth IRA contribution she may make in 2012 is $3000. This rule applies to regular IRAs as well. If instead Mrs. Perez had made a total of $3000 in contributions to a Roth IRA in 2012, a maximum of $2000 could be made to a regular IRA in this tax year. Contributions to Roth IRAs are never tax-deductible. Rather, they are generally free from taxation at distribution.
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Roth IRA Investments Like a traditional IRA, certain investments are not allowed to be used to hold Roth IRA funds. Life insurance and most collectibles are prohibited. Collectibles that may be utilized include certain gold, silver and platinum coins, and certain gold, silver, platinum or palladium bullion. Available Roth IRA savings vehicles include, but are not limited to, mutual funds, annuities, individual stocks, taxable bonds and certificates of deposit. Frequency of Contributions Unlike some qualified plans, annual contributions do not have to be made to Roth IRAs. A Roth IRA may be contributed to each year an individual meets its eligibility requirements, occasionally until the plan is liquidated, or on a one-time basis only. There is no requirement that any dollar amount must be contributed, as long as the amount is within the mandatory contribution limits. Contributions After Age 70 ½ Contributions may continue to be made after age 70 ½ to Roth IRAs, as long as there is compensation. This is in contrast to traditional IRAs, which require contributions to end at this age, since required minimum distributions must be made. Spousal Roth IRAs Like traditional IRAs, contributions of up to $10,000 (2012) or 100% of an individual and spouse’s combined compensation, whichever is smaller, may be made to Roth IRAs for the couple. Each spouse is limited to a $5000 maximum, unless they are 50 or over, in which case the spouses could contribute up to $12,000, or $6000 each. Excess Contributions A six percent tax is applied to Roth IRA excess contributions. Excess contributions are generally defined as contributions greater than the maximum annual contribution, plus any remaining excess contribution from prior years, less any distributions from the Roth IRA. As long as an excess contribution is withdrawn by April 15 following the tax year to which the excess contribution applies, the six percent penalty will not be applied to the contribution.
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Roth IRA Distribution Rules The primary advantage of Roth IRAs lies in the way in which they are taxed upon distribution. Unlike traditional IRAs, which may be both tax-deductible and tax-deferred, Roth IRAs withdrawals may be tax-free. After-tax contributions are used to fund a Roth IRA, and as long as a qualified distribution is taken, the distribution is completely free from federal taxation. Qualified Distributions As can be seen, an important term when discussing taxation of Roth IRA withdrawals is the term qualified distribution. As long as a withdrawal from a Roth IRA is considered a qualified distribution, it is received taxfree. IRC section 408A(d)(2) defines what is considered a qualified distribution: (2)Qualified distribution. For purposes of this subsection— (A) In general. The term “qualified distribution” means any payment or distribution -(i) made on or after the date on which the individual attains age 59 ½, (ii) made to a beneficiary (or to the estate of the individual) on or after the death of the individual, (iii) attributable to the individual’s being disabled (within the meaning of section 72(m)(7), or (iv) which is a qualified first-time homebuyer distribution. (B) Certain distributions within 5 years. A payment or distribution shall not be treated as a qualified distribution under subparagraph (A) if – (i) it is made within the 5-taxable year period beginning with the 1st taxable year for which the individual made a contribution to a Roth IRA (or such individual’s spouse made a contribution to a Roth IRA) established for such individual, or (ii) in the case of a payment or distribution properly allocable…to a qualified rollover contribution from an individual retirement plan other than a Roth IRA (or income allocable thereto), it is made within the 5-taxable year period beginning with the taxable year in which the rollover contribution was made. In summary, a qualified distribution is one made after the first five tax years from the first contribution to a Roth IRA, and which is made either:
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a) b) c) d)
after the individual reaches age 59 ½, or after the death of the individual, or because of the disability of the individual, or for payment of first-time homebuyer expenses.
For example, assume Joe Brown, age 20, makes his first Roth IRA contribution on December 31, 2007, and makes additional $2000 contributions in June 2008, February 2009, August 2010, and May 2011. In January 2012, he buys his first home and withdraws $10,000 plus all earnings from his Roth IRA. This distribution would be considered a qualified distribution, and would be considered tax-free. Note how the five-year period is calculated in this example: Year 1: 2007 Year 2: 2008 Year 3: 2009 Year 4: 2010 Year 5: 2011 Qualified distribution: January 2012 The withdrawal is made after five tax years, not five 365-day periods. If the qualified distribution rule required five 365-day periods, Joe would not have been able to withdraw his funds tax-free until after December 31, 2012. If a person waits until April 15 of the following year to make a Roth IRA contribution for the preceding tax year, the contribution is considered to be made on the last day of the preceding tax year for the purposes of calculating the five-year period under the qualified distribution rules. Taxation of Non-Qualified Distributions From a Roth IRA Even if a distribution made from a Roth IRA is not a qualified distribution, it is taxed in a more favorable manner than are regular IRAs. Currently, the Roth IRA rules state that contributions are considered to be withdrawn before earnings. Traditional IRA rules, in contrast, state that withdrawals are considered to be comprised first of earnings.
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The taxation rules of the Roth IRA mean that it will normally make monetary sense to place funds in a Roth IRA rather than make a nondeductible traditional IRA contribution. The impact of the differing taxation treatments in this scenario depends on how the funds are distributed. If the entire amount is distributed at once, or the entire amount within one tax year, there is no difference in the amount of tax due. If, however, an amount equal to the amount contributed is distributed over more than one tax year, the difference in tax treatment has an impact on the tax amount due. The regular non-deductible IRA contribution earnings will be taxed before those of the Roth IRA earnings would be. Required Beginning Date Unlike traditional IRAs, there is no mandatory distribution beginning date under Roth IRA rules. Contributions can remain in the Roth IRA up until the individual’s death. No required minimum distributions need be made. Pledging a Roth IRA as Collateral As with a regular IRA, if a Roth IRA is pledged as collateral, the amount pledged is treated as a distribution, and taxed as one. Roth IRA Distributions At Death Since Roth IRAs are not subject to minimum distribution rules, the rules applying to traditional IRAs that have begun minimum distributions prior to the owner’s death have no applicability to Roth IRAs. However, the IRA rules applying to IRAs when distributions have not begun prior to the death of the IRA holder do apply to Roth IRAs. Therefore, a spouse can continue a Roth IRA at the death of the original Roth IRA holder if the spouse was named as designated beneficiary. A non-spouse beneficiary must receive the distribution within five years after the death of the Roth IRA holder, or may take the distribution over the beneficiary’s life or life expectancy if the beneficiary starts the distribution no later than one year after the date of the Roth IRA holder’s death.
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Roth IRA Distributions Due To Divorce Distributions from a Roth IRA due to divorce are treated just as those from regular IRAs. The receiving spouse may be able to transfer the proceeds to his or her own Roth IRA as long as the distribution meets the requirements of the tax code: 1. The distribution is made to the credit of the receiving spouse. 2. The distribution is made according to a Qualified Domestic Relations Order (QDRO). 3. The same property received in the distribution, if any, is rolled over. Rollover Rules of the Roth IRA Remember that rollovers are a method of moving moneys from one IRA plan to an eligible retirement plan without creating a taxable transaction. A rollover is completed when a distribution is made from an IRA plan to the IRA holder and is placed in an eligible retirement plan within sixty days of the distribution. Rollovers From A Roth IRA to a Roth IRA Rollovers may be made from one Roth IRA to another Roth IRA. One rollover may be made from a plan each tax year. If more than one Roth IRA is held the rules allow for a distribution from each separate plan to be rolled to another Roth IRA. Rollovers From A Traditional IRA to a Roth IRA In 1998, (or, as the tax legislation states, “after December 31, 1997, and before January 1, 1999”) special rules applied to rollovers from traditional IRAs to Roth IRAs. During this period, “conversion” rules applied. To understand the benefits of these provisions, the normally applicable rules must be examined. Generally, when a distribution from traditional IRA is rolled to a Roth IRA, the portion of the distribution attributable to earnings and to deductible contributions is includible in the gross income of the IRA holder in the year of distribution. For example, Jane Wright has a regular IRA to which she has made $12,000 in deductible contributions. The IRA includes $2000 in earnings. Normally, she would be taxed on distributions from this regular IRA when she begins taking distributions, e.g., at retirement. If, rather than keeping the amounts in the regular
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IRA, she distributes the entire amount and rolls it to a Roth IRA, she would have to include $14,000 in gross income for that tax year. When she begins taking distributions from this Roth IRA, she will not have any tax liability related to the distributions, as long as the distribution is a “qualified distribution.” Conversion Rules
In 1998, however, the conversion rules allowed the amount includible in gross income to be pro-rated over four tax years. So, if Jane Wright made her $14,000 rollover from a regular IRA to a Roth IRA in 1998, she could have included $3500 in income in 1998, $3500 in 1999, $3500 in 2000 and $3500 in 2001. Not all individuals were able to take advantage of the conversion rules. Only those with adjusted gross income less than $100,000 in a tax year were able to rollover or convert a traditional IRA to a Roth IRA in 1998. Qualified Plan After-Tax Roth-IRA Contributions EGTRRA of 2001 allows certain qualified plans to treat elective deferrals made by employees as after-tax Roth IRA contributions. 401(k) and 403(b) plans may, after 2005, include a “qualified Roth contribution program.” If the employer includes this program, the employer must establish a “designated Roth account” for each employee. The employee may then elect to make “designated Roth contributions” to their designated Roth account. A qualified Roth contribution program gives participants in qualified plans the ability to take advantage of the tax treatment applicable to Roth IRAs. Without such a program in place, distributions from 401(k) and 403(b) plans are taxed just like distributions from a regular IRA: generally taxable upon withdrawal. The distributions made from a designated Roth account will be taxed like Roth IRAs; distributions will generally be received tax-free. Maximum Designated Roth Contribution Amounts The maximum amount that an employee may elect to place in their designated Roth account is equal to the maximum elective deferral amount applicable to the qualified plan. In 2012, the maximum amount is $17,000. This amount is subject to adjustment for inflation.
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Qualified Distributions from Designated Roth Accounts Qualified distributions from a designated Roth account will not be includable in the employee’s taxable income. Qualified distributions: • must be made after five tax years beginning with the earlier of (1) the first tax year the individual made a designated Roth contribution to the employer plan currently covering the employee, or (2) the first tax year the individual made a designated Roth contribution to a previous employer plan, if a rollover from that plan established the designated Roth account for the employee under his or her current plan; and • must be made on or after the date on which the employee reaches age 59 ½; or • must be made to a beneficiary or the employee’s estate on or after the death of the employee; or • must be attributable to the employee’s disability. Rollovers from Designated Roth Accounts Rollovers from designated Roth accounts will only be able to be made to another designated Roth account within an employer plan, or to a Roth IRA. The employee will not be able to roll these amounts to a qualified plan that does not include a qualified Roth contribution program, nor to a regular IRA. Using an Annuity For IRA Funds An annuity can be used as an Individual Retirement Account. The insurance industry usually terms IRA annuities qualified annuities. We have discussed non-qualified annuities thus far in this manual. Tax Rules When a qualified annuity is purchased as an IRA, it takes on the tax regulations of an IRA rather than of an annuity. In Exhibits 14.1 to 14.3 comparisons of tax rules for a regular IRA annuity, a Roth IRA annuity and a non-qualified annuity are made. Fixed Annuities Used As An IRA Interest Rate Tax-deferral is an annuity feature whether the annuity is purchased as an IRA or not. Therefore, the interest rate paid on a fixed annuity
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purchased as an IRA plays a greater role in its relative attractiveness as an investment than when purchased as a non-IRA investment, when taxdeferral is often a primary purchasing factor. As you now know, fixed annuities generally pay a rate guaranteed for continuous one-year periods. Fixed annuity rates do not generally provide the earnings potential found in the returns from other types of annuities, nor do they generally compare favorably to securities-based products, such as mutual funds. Risk and Conservation of Principal However, even though the return of a fixed annuity may not be as high as the potential return from other products, the relative safety of fixed annuities may be important to a customer. Fixed annuities are generally considered to be low risk, conservative products. This is because the legal reserve rules require life insurance companies to comply with state regulations regarding investments, actuarial assumptions, and reserve levels. Some annuities also include a guarantee of principal provision, ensuring the return of principal if the customer liquidates the annuity contract in full. Therefore, a fixed annuity could be suitable for a conservative IRA owner, one who is concerned about conservation of principal and rate guarantees. Surrender Charges Surrender charges are assessed for certain withdrawals made from fixed annuities within a certain time frame. The time frame, or surrender period, is generally from five to seven years. Generally, withdrawals of earnings or up to 10% of accumulated value do not incur charges, and so are known as penalty free withdrawals. The surrender charge period and the terms of penalty free withdrawals are both important considerations for clients, especially as they grow closer to the time when they are going to begin to take money out of an IRA. Calculation of RMD for Traditional IRAs Many insurance companies will calculate and distribute traditional IRA required distribution amounts. A fixed annuity can be annuitized so the annuity method of required minimum distribution calculation is available. The other minimum distribution methods can be accomplished through random or systematic withdrawals from an annuity. Some annuity companies even market and specialize in pre-59
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½ distributions through the amortization method. Normally, no fee is assessed by insurance companies for calculating required minimum distribution payment amounts. Features Fixed annuities have some unique features. For example, many annuities include a waiver of surrender charges for withdrawals made in conjunction with certain stays in a hospital or long-term care facility. Fixed annuities may also offer bail-out options allowing a customer to liquidate the contract without penalty if the rate falls below a certain level. Variable Annuities Used as an IRA Transfer of Sub-Account Units The ability to transfer units between sub-accounts makes a variable annuity an excellent long-term retirement investment vehicle. Younger savers may purchase units of growth or aggressive growth sub-accounts, having the advantage of time to ride the ups and downs of the market. Later, variable annuity holders may shift to more conservative subaccounts as retirement nears and conservation of unit values becomes a more important consideration. Systematic Withdrawals and Annuitization The systematic withdrawal feature and annuitization features make a variable annuity an extremely flexible distribution tool for retirement. Under systematic withdrawal programs, payments may be started and stopped, and the amount of the withdrawal increased or decreased, as the owner desires. Annuitization options under variable annuities are generally more flexible than those offered through fixed annuities. Self-Directed Savings The purchaser who wants to direct his or her own sub-account investing will find variable annuities an attractive IRA savings option. Variable annuities offer many investment options, and the holder may move units from one sub-account to another very simply, often via a phone call or over the Internet.
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Calculation of RMD for Traditional IRAs A variable annuity offers the availability of several required minimum distribution options including the annuity required minimum distribution method. The amortization, recalculation and nonrecalculation required minimum distribution methods may be available through systematic withdrawal as well. Some insurance companies even guarantee the calculation of required minimum distributions under certain circumstances. Whether guaranteed or not, many people find the idea of required minimum distribution calculations automatically handled for them quite attractive. Withdrawals Variable annuities allow for penalty-free withdrawals during the surrender charge period. After the surrender period is over, withdrawals may be made at any time for any amount from the variable annuity. A retiree often needs products in his or her portfolio that allow access to income outside of any fixed income payments he or she is receiving. Stepped up Death Benefit As has been discussed, variable annuities often include a stepped up death benefit feature. A stepped up death benefit fixes the variable annuity value at certain intervals, e.g. every five to seven years. This value is guaranteed to be paid as the death benefit if the annuity value is lower than the stepped up value at the time of death. This can be important to the retiree who desires to protect assets for the benefit of his or her beneficiaries. Equity-Index Annuities Used As An IRA Risk and Return Guarantees The return on equity-index annuities can be greater than fixed annuities. This can make them attractive to those looking for a higher return than may be found in a standard fixed annuity, and equity-index annuities may come with some return guarantees. The purchaser must also understand, however, that the equity-index annuity has the potential for returns less than those found in a fixed annuity. For example, many equity-index annuities guarantee 3% on 87.5% of premium, while fixed annuities typically guarantee 3% on the entire premium contributed.
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Surrender Charges and Vesting During the equity-index annuity term, surrender charges may apply, or accumulated values may not be fully vested. As with the other annuity types, the length of the surrender charge or vesting period becomes increasingly important as an IRA owner is nearing the time of distribution. Calculation of RMD for Regular IRAs Insurers can generally calculate RMD for traditional IRA annuities, whether the annuity used is fixed, variable or an equity-index annuity.
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Exhibit 14.1 Comparison of Features of Non-Qualified and Regular IRA Annuities. Feature Premature Distribution Tax
Income Tax
Tax-Free Transfers Distributions Must Begin Annuitization Options
IRA Pre-tax withdrawals prior to 59 ½ are assessed a 10% tax unless the withdrawal is: • due to disability, • due to death, • part of a series of substantially equal payments which are made over the life expectancy of the IRA holder, or the joint life expectancy of the IRA holder and beneficiary, • a distribution for certain medical expenses, • a distribution to an unemployed individual for health insurance premiums. • a distribution for certain higher education expenses • a distribution for certain first-time homebuyer expenses Due on total withdrawn, except portion attributable to non-deductible contributions. Allowed through IRA rollover and transfer rules. Generally, at age 70 ½, per RMD rules. Must not violate RMD requirements.
Non-Qualified Annuity Earnings withdrawn prior to 59 ½ are assessed a 10% tax unless the withdrawal is: • due to disability, • due to death, • an immediate annuity, • part of a series of substantially equal payments which are made over the life expectancy of the contract holder of the joint life expectancy of the contract holder and beneficiary.
Due when earnings are withdrawn. Assessed on earnings only. Allowed through 1035 exchange rules. By contractual annuity start date. Based on contract terms.
Taxation rules described in general terms only for comparison purposes.
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Exhibit 14.2 Comparison of Features of Non-Qualified and Roth IRA Annuities. Roth IRA Non-Qualified Annuity Feature Currently, distributions from a Earnings withdrawn prior to Premature Distribution Roth IRA are considered to be 59½ are assessed a 10% tax Tax
Income Tax
Tax-Free Transfers Distributions Must Begin
Annuitization Options
made up of contributions prior to earnings. If a distribution is not a qualified distribution, earnings in the distribution are subject to an additional 10% tax. Qualified distributions are generally distributions which are made after the first five tax years from the first contribution to a Roth IRA, and which are made either: • after the individual reaches age 59 ½, • after the death of the individual, • because of the disability of the individual, or • for payment of first-time homebuyer expenses. If a qualified distribution, distributions are tax-free. If a non-qualified distribution, contributions are considered to be withdrawn first and are not taxable. Earnings within a qualified distribution are not taxable. Allowed through IRA rollover and transfer rules. No legislated requirement to begin distributions. Product used to hold Roth IRA funds may require distributions by a specific date, however. Since no requirement for distribution, annuitization options would be those provided by the product used to hold the Roth IRA funds.
unless the withdrawal is: • due to disability, • due to death, • an immediate annuity, • part of a series of substantially equal payments which are made over the life expectancy of the contract holder of the joint life expectancy of the contract holder and beneficiary.
Due when earnings are withdrawn. Assessed on earnings only.
Allowed through 1035 exchange rules. By contractual annuity start date.
Based on contract terms.
Taxation rules described in general terms only for comparison purposes.
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Exhibit 14.3: Comparison of a Non-Qualified Variable Annuity to Qualified Retirement Plans Retirement Investment Vehicle
Variable Annuity
SEP
SIMPLE
SelfEmployed Qualified Plans
401k
Eligibility
Contributions
Distributions
Any person able to enter into a contractual obligation.
No regulated limit. Maximum contributions limited by contract terms.
Based on contract terms, generally age 85 - 90.
Self-employed and small businesses
The smaller of $50,000 or 25% of eligible compensation.
Must begin at age 70 ½, prior to 59 ½, additional tax applies
Small businesses with no more than 100 employees who earned $5000 or more in compensation
Salary reduction contributions up to a maximum of $11,500 for 2012
Must begin the year following age 70 ½, prior to 59 ½, additional tax applies
Self-employed sole proprietor or partner
Generally, the smaller of $50,000 or 25% of compensation
Must begin the year following age 70 ½, or retirement, prior to 59 ½, additional tax applies
Partnerships, corporations
Generally, total contributions may be the sma50,000 or 25% of compensation; employee may defer up to $17,000 2012.
Must begin the later of the year following age 70 ½ or retirement, prior to 59 ½, additional tax applies
Salary Reduction
TaxDeferred
Vesting Available
No
Yes
No
No
Yes
No
Yes
Yes
No
No
Yes
Yes
Yes
Yes
Yes
Taxation rules described in general terms only for comparison purposes.
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SEP Plans Simplified Employee Pension plans (SEPs) are retirement plans that allow employer contributions to employee accounts. SEPs are a form of IRA, so most of the rules applying to IRAs also apply to SEPs. A selfemployed person in any of the markets, including the retiree, can take advantage of a SEP. Eligibility SEPs are available for the self-employed and small businesses. A self-employed person is one who has an unincorporated business, is a sole proprietor or a partner in a partnership. A self-employed person who is also employed may contribute to a SEP. For example, Ms. Anderson, a member of the working middle years market, is a computer programmer employed by a large software company. She also works as a consultant in her own business. She may contribute to a SEP based on her net earnings from her consulting business. A small business may be a sole proprietorship, partnership or a corporation. Employees of the business are eligible for a SEP plan if they are at least 21 years of age, have worked for the business for at least three of the preceding five years and have made at least $550 (a figure subject to indexing for inflation) during the current year. Tax-Deferral SEP contributions grow tax-deferred. And since SEP contributions can be much greater than IRA contributions, the impact of tax deferral on accumulations within the SEP can be much more significant than in a contributory IRA. Tax Deductibility The deductible contributions maximum for a SEP is 25% of compensation up to $250,000, up to a maximum of $50,000. This $250,000 figure is subject to adjustment for inflation. The employer must
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contribute the same percentage for all eligible employees. This percentage also applies to the owner. Compensation includes wages, tips, salaries, commissions, fees and bonuses. For the self-employed person, compensation is equal to earned income from the business. Contributions do not have to be made each year, nor does the same percentage have to be contributed each year contributions are made. For example, in year one an employer contributes 3% of compensation to a SEP-IRA for each eligible employee. In year two, the business does extremely well, so the employer contributes 10% of compensation per employee. In year three, profits are still way up, but the employer decides to purchase a new building to accommodate the growth in the business, so contributes 3% again for each employee. Contributions are not considered compensation for the employee and are not taxable until withdrawn. Employer contributions are deductible by the employer. Investment Options A SEP allows the same investment options as an IRA, including the exclusion of life insurance and most collectibles. SEP funds may be moved to another SEP plan, or to an IRA, via rollover or transfer rules. To implement a SEP plan, the employer sets up SEP-IRA accounts for each employee. The employee owns the SEP account just as he or she would an IRA account. Since the accounts are IRAs, the employee may make IRA contributions to the SEP accounts, and roll, transfer or withdraw funds as they could an IRA. Deductibility Limits IRA contributions made by an employee to a SEP are subject to the contribution limits and deductibility limits of any other IRA. A SEP is considered a qualified plan for the purpose of determining active participation status. In other words, if an individual is an eligible employee in a SEP plan, he or she is considered an active participant and is subject to IRA deductibility limits.
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Distributions SEPs are subject to the same distribution rules as those discussed in the Exhibits for IRAs. Distributions after age 59 ½ are not subject to the premature distribution tax, and required minimum distributions must begin by April 1 of the year following the year the SEP owner turns 70 ½. Advantages The advantages of SEPs include: Ease of administration Like an IRA, a SEP plan can be opened with a minimum of paperwork. If the IRS prototype SEP plan is used, the employer completes an IRS form 5305 on each employee and maintains a copy. The product providers have trustees which will handle the minimal tax reporting issues and statement generation the SEP requires. Flexibility. Contributions may be made to many investments and do not have to be made annually. Easy to transfer and combine. SEP and plans may be rolled and transferred to and from like an IRA. Tax deductibility. Employer contributions are tax deductible. Disadvantages of SEP Plans Disadvantages in a SEP plan include the lack of the vesting options and loan provisions found in qualified plans. Fixed Annuities as SEP Vehicles A fixed annuity can be an important component of a SEP plan. An individual’s retirement portfolio can be divided between fixed, growth and liquid assets. Placing retirement money in a guaranteed product like a fixed annuity can protect a portfolio’s overall return against the risk of negative price fluctuation of growth assets. Once retirement occurs, a fixed annuity can be a great distribution vehicle. It offers both irrevocable annuitization plans, and regular distribution through systematic withdrawal.
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Variable Annuities As SEP Vehicles A variable annuity can be the one product used for the entire retirement savings cycle. The young saver can open a variable annuity, selecting primarily growth sub-accounts. As time passes, the sub-accounts may be added to or transferred from, and new sub-accounts may be selected to meet the objectives and risk tolerance of a possibly more conservative, older saver. When retirement income is desired, the variable annuity offers several liquidation options. As discussed, some variable annuities offer a fixed account, basically a fixed annuity within the variable annuity. If the variable annuity purchased offers such an account, the purchaser has the option of using it for the fixed portion of his retirement portfolio. If not, bond subaccounts can be utilized for this objective. Equity-Index Annuities As SEP Vehicles An equity-index annuity, as a vehicle with risk and return opportunities falling between the fixed and variable annuities, can be the appropriate SEP vehicle for the customer with risk tolerance that matches that of an equity-index annuity.
SIMPLE Plans Another type of IRA is the SIMPLE IRA. SIMPLE stands for “Savings Incentive Match Plan for Employees of Small Employers”. It is a retirement plan which allows both employer and employee contributions. Eligibility Employers may establish a SIMPLE plan if the employer had no more than one hundred employees who earned $5000 or more in compensation in the prior year and if the employer does not maintain another qualified plan during the year. Employees who are “reasonably expected” to earn at least $5000 in compensation in a tax year and who received at least $5000 in compensation from the employer in any two preceding years may elect to make salary reduction contributions to a SIMPLE plan.
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Tax-Deductibility Employer contributions to a SIMPLE plan are deductible to the employer in the tax year for which they were contributed. Employee contributions are salary reduction contributions, meaning the contributions are pre-tax dollars. By making contributions, the employee reduces his or her taxable compensation by the amount contributed. Contributions The employee may elect to make salary reduction contributions to a SIMPLE plan up to a maximum “applicable dollar amount.” The applicable dollar amount is equal to the amounts in the following table, according to EGTRRA: $7000 for 2002 $8000 for 2003 $9000 for 2004 $10,000 for 2005 and thereafter After 2005, the applicable dollar amount is adjusted for inflation in $500 increments. It is $11,500 for 2012. Individuals 50 and over may make “catch up” elective deferrals to a SIMPLE plan. The additional amount that such individuals may defer is the lesser of the “applicable dollar amount,” as shown in the table below, or the excess, if any, of (a) the participant’s compensation for the year, over (b) any of the participant’s other elective deferrals for the year. For tax years beginning in: 2002 2003 2004 2005 2006 and thereafter
The applicable dollar amount is: $ 500 $1000 $1500 $2000 $2500
The applicable dollar amount remains at $2500 in 2012. The employer generally must make a matching contribution equal to the amount deferred by the employee, but not exceeding 3% of the employee’s compensation. Compensation is deferred as wages, tips and other compensation from the employer subject to federal income tax. It includes salary reduction contributions.
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The employer may contribute less than 3%, but not less than 1%, of the employee’s compensation, but the lower contribution percentage may not be made more than two calendar years of a five-year period. If the employer elects to make this lower contribution amount, the employer must notify the employees in a reasonable amount of time prior to the sixty-day period prior to January 1 of the plan year. The employee can make or modify a salary reduction election during this period. The employer has the option of making a nonelective contribution rather than a matching contribution. If so, the nonelective contribution must be equal to 2% of compensation for each eligible employee who has at least $5,000 in compensation. The maximum compensation amount for the purposes of this calculation is $250,000, a figure subject to adjustment for inflation. Investment Options SIMPLE plans, as IRAs, allow the same investment options as an IRA. Like SEPs, the employer sets up a SIMPLE account for each participant. The employee is 100% vested, or has ownership of, all contributions made to a SIMPLE plan. Distributions If a withdrawal is made from a SIMPLE plan in the first two years in which the employee participates and the withdrawal does not qualify as an exception to the premature distribution tax, the tax is increased from 10% to 25%. The other distribution and premature distribution rules which apply to IRAs apply to SIMPLE plans. Advantages of SIMPLE IRA plans Ease of establishment. A SIMPLE plan, if the IRS prototype is used, is as easy to establish as a SEP. Easy to transfer and combine. SIMPLE plans may be added to and withdrawn from through IRA rollover and transfer rules. Tax deductibility. Employer contributions are tax deductible, and salary deferred contributions reduce taxable income for the employee.
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Annuities as SIMPLE Plan Vehicles The decision to use annuities within a SIMPLE plan include the same issues as those discussed in relation to SEPs. Qualified Plans for the Self-Employed Another retirement plan available to the self-employed is the SelfEmployed Retirement Plan. Self-Employed Retirement Plans may be opened by the self-employed sole proprietor or partner in a partnership. Congressmen Eugene Keogh, sponsored original legislation allowing self-employed qualified plans in 1962, and the plans allowed under his legislation as enacted were referred to as “Keogh” plans. Since the first Keogh plans, most of the special rules which made qualified plans for the self-employed distinctly unique from other qualified plans have been eliminated. Now, it is more common to refer to retirement plans for the self-employed by the type of plan, rather than as Keogh plans. Contributions Generally, money purchase or profit sharing plans are used for selfemployed retirement plans. Contributions are limited to the smaller of 25% of eligible compensation or $50,000. Eligible compensation for determining deductible contributions to these plans, like a SEP, is $250,000, which may be indexed for inflation. . Individuals 50 and over may make “catch up” elective deferrals to these plans. The additional amount which such individuals may defer is the lesser of the “applicable dollar amount,” as shown in the table below, or the excess, if any, of (a) the participant’s compensation for the year, over (b) any of the participant’s other elective deferrals for the year. The amount of catch up deferrals which may be made under EGTRRA are as follows: For tax years beginning in: 2002 2003 2004 2005 2006 and thereafter
The applicable dollar amount is: $1000 $2000 $3000 $4000 $5000
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The applicable dollar amount in 2012 is $5,500. Eligibility The minimum requirements for employee eligibility in these selfemployed retirement plans are that full time employees at least 21 years of age who have either one year of service with the employer are eligible, or eligible employees are those who have two years of service if 100% vesting in the plan is provided after two years. . Vesting Vesting refers to the incidence of ownership in the employee’s account allocation. For example, a three-year vesting schedule might provide a one year employee with a thirty percent ownership in his or her account allocation, a two year employee with a seventy-five percent ownership and a three year employee with one hundred percent ownership. If this employee separated from service after one year, he or she would be entitled to thirty percent of the value of his or her plan account, after two years to seventy-five percent, and after three years to one hundred percent. Self-employed retirement plans allow the use of participant vesting. . Investment Options Self-employed retirement plans may be funded with a wide variety of investments, including life insurance, annuities, mutual funds, bank accounts, guaranteed investment contracts (GICs), and stock. The amount of life insurance in a qualified plan is subject to regulations which require that the benefits in a qualified plan must be “incidental” to the plan. In other words, a qualified plan’s basic function is to provide retirement benefits, not life insurance death benefits. Tax Deductibility Self-employed retirement plan contributions are tax deductible to the employer. Employees may make voluntary contributions of up to ten percent of earned income. The total of the employer and voluntary employee contributions cannot exceed the overall contribution limit for the employee. Voluntary employee contributions are after tax contributions.
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Distributions Distributions from a self-employed retirement plan must generally begin by April 1 of the year following the year the participant reaches 70 ½ or retirement age, whichever is later. (Participants of qualified plans who are 5-percent owners must begin distributions at this time. Selfemployed participants generally are 5-percent owners, as defined by the tax code.) Distributions made prior to 59 ½ are subject to the ten percent distribution tax. The exceptions to the premature distribution tax differ for a qualified plan for the self-employed from those for the IRA, SIMPLE and SEP plans. The exceptions are: a) death of the participant. b) disability. Disability is strictly defined by the IRS. Generally, a physician must determine that an IRA holder has a condition that will last for a contiguous period of at least twelve months under which he or she cannot do any substantial gainful activity because of his or her physical or mental condition. c) early retirement in accordance with a plan’s early retirement provisions, after age 55. d) Payments which are part of a series of substantially equal payments which are made over the employee’s lifetime. These payments may also be made over the employee and a designated beneficiary’s lifetime. At least one payment must be made annually. The payments may not be modified until the employee reaches age 59 ½, or at least five years from the first payment. whichever is greater. If the payments are modified prior to this time period, the entire amount distributed will become subject to the additional 10% tax, unless the modification in payments was due to disability or death of the employee. e) made to an employee for medical care, to the extent they are deductible under the internal revenue code. f) distributions made as a direct rollover or rollover to an IRA or another qualified plan. The retirement plan will dictate when distributions may be made from the plan. Typically, distributions may not be made prior to the retirement age in the plan unless the employee has separated from service. Therefore, the selection of investments used in the plan are very important. Unlike an IRA or a SEP where the funds belong to the employee and may be rolled and transferred at any time, the funds in a qualified retirement plan for the self-employed must remain in the plan while the plan is active and the participant is employed, as stated above.
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More and more employers are providing their employees with a wide selection of allowable investments within the plan so different and changing objectives of participants can be met. Advantages Self-employed retirement plan advantages include: Tax deductibility. Employer contributions are tax deductible. Vesting. Vesting schedules have the advantage of providing incentive for employees to stay with a company during the vesting period. If an employee leaves during the vesting period, the amount in the employees plan account is reallocated among the remaining employee accounts. The reallocated amount may be used to reduce future employer contributions. Vesting can be an attractive advantage for a plan. Investment Options. Self-employed qualified retirement plans allow a wide variety of investment options. High Contribution Limits. Self-employed qualified retirement plans allow contributions of up to 25% of compensation, up to a maximum of $50,000. Disadvantages Disadvantages of a self-employed retirement plan include: More complicated paperwork than a SEP or a SIMPLE plan. The requirement of some government reporting regarding the plan. Depending on the complexity of the plan and the type of qualified plan used, administrative fees are charged which are significantly higher than those for a SEP or IRA plan. Administrative fees may be $50 - $75 annually for a retirement plan for a self-employed individual with no employees, and generally increase in amount based on the number of employees and complexity of the plan.
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Life Insurance in a Self-Employed Retirement Plan Life insurance can be used in self-employed retirement plans. However, the premiums paid for the self-employed owner are not deductible. Annuities, whether fixed, equity-indexed or variable, may be used for self-employed retirement plan accumulations, and are not subject to the special rules that apply to life insurance purchased on a partner or proprietor. Summary of Using an Annuity Within a Qualified Plan The features, return opportunities, and risks of any annuity product must be considered when determining whether to use an annuity within a qualified plan. Variable annuity sub-accounts may have the greatest risks, along with the greatest opportunity for return, among annuity products used in qualified plans. Fixed annuities have the lowest amount of risk, along with the lowest potential for return. Equity-index annuities have risks and returns that generally fall between these two products. If a customer is younger, or is not risk-averse, the variable annuity may be the most flexible product for a qualified retirement vehicle. As mentioned earlier, because sub-accounts may be transferred to and from, the customer can move funds to reflect the objectives as he or she moves from wanting relatively aggressive growth to more conservative products as retirement draws nearer.
Non-Qualified Retirement Vehicles Along with qualified retirement savings vehicles, non-qualified retirement savings vehicles can be used, either as a supplement to a qualified plan, or if a person is not eligible for a qualified plan, as a stand-alone retirement plan. Annuities were created as non-qualified retirement savings vehicles. Annuity Features and Non-Qualified Retirement Vehicles Features such as annuitization options, medical waivers, rate guarantees, bail out rates, stepped up death benefits, sub-account options, etc., apply whether the annuity is purchased as an IRA or qualified annuity or as a non-qualified. However, tax regulations surrounding a non-qualified annuity are different than those of a qualified or individual retirement annuity. Chapters Five and Eleven discussed the taxation of non-
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qualified annuities. This chapter has briefly looked at the taxation issues of qualified and IRA annuities. Premature Distributions The 10% premature distribution tax for distributions taken prior to 59 ½ applies to both non-qualified and qualified annuities. However, the 10% tax is levied on pre-tax contributions and accumulations as well as earnings in a qualified or individual retirement annuity. In a non-qualified annuity, contributions will always be after-tax, so the 10% tax on premature distributions is assessed on earnings only. Distributions Distributions from a non-qualified annuity do not have to be made at age 70 ½, as distributions from traditional IRA or qualified annuities must be. Instead, the distribution start date, normally called the annuity start date or maturity date, is dictated by the non-qualified annuity contract. In some states, distributions from non-qualified annuities are required to start by a certain age or within a certain time frame. Other states allow a non-qualified annuity to remain in the deferred state until the death of the annuity owner or annuitant. Taxation at Withdrawal Non-qualified deferred annuities are tax-deferred products, just like qualified plans and IRAs. No part of the contributions are tax deductible however, nor may they be made as salary deferral contributions. Income tax is paid on earnings as they are withdrawn from non-qualified annuities. Currently, withdrawals from annuities are taxed as though the earnings are distributed first. Withdrawals from qualified plans and regular IRAs are also taxable as withdrawn, and pre-tax contributions are taxable. In the case of an IRA with non-deductible contributions, the ratio of non-deductible contributions to the total value of the IRA is applied to each distribution to determine the non-taxable portion. Roth IRA distributions are not taxed, as long as the distribution is a “qualified distribution.” 1035 Exchanges Non-qualified annuities may be transferred to another annuity tax free through IRS section 1035 rules. The 1035 rules state that the annuity moneys must be transferred directly to the new annuity company to
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retain tax deferral status. If the annuity were distributed to the annuity owner, the distribution would be taxable. Qualified annuities avoid taxation if transferred via qualified plan and IRA transfer and rollover rules. Both non-qualified annuities and qualified annuities can avoid current tax ramifications if transferred according to the appropriate regulations. However, product penalties are not waived through these regulations. If an annuity is still within the surrender period when transferred, the insurance company will apply surrender charges when the annuity is liquidated and transferred to a new product. In addition, the new annuity contract will invoke a new surrender schedule and begin a new surrender period. The loss due to surrender penalties should be calculated to determine whether any transfer to a new annuity product is in the best interest of the customer. Using an Annuity to Supplement Qualified Retirement Plans Unlike qualified plans, which have limits on the annual contribution amount, a non-qualified annuity has no regulated contribution limit. An annuity can be an excellent place to place funds for tax-deferral once the maximum amount has been placed in an IRA or a qualified plan. Qualified plans should normally be maximized first, since the funds placed in them are before-tax dollars.
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CHAPTER FIFTEEN: HOW AN ANNUITY MEETS GIFTING TO MINOR NEEDS Gifting To Minors Purchasing an annuity as a gift to a minor may seem attractive. Under today's kiddie tax rules, a parent must pay income tax on a child's unearned income over $1900 (2012) if the child is under 18, and college students under the age of 24. An annuity would not generate unearned income during the deferral phase, and therefore would reduce the parent's tax burden. However, unless the minor will be holding the annuity until age 59 ½, the ten percent premature distribution tax will erode the ultimate return on the annuity for the minor. Before looking at an example of the impact of the distribution tax, it is important to note that a minor cannot own an annuity because a minor cannot enter into a contractual obligation. Therefore, the use of a trust for the benefit of the minor, or the use of the Uniform Transfers or Uniform Gift to Minors Act in setting up a Custodian for Minor account is necessary. Since a wide variety of trusts with differing provisions might be set up for a minor, we will focus on using the UTMA or UGMA provisions for gifting to the minor for explanatory purposes. Uniform Gift To Minors Act Generally, the UGMA, as adopted by the various states, allows the gifting of certain types of property, such as securities, money, life insurance and annuity contracts to a minor by means of a custodianship. The property is registered in the name of the custodian for the minor, or delivered to the custodian, depending upon the type of property involved. Uniform Transfer to Minors Act In 1983, the National Conference of Commissioners on Uniform State Laws approved the UTMA, which significantly broadened the type of
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property which could be transferred through a custodial gift. UTMA allows any kind of property, real or personal, tangible or intangible, to be transferred to the minor. Currently, about two-thirds of the states have adopted UTMA provisions. Whether UGMA or UTMA is the basis for a state's provisions, applicable state law should always be checked prior to gifting to ensure property is being transferred appropriately. Not only do the states' provisions vary regarding what property may or may not be transferred, but also at what age the property may be distributed to the minor. The Custodian An individual making the gift is the donor and the recipient is the donee. In a UGMA or UTMA situation, there is also a custodian involved. Generally, the custodian may be the donor, an adult other than the donor, a trust company or a bank with trust powers. Some states require that the custodian must be an adult member of the minor's family, or the minor's guardian. The custodian does not have fiduciary responsibilities such as filing income tax returns, nor are there legal documents such as a trust or court document required naming the custodian, other than the forms completed for the registering of the property. The ease of gifting through the use of the UTMA or UGMA is one of the reasons for their popularity. There may not be more than one custodian. However, the custodian may name a successor custodian to act as custodian upon his or her death. Under UGMA, if the custodian has not picked a successor custodian, the minor's guardian will be appointed. In the situation where there is no guardian and the minor is 14 years of age or older, the minor may pick the successor. If the minor is under 14, the court will select the successor custodian. UTMA states that if no successor custodian was named and the minor is at least 14, the minor may select the custodian. If the minor is under the
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age of 14, the minor's guardian will be appointed as custodian, and if there is no guardian, the court will appoint the successor. Again, state laws vary regarding the appointing of successor custodians and who or who may not be named. Disadvantages of UGMA and UTMA Gifting through an UGMA or UTMA has one potentially grievous disadvantage: once the minor becomes owner of the property, at age 18 in the case of UGMA, possibly later through UTMA transfers, he or she can do whatever he or she wishes with the gifted property. Neither the custodian nor donor can dictate the use of the property at this point. In order to exert control over the use of money transferred to another, a trust must be used. Trusts are discussed in Section V of this manual. Gifts can, of course, be made without the use of a custodianship, trust or any other vehicle. A parent or grandparent can save money in his or her own name and give it to the child to pay for college expenses, or pay the college directly. Detailed gifting rules are also in Section V. Under a custodian account, the social security number of the minor is used to report taxes. And, once the minor reaches the age in which the property transfers to his or her ownership, the custodial relationship is dropped, and the minor (now an adult for contractual purposes) may transact on the annuity directly. A contract structured as a custodian for minor account is set up as follows: Owner: John Smith, as Custodian for Andrew Smith, under the [state name] UTMA or UGMA. Annuitant: Andrew Smith Beneficiary: Estate of Andrew Smith Assume Andrew Smith is six years old when a $10,000 annuity is gifted to him. At age 18, Andrew will use the money for college. Assume the variable annuity returns a steady 10% over this period of time. At Andy's age 18, the contract is valued at $31,384. $21,384 is interest. If Andy withdraws the entire annuity in a lump sum, he would owe $2138 ($21,384 x 10%) in premature distribution tax. Paying the distribution tax
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reduces the 10% return to 9.38%. If Andrew is also in a 15% income tax bracket, he would also owe $3208 in income tax. His return, after paying both the premature distribution tax and income tax, would be reduced to 8.3%. Note: If Andrew withdrew his funds over his four college years he would still have to pay taxes on the interest first so the reduction in return would still be significant. A few companies offer annuitization for a period as short as three or four years, but his return would be reduced by almost as much by taxation by annuitizing over such a short period. Compare putting this same gifted money into a taxable 10% account. Because kiddie tax rules allow a standard deduction from unearned income of at least $950, and the remaining amount is taxed at the child's tax bracket (10%), this size gift will not generate much income tax over the years. The total tax owing would be at most about $797 over the twelveyear period. Therefore, the value of the account after taxes, assuming taxes were paid out of account values, would be $30,587, and the after tax return would be 9.76%. In this case, using an annuity to gift to a minor through an UTMA or UGMA does not result in increased tax benefits, and the return over the 12-year period in a taxable account is higher than that found in our fictional annuity product. An alternative could be that a parent or grandparent open an annuity under his or her own name and social security number, and gift money they withdraw from the annuity to the college student. If the donor is over 59 ½ at the time of the distribution, the 10% premature distribution tax would be avoided. Based on the example above, if grandparents gift the proceeds of the annuity to Andrew when he enters college, and the grandparents are in a 15% tax bracket at the time of distribution, the total federal tax would be approximately $3208, bringing the return to about 9.04% over the 12 year period. However, if the grandparents were in a 25% tax bracket at the time of distribution, the total federal tax would be about $5400, bringing the return to about 8.30% over the 12-year period. The effect of income tax on gifting an annuity or proceeds of an annuity should be weighed against the issues of rate of return on alternative products, the length of time the annuity will be held, the size of the annuity, and the risk tolerance of the customer. In addition, depending upon the timing and size of the gift, gift tax issues may also need to be considered.
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CHAPTER SIXTEEN: HOW AN ANNUITY MEETS HOME SAVINGS NEEDS Saving For A Home Purchase Saving for a first home is an exciting goal. Visions of a white picket fence, climbing roses, and a rocker on the front porch can be sweet motivation to an aspiring homeowner. However, many first-time homebuyers find their dreams are rudely broken by the reality of the costs of buying a home. The cost of homes, along with the costs of financing, are often greater than the unknowing anticipate. Planning wisely for the purchase of a home is not only a means to obtain the dream home itself, but can also aid the purchaser in making the best financing deal, saving mortgage costs over the life of the mortgage. If a large down payment amount is available, the purchaser has more bargaining power with a mortgage holder than if a minimal amount is held. The purchaser with twenty percent down can qualify, assuming good credit and sufficient income, for a lower rate and shorter term loan than can the purchaser with a five or ten percent down payment. To set a savings goal for a home purchase, the first step is to understand how a mortgage company determines the mortgage amount a purchaser can afford. Generally, if a down payment of ten percent is made, the maximum monthly housing expense a mortgage company will approve for a conventional loan equates to twenty-eight percent of gross income. (A conventional mortgage loan is one not offered through special government programs or not offered with above-market interest rates or other special conditions.) Total debt payments, including car loans, credit cards, other installment debt and housing expenses, generally cannot exceed thirty-six percent of gross monthly income. Mortgage lenders will often provide general qualification quotes over the phone if provided with income and expense information by a potential purchaser. Once the amount of mortgage the purchaser can currently afford is known, adjustments may be made to determine a
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future goal for anticipated growth in income and or reduction in debt between today and the home purchase goal date. For example, today an individual might be told he or she can afford a $100,000 mortgage. That individual may not be planning to buy a home for seven years. During this period, this individual’s student loan will be paid off, and he anticipates his income will increase by at least three percent annually. Using the guidelines of 28% of gross income and 36% of total debt, he calculates that the mortgage he should be able to afford in seven years is $125,000. He will use this more aggressive number as a basis for his savings goal, deciding it is better to try to save more than he will need than too little. Once the amount of mortgage is determined, a goal of ten to twenty percent of the mortgage, plus two to four percent more for closing costs, can be established. The down payment, plus the mortgage, will equal the approximate purchase price of the house to be purchased. Below is a table of home savings goals, and the annual amount needed to save, assuming different savings periods and annual returns. Savings Goal
6% Annual Return
Annual Savings Required 8% Annual 10% Annual Return Return
12 % Annual Return
5 Yr.
10 Yr.
5 Yr.
10 Yr.
5 Yr.
10 Yr.
5 Yr.
10 Yr.
$5000
$887
$379
$852
$345
$819
$314
$787
$285
$10,000
$1774
$759
$1705
$690
$1638
$627
$1574
$570
$15,000
$2661
$1138
$2557
$1035
$2457
$941
$2361
$855
$20000
$3548
$1517
$3409
$1381
$3276
$1255
$3148
$1140
$25,000
$4435
$1897
$4261
$1726
$4095
$1569
$3935
$1425
As with all savings goals, the earlier the savings begin, the better.
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Important Features of Home Savings Products Allow For Additions Those saving for a home need products that allow for additions. Products allowing monthly additions and those with automatic bank draft features are useful in meeting home savings goals. Availability of Funds When Goal Is Reached A home savings goal is typically one with a time frame of ten years or less. A product selected as a savings vehicle for this goal must allow sufficient liquidity so that the down payment may be accessed without penalty. Products with surrender charges or tax penalties for withdrawal at the time moneys will be needed should be avoided. Risk Appropriateness The length of the savings goal must be considered along with the individual’s risk tolerance in determining the appropriate product. Use of IRAs For A First-Time Home Purchase Beginning in 1998, two new methods of funding a first-time home purchase became available. One method is the use of a traditional IRA. Beginning in 1998, distributions for certain first-time homebuyer expenses may be made without the application of the 10% premature distribution tax. The other method is through the Roth IRA. A qualified first-time homebuyer distribution” is considered a qualified distribution under Roth IRA rules. Qualified distributions from Roth-IRAs are free of income taxation. Annuity Products As Savings Tools For Home Purchase Annuities are not likely to be the product of choice for saving for a home. The penalty for withdrawal prior to age 59 ½ makes it unsuitable for this use by the young saver and family markets. However, if an annuity is used to hold regular IRA or Roth IRA funds, the penalty for withdrawal prior to age 59 ½ rules applying to annuities do not apply. Rather, IRA rules apply to IRAs, regardless of the product used to hold the IRA accumulations. A fixed annuity could be suitably used as a regular or Roth IRA, if the investor is conservative, concerned with return fluctuations, and
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attracted to guaranteed rates. A variable annuity, with its many subaccount options may be suitable for a more aggressive saver. The equityindex annuity may be the right fit for a saver who is more conservative than the variable annuity purchaser. Fixed, equity-index and variable annuities can allow for additions, an important feature of home savings programs. The key issue in determining the suitability of an annuity product as a home savings product is whether the funds will be available at the time needed for the home purchase, without penalty. The surrender period or vesting period, and any withdrawal charges of the annuity product, along with potential returns and the risk tolerance of the purchaser, must all be considered carefully to determine if an IRA annuity or a non-qualified annuity would be the right home savings vehicle.
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CHAPTER SEVENTEEN: HOW AN ANNUITY MEETS COLLEGE SAVINGS NEEDS Accumulating Assets For A College Education A college education is now a requirement for many jobs, and if this trend continues, will be a requirement for even more jobs in the future. This is one reason so many parents and grandparents are concerned with putting away money for their children or grandchildren’s college education. Another compelling reason is the earnings gap cited by the US Census Bureau between those who have a college degree and those who have only a high school diploma. The Census Bureau data states that in 2000, people aged 25 and over with a college degree have a median income over sixty-four percent higher than those with a high school diploma and no college education. Cost of A College Education College expenses are increasing faster than the inflation rate. They are expected to increase at a pace of about seven percent annually. Both public and private school tuition are experiencing this staggering growth. Currently, a public, four-year, in-state college or university education costs about $8000 a year, including tuition, fees, room and board. Private universities have costs of about $18,000, with elite school expenses as high as $25,000 annually. Using a figure of $10,000 annually, and a rate of increase of 7% annually, the table following shows the potential cost of a four year degree over the next twenty years. These figures point out the importance of beginning a college savings program now so that savings have an opportunity to accumulate for this goal.
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Potential Increase in Annual College Expenses Today End of Year 1 End of Year 2 End of Year 3 End of Year 4 End of Year 5 End of Year 6 End of Year 7 End of Year 8 End of Year 9 End of Year 10 End of Year 11 End of Year 12 End of Year 13 End of Year 14 End of Year 15 End of Year 16 End of Year 17 End of Year 18 End of Year 19 End of Year 20
$10,000 $10,700 $11,449 $12,250 $13,108 $14,026 $15,007 $16,058 $17,182 $18,385 $19,672 $21,049 $22,522 $24,098 $25,785 $27,590 $29,522 $31,588 $33,799 $36,165 $38,697
College Funding Product Features The following features are important in selecting a college-funding vehicle. Allow For Additions Unless a lump sum product will be used, a product selected for college savings must allow additions. College funding is often a savings goal lasting for several years. Many savers contribute to college funds on a monthly basis. Liquidity The product must have available funds at the time college expenses are incurred. Risk Appropriateness The product must match the risk tolerance of the purchase, taking into consideration the time frame of the investment. Generally, the closer the
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time of college approaches, the more conservative, stable principal products should be used. If college is still five or more years away, products with an opportunity for growth are appropriate. Gifting As A College Funding Method Parents, grandparents or other interested parties may gift money to a college student for use in paying college expenses. One common method of gifting to a young person is through UGMA or UTMA rules, as was discussed earlier in this course. The Coverdell Education Savings Account The Coverdell Education Savings Account (ESA) is a tax-favored education program now available for college savings, created in the Taxpayer Relief Act of 1997. It is a trust created for the purpose of paying trust beneficiaries’ education expenses. Beginning after 2001, this plan allows $2000 per beneficiary to be placed in the Coverdell ESA annually. The beneficiary receives the proceeds from the Coverdell ESA without income taxation as long as the proceeds are used to pay higher education expenses in the manner required by the Act. Advantages of the Coverdell ESA Tax-Free Withdrawals Coverdell ESAs eliminate the tax-bite from college savings. If $2000 is placed into an Coverdell ESA for 18 years, and the IRA earns 10%, the beneficiary will save over $9600 in income taxes, assuming a 15% tax rate, when compared to a taxable savings account. Availability The Coverdell ESA does not require that the contributor earn compensation, as the regular and Roth IRAs do. Although contributions are subject to eligibility limits based on adjusted gross income, they are available to a large segment of the population.
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Ability to Make Rollovers Rollovers may be made from an Coverdell ESA to another Coverdell ESA. Under certain conditions, they may even be rolled over to a different beneficiary’s Coverdell ESA. Contribution and Eligibility Rules of the Coverdell ESA Eligibility Anyone can make a contribution to an Coverdell ESA who has a adjusted gross income under certain levels. The ability to make contributions phases out for single taxpayers at a modified adjusted gross income between $95,000 and $110,000. Contributions by taxpayers filing a joint return are phased out at a modified adjusted gross income between $190,000 and $220,000. Contributions Contributions to Coverdell ESAs must be made in cash, like contributions to other IRA products. They are limited to a maximum of $2000 per beneficiary, and must not be made to the trust for the benefit of a beneficiary who has reached age 18, unless the beneficiary has special needs. Qualified State Tuition Programs Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001, if a contribution was made to a “qualified state tuition program” during a tax year for a beneficiary, no contribution could be made to an Coverdell ESA during that same tax year for that beneficiary. However, after 2001, this prohibition no longer applies. Contributions may be made to both Coverdell ESAs and Qualified State Tuition Programs in the same tax year. A qualified state tuition program provides a vehicle to accumulate college funds tax-free. It is a program established and maintained by a state, or an agency or instrumentality of a state, which allows a person to purchase tuition credits or certificates for a designated beneficiary, or to make cash contributions to an account used to pay the qualified higher education of a beneficiary. In order to be considered a qualified state tuition program, several conditions must be met. For example, penalties for withdrawal of earnings that are not for qualified higher education
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expenses, or are not due to the death or disability of the beneficiary, or are not made because of the receipt of certain scholarship money, must be part of the state tuition program rules. Qualified state tuition program distributions are generally received tax free if they are used for higher education expenses. Coverdell ESA Investments Coverdell ESA moneys may not be placed in life insurance. However, annuities or variable annuities may be used as Coverdell ESAs. Excess Contributions to Coverdell ESAs A six percent excise tax is applied to excess contributions to Coverdell ESAs. An excess contribution is one which exceeds the maximum Coverdell ESA contribution limit or which is made during the same tax year a contribution is made to a qualified state tuition program. If the excess contribution is returned prior to the contributor’s tax due date, it will not be charged the excise tax. Distributions From Coverdell ESAs Tax-free distributions must generally be for the payment of “qualified education expenses.” Qualified education expenses include qualified elementary and secondary education expenses and qualified higher education expenses. Qualified higher education expenses are defined in IRC section 529 (e)(3): (3) Qualified higher education expenses. (A) In general. The term “qualified higher education expenses” means-(i) tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution; and (ii)
expenses for special needs services in the case of a special needs beneficiary which are incurred in connection with such enrollment or attendance.
(B) Room and board included for students under guaranteed plans who are at least half-time….
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Qualified elementary and secondary education expenses are defined in Code Section 530(b)(4): In general. The term “qualified elementary and secondary education expenses’ means— (i) expenses for tuition, fees, academic tutoring, special needs services in the case of a special needs beneficiary, books, supplies, and other equipment which are incurred in connection with the enrollment or attendance of the designated beneficiary of the trust as an elementary or secondary school student at a public, private, or religious school. (ii) expenses for room and board, uniforms, transportation, and supplementary items and services (including extended day programs) which are required or provided by a public, private, or religious school in connection with such enrollment or attendance, and (iii) expenses for the purchase of any computer technology or equipment (as defined in section 170(e)(6)(F)(i) or Internet access and related services, if such technology equipment, or services are to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in school. Clause (iii) shall not include expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature. If the distribution exceeds qualified higher education expenses in a tax year, the earnings portion of the distribution is taxed. The taxable portion is determined using the following formula: (amount used for higher expenses / amount distributed ) x earnings in the distribution
For example, assume Brad Holmes, Jr. has qualified education expenses of $8000. A distribution of $10,000 is made from his Coverdell ESA. The earnings portion of the distribution is $2000. Calculating the taxable portion of this distribution is done as follows: 1. Determine the ratio of the qualified higher education expenses to the distribution: $8000 / $10,000 = .80 2. Multiply the result by the earnings portion of the distribution: $2000 x .80= $1600 non-taxable distribution, $400 is taxable
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HOPE and Life-Time Learning Credits Prior to the passing of the Economic Growth and Tax Relief Reconciliation Act of 2001, if a distribution was made from a Coverdell ESA for a designated beneficiary in any tax year, neither a HOPE or Lifetime Learning Credit could be taken for the expenses of that beneficiary during the same tax year. After 2001, this prohibition is amended so that a HOPE or a Lifetime Learning Credit may be taken in the same year as an exclusion from income due to a Coverdell ESA distribution. Additional Tax on Distributions A 10% tax is imposed on certain distributions from Coverdell ESAs. The tax is imposed on the portion of the distribution which is includible in income. This 10% additional distribution tax is applied to any taxable distribution which is not: •
• •
Due to the death of the designated beneficiary. To qualify under this exception, the distribution must be made to a beneficiary or the estate of the designated beneficiary. Due to the designated beneficiary’s disability, or Due to certain scholarships, education assistance allowances or payments which are excludable from gross income under other laws of the US.
Naming a New Beneficiary A new beneficiary may be named on a Coverdell ESA, as long as the new beneficiary is a member of the original designated beneficiary’s family, or the spouse of the designated beneficiary. If a beneficiary were named that did not meet these requirements, the entire value of the Coverdell ESA is treated as a distribution, and the earnings are subject to the 10% additional tax on distributions.
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Distributions Due to Death Spousal Beneficiary If a Coverdell ESA is transferred to a surviving spouse at the death of the designated beneficiary, the transfer is not taxable. The surviving spouse can be treated as the Coverdell ESA designated beneficiary. Non-Spousal Beneficiary If a non-spouse receives the distribution upon the death of a designated beneficiary, the Coverdell ESA ceases to be considered a Coverdell ESA. The fair-market value of the IRA is included in the gross income of the non-spouse beneficiary in the tax year which includes the date of the Coverdell ESA designated beneficiary’s death. Distributions Due to Divorce Distributions from a Coverdell ESA under a divorce decree or separation agreement are not taxable. Rollovers From A Coverdell ESA to A Coverdell ESA Rollovers may be made from a Coverdell ESA to a Coverdell ESA if the rollover is made to a Coverdell ESA for the same designated beneficiary, or a member of the designated beneficiary’s family, or the designated beneficiary’s spouse. Like other IRA rollovers, discussed later, the rollover must be completed within sixty days. Termination of Coverdell ESAs Generally, a Coverdell ESA terminates when the designated beneficiary reaches age 30. Any remaining balance is taxable at this time, and the earnings are subject to the additional 10% tax. There is an exception to the age 30 Rule for beneficiaries who have special needs. Coverdell ESAs for beneficiaries with special needs may continue after the beneficiary’s age 30, and will not be deemed distributed for tax purposes. Using an Annuity as a Coverdell ESA When an annuity is used as an ESA, the annuity takes on the tax rules of the ESA. Therefore, the Coverdell ESA annuity withdrawals will be taxfree if the withdrawals comply with the tax-free withdrawal rules of the
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Coverdell ESA. The age 59 ½ rules applying to regular annuities do not apply to Coverdell ESA annuities. Ownership An annuity can be owned as a Coverdell ESA. Check with the insurance company to determine the appropriate ownership structure used by that insurance company. Coverdell ESAs may be trusts or custodianships. Ability to Make Additions The ability to make additions is a feature of all flexible annuities. The Coverdell ESA contributor could make additions annually, monthly, or anytime they wish, up to the maximum contribution allowed. Guaranteed Rates The guaranteed rates available in fixed annuities, equity-index annuities or in the fixed account of a variable annuity appeal to the conservative Coverdell ESA contributor. Coverdell ESAs are a new product, but annuity issuers expect that as Coverdell ESAs accumulate funds, many will be rolled to fixed annuity Coverdell ESAs as college nears and guaranteed rates become more important to the IRA beneficiary. Liquidity Cash values can be accessed in annuities through withdrawals, full surrender or via annuitization. Some annuities however, have rolling surrender charges. Each contribution to an annuity may have a surrender charge period or vesting period applied. Therefore, it is important to plan contributions and withdrawals to avoid surrender charges when an annuity is purchased for college savings. Annuitization may be a surrender penalty free alternative to withdrawals. As mentioned earlier, annuitization may avoid surrender charges, depending on the contract. Payments can be timed to coincide with the annual payment of college tuition and fees. Premature Distribution Tax Annuities are subject to premature distribution taxes. If not used as a Coverdell ESA, the rules applicable to annuity premature distributions will apply to the college savings.
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Variable Annuity Sub-Accounts Sub-accounts do not include guaranteed returns. In some cases, a minimum return from a variable annuity is guaranteed at the death of the variable annuity owner or annuitant, but the return of any individual sub-account is not guaranteed. The absence of guarantees is offset by the opportunity for growth. Variable Annuity Sub-Account Tax-Free Transfers The ability to transfer assets without incurring tax ramifications can be an important benefit for any long-term savings goal. To illustrate this benefit as compared to taxable transfers between mutual funds, assume a savings program is begun fifteen years prior to college, and $2000 is contributed annually. Assume funds are placed in a variable annuity and in mutual funds that return exactly the same amount annually over this period. Assume two transfers are made during the fifteen-year period. The individual is in a 28% tax bracket. Further assume the taxes levied on the mutual fund transfers are paid at the end of the year from the mutual fund accumulations.
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Variable Annuity End of Year
After Tax Value
5
$15,431.22
Average Annual Return 10%
Mutual Fund After Tax Value $14,470.48
transfer to another sub-account taxes paid: $0 10
$39,900.78
transfer to another fund taxes paid: $960.74 12%
$34,921.22
transfer to another sub-account taxes paid: $0 15
$56,567.65
Average Annual Return 10%
12%
transfer to another fund taxes paid: $3286.40 7.5%
$55,598.45
contract liquidated; taxes paid: $10,331.86
7.5%
fund liquidated; taxes paid: $4152.26
Even though this individual pays taxes on all earnings at liquidation of the variable annuity at the end of fifteen years, his after-tax value is greater by $969 in the variable annuity due to the effect of tax deferral on earnings over the fifteen-year period. (This is a hypothetical illustration and may not be used with a customer.) Use of An Annuity in a Coverdell ESA Annuities may be used as a Coverdell ESA vehicle. Since Coverdell ESAs may be long-term accounts, the ability to place money in a variable annuity’s growth or aggressive growth sub-account, or placing them in an equity-index annuity, may help the college savings to grow more rapidly than in a fixed annuity. Using an Annuity As A College Funding Vehicle Annuities may be a suitable college funding tool if owned by a parent or grandparent who will be over 59 ½ at the time withdrawals will be taken for college expenses. If used as a Coverdell ESA, the surrender period should be ended prior to the beneficiary needing the funds for college. As with all purchases, the owner must be willing to accept the risks of the annuity selected.
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CHAPTER EIGHTEEN: HOW AN ANNUITY MEETS OTHER CLIENT NEEDS
Reduction of Current Tax Liability Annuities are tax deferred. Clients who are not using the interest earned on CDs, taxable mutual funds, etc., may want to purchase an annuity to reduce income tax on interest, capital gains and dividends earned but not used. If the contract and the owner’s state of residence allow, the maturity date on the contract may be extended to age 100, meaning that the owner may be able to defer taxation throughout his or her lifetime. The beneficiary will owe tax on the gain when it is constructively received.
Income Using an annuity as an income vehicle places the financial decision for buying an annuity primarily upon return because tax-deferral is reduced or lost if regular withdrawals are made. These questions must be answered: Is the return of the annuity after expenses comparable or better than other income producing vehicles within the client's risk tolerance? Does the client have sources of income other than the annuity? Would an immediate annuity, with guaranteed income, be a better choice than a systematic withdrawal program where the payments could vary? All these issues should be weighed before selecting a deferred variable annuity for income alone. The best annuitization or annuity income options are based upon the customer’s specific situation and desires. For example, if a customer wants income for life, whether a period certain and life or life refund option is ultimately selected may depend on whether or not the customer has any
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living beneficiaries. With many income options available, a good number of customer situations can be addressed.
Low Risk Tolerance - Fixed Annuities The insurance company guarantees the contractual obligations made to a fixed annuity purchaser. The financial strength of the insurance company, as well as state regulations governing the financial practices of insurance companies contribute to the fact that many customers purchase annuities because of the relative low risk of losing principal when compared to more aggressive investments. Financial Strength Insurance companies are rated by a variety of rating agencies, such as A.M. Best, Standard & Poors Insurance Rating Services, Moody’s Investor Service, and Duff & Phelps Credit Rating Company. These ratings can give the customer the ability to use a third-party (someone outside of the insurance company and its agents) to help determine if the insurance company the customer is considering as an annuity issuer is a healthy one. A.M. Best Company, Best’s Insurance Reports. Best’s Insurance Reports rate insurance companies on their ability to meet policyholder and contractual obligations. Company ratings range from a high of “A++” down to “F.” Standard & Poor’s Insurance Rating Services. Standard & Poor’s rates the insurer’s claims paying ability. They rate subscribing companies (companies which pay a fee for the rating) from “AAA” to “D.” Non-subscriber ratings are from “BBBq” to “Bq.” Moody’s Investor Service Insurance Financial Strength Ratings Moody’s assigns ratings based on the overall financial strength of an insurance company, and therefore, the company’s ability to meet obligations to its policyholders. Moody’s highest rating is “Aaa” and its lowest “C.”
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Duff & Phelps Credit Rating Company, Insurance Rating Service Duff & Phelps assigns claims paying ability ratings which reflect the likelihood that the insurance company will meet its policyholder obligations. Duff & Phelps claims paying ability ratings range from “AAA” to “CCC-.” State Regulations Each state has sets of regulations meant to protect its citizens from an insurance company defaulting on policyholder obligations. Each state mandates reserve requirements, for example. Reserves are the difference between future claims and future premium. Insurance companies also must maintain a surplus, a certain amount by which its assets exceed the value of its liabilities and capital. States also have some form of guaranty associations. Insurance companies which are part of these guaranty associations are liable for cash values, death benefits, and other contractual monetary obligations if another of its members is not able to meet them. A typical guaranty association will have a maximum limit of $300,000 per policyholder benefit, and $100,000 per annuity cash value or present value. These limits vary by state, however. The guaranty association may require all insurance companies doing business in the state to be part of the association, or only those domiciled in that state. Guaranty associations may not be used as a sales tool for the solicitation of insurance business. Annuities are guaranteed by the company issuing the contract, and also by the safety net of state regulation. Fixed and immediate annuities are generally considered to have a low level of risk, therefore, when compared to other investment alternatives.
Incapacity In order to transact on an annuity if the annuity owner, or joint owner, becomes incapacitated, a durable power-of-attorney will be needed. Many times, older customers may purchase an annuity and desire to put a child on as joint owner, in case the parent enters a nursing home, has a stroke, or is in some other way unable to handle his or her financial affairs. However, as noted in earlier chapters, jointly owned annuities require both signatures for any transactions. And, if the property used to purchase the annuity was not jointly held prior to purchase, an immediate gift of 50% of
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the property will be made to the joint owner. Therefore, it may be best for the parent to own the annuity solely, and for the child to be given powerof-attorney for the parent. The power-of-attorney will allow the child to carry out transactions for the parent if necessary. Many older customers know that the chances of entering a nursing home are statistically high. Therefore, the nursing home waiver feature is very attractive to them. The key here is to know whether the annuity waiver covers the annuitant, owner, or possibly both, so that the contract is set up properly.
Living Trusts A living trust may own an annuity. Commonly, the annuity is structured as follows: Owner: The living trust (The John Smith Family Trust, dated 6/1/93) Annuitant: John Smith Primary Beneficiary: Zelda Smith, wife of John Smith (so that she may continue the contract at John's death) Contingent Beneficiary: The John Smith Family Trust, dated 6/1/93 (in case of simultaneous death of John and Zelda). The trustees of the trust (probably John and Zelda) sign as owners of the contract, in their capacity as trustees. Another method of structuring an annuity to incorporate a living trust is to simply name the trust as beneficiary. A living trust does not result in property changing hands until the death of a grantor, therefore, some experts suggest just naming the living trust as the beneficiary on life insurance products.
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CHAPTER NINETEEN: ANNUITY ALTERNATIVES Since annuity products are often purchased for their savings component as well as for taxdeferral and annuitization, it is helpful to compare their features and characteristics to other savings vehicles. In the comparisons within this chapter, it is assumed the equityindex annuity is a non-registered product.
Certificates of Deposit A common savings vehicle, particularly among older people not familiar with products outside a bank, is a certificate of deposit or CD. Risk A bank certificate of deposit is one of the most conservative products that could be selected as a savings vehicle. The FDIC guarantees CDs up to certain limits, so the risk of losing any of the investment made is generally considered negligible if it exists at all. This can be very attractive to people in their retirement years who want to know that every cent invested will come back to them, and for whom significant opportunity for growth is secondary. CDs may earn a fixed or variable rate. Variable rate CDs have lower volatility than fixed rate CDs when general market interest rates change. The major risk that may be present in a CD investment is purchasing power risk. CDs may not keep up with the rate of inflation over time. The attraction of the low risk and stability of investment or principal is offset by the relatively low potential for growth. For the younger saver, or the more aggressive investor of any age, a CD cannot meet the desire for potential high growth.
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Uses of CDs CDs may be used as a liquid investment to meet emergency expenses, planned recreation or other short-term savings needs, or as a long-term savings vehicle. CDs may be used to generate income for the owner. Many CDs allow interest to be paid out monthly, quarterly, semi-annually or annually. This can be an important feature for the purchaser on a fixed income, who uses CD interest to meet living expenses. Maturities
maturity of the CD.
Certificates of deposit come in a wide variety of terms or maturities. CD maturities range from thirty days to ten years. The amount required to open a CD varies, from as little as $50 to as much as $10,000. Some CDs allow additions. These are often variable rate CDs that may also have a fluctuating interest rate. Or, a CD allowing additions may include the provision that the addition extends the
Tax Considerations Earnings on CDs are generally taxed as ordinary income. If a CD is jointly owned, the interest earned is considered to be owned by both persons for federal income tax purposes, unless local laws state otherwise. Fees Although banks are charging more and more fees for services, there is no fee for opening a CD. However, CDs do have a substantial penalty for early withdrawal if a CD is closed or liquidated prior to maturity. A typical withdrawal charge is three to six months interest, earned or unearned.
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Comparison of a CD to Annuity Products Feature
CD
Fixed Annuity
Variable Annuity
Equity-Index Annuity Minimum rate guaranteed by the issuing insurance company. May include minimum index benefit and death benefit guarantees. Variable
Guarantees
Guaranteed by the FDIC up to specific limits
Guaranteed by the issuing insurance company. Minimum rate and death benefit guaranteed.
Cash values not guaranteed. Minimum death benefit guaranteed by issuing insurance company.
Return
Low to moderate, may not exceed inflation rate over time.
Moderate
Variable, based on sub-account investments.
Risk
Purchasing power.
Potential for default and interest rate risks.
Dependent on subaccounts chosen, may have exposure to all investment risks.
Potential for market risk.
Taxation
Earnings taxed as ordinary income annually.
Distributions are taxable on an interestfirst basis. Cash values grow tax-deferred.
Distributions are taxable on an interest-first basis. Cash values grow tax-deferred.
Distributions are taxable on an interest-first basis. Cash values grow tax-deferred.
Charges
Penalty for early withdrawal.
Typically, back-end surrender charge.
Typically, back-end surrender charge.
Back-end surrender charge or vesting schedule apply.
Mutual Funds Mutual funds are very popular savings vehicles. There are thousands of mutual funds, so virtually every investment option is available, from relatively stable, low risk bond funds to aggressive, high growth stock funds. Diversification Mutual funds are pools of securities purchased for a specific fund objective. The securities may be stocks or bonds, or short term “cash” instruments which are highly liquid. Individuals buy shares in these pooled funds. A key advantage of mutual funds is that they are diversified. Diversification means that since many different securities make up the pool of investments, the risk of poor performance associated with any one of the securities is offset by the performance of
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other securities in the pool. This is the same advantage found in variable product sub-accounts. Types of Mutual Fund Securities Stock securities, or equities, include, among other types, common stocks, preferred stocks, foreign stocks, stocks from small capital companies representing potential high-growth, or stocks from established larger companies that can represent high dividend potential. Bonds may be government-issued or corporate-issued. Bonds backed by the federal government are considered to have the lowest risk of default, and those from corporations with potential or existing credit problems are considered as having the highest risk. The returns on both stocks and bonds generally reflect their risk level, with the securities with the highest risk generally having the highest earnings or growth potential. Tax Considerations Dividends and short-term capital gains from mutual funds are taxed as income when earned, and long-term capital gains are taxed as capital gains for federal tax purposes. Objectives The investment objective of a mutual fund can include high income from dividends, growth from the increased value of shares, total return (which is the increase in share value from both dividends and growth), stable income, or stable share value, among many, many others. Groups of funds with similar investment objectives, e.g. all aggressive growth funds, have generally accepted suggested investment time frames. A fund with conservative securities and an objective of stable share value will have a shorter suggested investment time frame than an aggressive stock fund whose shares could fluctuate greatly over time. The longer the investment time frame, the less impact any particular market upturn or downturn will have on the overall return of a mutual fund. Loads Mutual funds are either load or no load funds. A load is a sales charge used to pay commission to the distributors and sellers of the fund, e.g. a broker. Loaded funds may assess the sales charge as a front–end or back-end charge, or may distribute the sales charge over a specified period. Sales charges range from as little as one or two percent to eight
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or nine percent of the amount invested. Most sales charges are about four to four and one-half percent. In the case of a back-end charge, if shares in the fund are liquidated prior to the end of a specified period, e.g. five years, a charge is levied against the amount withdrawn. Therefore, if the shares are held until after the specified period, the sales charge is avoided. Fund Families If a mutual fund family is selected that has a wide variety of fund options, a saver could potentially remain within that mutual fund family for his or her entire life. An advantage of staying within one family of funds when a different type of fund is desired is that sales charges are generally not invoked when transferring shares within the same family. Conversely, if a fund were purchased outside of the family, a new sales charge would be incurred, unless a no-load fund was selected. However, transfers within a fund family do have tax ramifications. A transfer of mutual fund shares to another fund is considered a sale of shares by the IRS, so any income and capital gains realized by the transaction are taxable. Opening Requirements Many mutual funds allow low monthly automatic investments, such as $50, which can make them attractive to the younger, small investor who is just beginning to save for retirement. Common non-monthly opening requirements range from $1000 to $5000. Risk Besides the risks attributable to the types of securities invested in, all mutual funds contain some market risk, meaning that the value of shares in a mutual fund may go up or down. If a distribution must be made when share values are low, the owner may sustain a loss: the share value at the time of liquidation may be lower than the share value was at time of purchase. Choosing a mutual fund with the correct amount of risk with plans to remain in the fund for the suggested time frame for that fund is very important to help reduce the effects of market risk.
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Comparison of a Mutual Fund to Annuity Products Feature
Mutual Fund
Fixed Annuity
Variable Annuity
Guarantees
None
Guaranteed by the issuing insurance company. Minimum rate and death benefit guaranteed.
Cash values not guaranteed. Minimum death benefit guaranteed by issuing insurance company.
Return
Variable, based on funds selected.
Moderate
Variable, based on sub-account investments.
Risks
Dependent on funds chosen, may have exposure to all investment risks.
Potential for default and interest rate risks.
Dependent on subaccounts chosen, may have exposure to all investment risks.
Potential for market risk.
Taxation
Dividends, and short-term capital gains taxed as ordinary income annually. Longterm gains taxed as long-term gains. May have sales load.
Distributions are taxable on an interest-first basis. Cash values grow tax-deferred.
Distributions are taxable on an interest-first basis. Cash values grow tax-deferred.
Distributions are taxable on an interest-first basis. Cash values grow tax-deferred.
Typically, back-end surrender charge.
Typically, back-end surrender charge.
Back-end surrender charge or vesting schedule apply.
Charges
Equity-Index Annuity Minimum rate guaranteed by the issuing insurance company. May include minimum index benefit and death benefit guarantees. Variable
Municipal Bonds Municipal bonds are issued by municipalities and states for projects such as roads, schools and buildings. A primary advantage of municipal bonds is that the interest generated from the bonds is generally exempt from federal income tax. It is important to note that although interest income from municipal bonds is federally tax exempt, capital gains earned by municipal bond transactions are not exempt from federal taxation.
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Municipal bonds are generally issued in $5000 denominations. Interest payments are generally paid semi-annually. The return on the bond may be fixed or variable. Risk Characteristics of Municipal Bonds There are several general types of municipal bond issues. To understand the risks related to a municipal bond, it is important to know the differences in the terms of an issue. Of particular significance is the method of revenue backing the issue’s obligations. General Obligation Bonds General obligation bonds are backed by the full faith, credit and taxing authority of the issuing municipality. Therefore, revenue from any taxable source of the municipality can be used to pay any obligations of the bonds. General obligation bonds are generally considered to have the lowest default risk of municipal bonds backed by the tax authority of a municipality. Special Tax Bonds Special tax bonds are secured by a specific tax or taxes of a municipality. The default risk of a special tax bond is based on the ability of the tax to generate the revenue needed to support the bond issue. Revenue Bonds Revenue bonds are backed by the revenue produced by the project being funded. For example, a highway may be built by the issue of a revenue bond and secured by tolls to be collected once the highway is complete. The risk of default in a revenue bond varies depending upon the specific terms and revenue generating methods of the issues. Housing Authority Bonds Housing authority bonds are backed by the full faith and credit of the US government. They are issued to build low-rent housing projects. A federal agency, the Housing Assistance Administration, pledges an annual contribution to these projects. Because housing authority bonds are backed by the US government, they are considered high quality bonds with no default risk.
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Industrial Revenue Bonds Industrial revenue bonds are issued by a municipality on behalf of a corporation or business. The business will lease the facility built and the income from the lease is used to meet the issue’s payment obligations. The default risk of these bonds is dependent on the viability of the business use of the property and the ability of the business to generate sufficient payments to meet the issue’s obligations Insured Municipal Bonds Insurance can be purchased on municipal bonds by the issuer to protect bond purchasers from the risk of default. Since the risk of default is reduced, bond rating agencies will assign a higher credit rating to an insured municipal bond issue than for the same issue had it been uninsured. Since the insurance costs the issuer money, the interest rate of the bond issue will generally be lower than if the issue were uninsured. However, yields on insured issues are generally competitive with other high quality municipal bond issues. Some professionals question the necessity of insurance for municipal bonds, since only the highest quality bonds are able to obtain insurance. Besides the differing default risks of municipal bonds, they are subject to interest rate risk as well. They are sold in the secondary market through municipal bond dealers, securities brokers and commercial banks. Their price is greatly impacted by the default risk and current interest rates. Uses of Municipal Bonds Municipal bonds are used to generate tax-exempt income, often for those in retirement. If a municipal bond is issued within a state with income tax, the bond is typically double-tax exempt, meaning the interest income is exempt from both state and federal taxation. Some issues are triple tax-exempt, and interest is exempt from local, state and federal tax. Tax Considerations As mentioned, interest from municipal bonds is generally exempt from federal income tax. Income from municipal bonds is also often exempt from state taxation in the state in which they are issued. Capital gains, however, are not exempt from federal taxation.
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Private Activity Bonds There are certain types of municipal bonds whose interest is not exempt from federal income tax. Interest on private activity or private purpose bonds may not be exempt. Bonds falling into this category are used to fund industrial development or other private activity and are issued after August 7, 1986. Determination of whether a bond is or is not exempt from federal income tax depends on a number of complex factors. Special law firms render opinions regarding the taxability of a municipal bond issue. If a bond purchased by a fund is considered to be a private activity bond, the fund will provide shareholders the tax information necessary for the shareholders to properly report income from such bonds. Private activity bond interest is generally considered a tax-preferred item in the calculation of alternative minimum tax for individuals and corporations. Comparison of a Municipal Bond to Annuity Products Feature
Municipal Bond
Fixed Annuity
Variable Annuity
Guarantees
None
Guaranteed by the issuing insurance company. Minimum rate and death benefit guaranteed.
Cash values not guaranteed. Minimum death benefit guaranteed by issuing insurance company.
Return
Moderate, varies based on bond selected. Default and interest rate.
Moderate
Taxation
Dividends are exempt from federal taxation. Short-term capital gains taxed as ordinary income annually. Longterm gains taxed as long-term gains.
Distributions are taxable on an interest-first basis. Cash values grow tax-deferred.
Variable, based on sub-account investments. Dependent on subaccounts chosen, may have exposure to all investment risks. Distributions are taxable on an interest-first basis. Cash values grow tax-deferred.
Charges
Commission to broker.
Typically, back-end surrender charge.
Typically, back-end surrender charge.
Risks
Potential for default and interest rate risks.
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Equity-Index Annuity Minimum rate guaranteed by the issuing insurance company. May include minimum index benefit and death benefit guarantees. Variable
Potential for market risk.
Distributions are taxable on an interest-first basis. Cash values grow tax-deferred.
Back-end surrender charge or vesting schedule applies.
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KEY DATES AFFECTING ANNUITY TAXATION Prior to August 14, 1982 Withdrawals are comprised of investment in the contract (principal) before income. (FIFO) August 14, 1982 and after 1) Withdrawals are comprised of income prior to principal. (LIFO) 2) Withdrawals prior to 59 ½ are subject to 10% additional tax on income, excepting the distribution of income allocable to any investment made ten or more years before the distribution. January 19, 1985 and after 1) All withdrawals of income prior to 59 ½ are subject to 10% additional tax on income. 2) Owner’s death on an annuity forces distribution to beneficiary. Distribution must be within five years of the owner’s death, or as an annuity not to exceed the life expectancy of the beneficiary commencing within one year of the owner’s death. A spousal beneficiary may continue the contract. After February 28, 1986 Annuities owned by non-natural persons are not treated for tax purposes as an annuity contract. An exception to this rule is an annuity owned by a trust or other agent for the benefit of a nonnatural person. Prior to April 23, 1987 Tax on gain in gifted annuity not due until contract surrendered. April 23, 1987 and after 1) Tax on gain in gifted annuity due at time of gift. 2) Annuities owned by non-natural persons must treat annuitant as owner for distribution at death rules.
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October 22, 1988 and after Annuities purchased within a twelve-month period from the same insurance company are treated as one for purposes of determining the taxable amount of a distribution.
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GLOSSARY Active Participant: An individual eligible to participate in a employer qualified plan. Accumulation Unit: A standard of measurement used in each sub-account to determine the value of the sub-account. Annuitant: Party on the annuity contract who is normally the measuring life. Annuitization: Making an irrevocable option to receive periodic payments. Annuity Unit: A standard of measurement used in the calculation of variable annuity income payments. Bail Out Rate: The minimum rate which an annuity may pay before the owner has the right to surrender, or bail out of, the contract without normally applicable surrender charges. Base Rate: Non-bonus annuity interest rate. Beneficiary: Party on the annuity who receives proceeds at death of owner or annuitant. Bonus Rate: Annuity interest rate which is inflated for a specified period of time above the base rate. Bucket Method of Investing: All moneys received within an interest crediting period for the same product are segregated from moneys received in other interest crediting periods in terms of investment return tracking. CD Annuity: Annuity which pays a guaranteed rate for a specified period, and normally does not allow additions, withdrawals or surrender.
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Compensation: Compensation includes wages, salaries, tips, commissions, fees, bonuses, and taxable alimony and separate maintenance payments. Compensation does not include deferred compensation received nor social security or railroad retirement income. Disability income is also not included in compensation for the purpose of calculating IRA contribution eligibility. Other items not included in compensation are rental income, interest income, dividend income, pension or annuity income, and foreign earned income. Contingent beneficiary: Class of beneficiary that receives death proceeds if all primary beneficiaries are deceased at time of the triggering death. Cost Basis: Generally, the amount invested in property. Coverdell ESA: An IRA plan created for the purpose of paying certain higher education expenses. Distributions used for this purpose are taxfree. Contributions are not deductible. Deductible Contributions: Contributions to a traditional IRA that may be deducted from gross income for tax purposes. Deferred annuity: Annuity in which earnings are not taxable until withdrawn. Deferred sales load: Charge assessed when accumulation units are surrendered, or a withdrawal is made. Typically, sales loads decline over time. Designated Beneficiary: Any individual or certain trusts named as beneficiary on an IRA. The designated beneficiary receives proceeds upon death of the account holder on traditional and Roth IRAs. The designated beneficiary of an Coverdell ESA is the individual for whom the Coverdell ESA is established; the individual who uses Coverdell ESA distributions for college expenses, for example. Direct Rollover: A qualified plan distribution made directly to an IRA trustee for the benefit of the qualified plan participant. Also known as direct transfer.
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Excess Accumulations: Any portion of a regular IRA required distribution not made within the required time frame. Excess Contributions: IRA or MSA contributions which exceed the maximum limit of the plan. FIFO: First in, first out. Annuities purchased prior to August 14, 1982 are considered to distribute principal first and income last. Fixed Annuity: Annuity which pays a fixed interest for a specified period of time, and which has a minimum guaranteed interest rate. Flexible Premium Annuity: Annuity which is opened with an initial premium and which accepts additional contributions. Floor: Under fixed annuities, the minimum rate that an annuity may pay before the owner has the right to surrender, or bail out of, the contract without normally applicable surrender charges. Under equity-index annuities, the minimum index benefit percentage applied to the contract. Free-look Period: The period of time, normally a period of days, from the date the issued contract is received to review the contract. If the owner decides not to take the policy within this period of time, the insurance company will return the contribution in full to the owner. Immediate Annuity: An annuity paying income within twelve months of purchase in exchange for a lump sum. This contract type is irrevocable. Initial Rate: Annuity interest rate paid from contract open date and guaranteed for a specified period of time from that date. LIFO: Last in, first out. Annuities issued after August 13, 1982 are considered to distribute income first, principal last.
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Market Value Adjustment: Adjustment made in contract value based on the change in interest rates since contributions were made to a contract if contract is surrendered. An increase in interest rates causes a negative market value adjustment. A decrease in interest rates causes a positive market value adjustment. Maturity Date: Also known as annuity start date and maximum deferral age. This is the date annuity payments or contract liquidation must commence. Some states regulate the maximum maturity date allowed on an annuity contract. Minimum Guaranteed Rate: Annuity interest rate contractually guaranteed after the initial rate period has ended. New Money Rate: Interest rate paid on new contributions to an annuity contract. Non-Deductible Contributions: IRA contributions that may not be deducted from gross income for tax purposes. Non-Qualified Annuity: Annuity that does not meet IRS requirements for qualified plans. Qualified plans include pension, profit-sharing, 401K, 403b and money purchase plans. Non-Qualified Distribution: A distribution from a Roth IRA that does not meet the requirements of a qualified distribution. The earnings in a non-qualified distribution are includible in the account holder’s income. Non-Recalculation Method: Regular IRA required minimum distribution method wherein the distribution is based on the life expectancy or joint life expectancies of the IRA holder and designated beneficiary. The initial life expectancy is reduced by one each distribution year. Nursing Home Waiver: Feature of an annuity contract wherein if a specified party is confined to a nursing home, hospital, long term care facility or other qualified facility, partial or full surrender of the annuity contract values may be made without applicable surrender charges. Particular provisions of a nursing home waiver vary.
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Owner: Party on the annuity contract who owns the annuity and has the right to change the beneficiary, and on deferred contracts, the right to withdraw funds, make additions, and in some cases change the annuitant or add or change the ownership. Payee: Party on the annuitized contract to whom the income is payable. Penalty-Free Withdrawal: Annuity feature wherein the owner may make a specified withdrawal amount, normally annually, without normally applicable surrender charges applied. Per Capita: Method of beneficiary distribution wherein all beneficiaries within the same class receive equal portions of the death proceeds. Per Stirpes: Method of beneficiary distribution wherein the share of a deceased beneficiary will pass to that beneficiary’s descendants. Portfolio Method of Investing: All moneys received for the same annuity product are combined with moneys received in other interest crediting periods in terms of investment return tracking. Premature Distributions: owner’s age 59 ½ .
IRA distributions made prior to the IRA
Premium Tax: Tax assessed in some states on annuity premium. Tax may be charged by the state as a front-end tax, when the annuity is opened, or as a back-end tax, when the annuity is annuitized, and is some cases when the annuity is surrendered or is distributed due to death. Premium Bonus: Bonus method wherein an the premium is increased by an additional percentage and this increased premium amount is credited with the stated interest rate. Primary Beneficiary: Class of beneficiary that has the first right to the death proceeds of an annuity. Principal Guarantee: Annuity feature wherein the principal in the contract is guaranteed to be returned upon full surrender of the contract.
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Probate: The process of ensuring property bequeathed through a will or intestacy laws is free from creditor claims. Qualified Annuity: Annuities meeting the IRS requirements of a qualified plan. Although Individual Retirement Accounts are not, strictly speaking, qualified plans, most insurance companies refer to IRA annuities as qualified annuities. Qualified Distribution: A distribution from a Roth IRA that is not includible in the Roth IRA holder’s income. A qualified distribution is one made after the first five tax years from the first contribution to a Roth IRA, and which is made either: a) after the individual reaches age 59 ½, or b) after the death of the individual, or c) because of the disability of the individual, or d) for payment of first-time homebuyer expenses. Qualified Higher Education Expenses: Term used in conjunction with Coverdell ESAs. Distributions for qualified higher education expenses are not includible in income. The term “qualified higher education expenses” means tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution. Rate On Additional Contributions: Annuity interest rate paid on additional contributions for a specified period of time. Recalculation Method: A regular IRA required minimum distributions method wherein the IRA owner’s life expectancy, or the joint life expectancies of the owner and spouse, is determined, or recalculated, each distribution year using an IRS life expectancy table. Regular IRA: An IRA plan allowing deductible contributions for certain individuals. The plan includes required minimum distribution rules and penalties for certain distributions prior to age 59 ½. Regular IRA money grows tax-deferred while in the plan. Earnings and deductible contributions are taxed when withdrawn.
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Renewal Rate: Rate paid on annuity contract value after initial interest rate period has expired. Required Beginning Date: The date required beginning distributions must commence from a regular IRA. April 1 of the year following the year the IRA owner reached age 70 ½ . Required Minimum Amount: The minimum amount required to be distributed from a regular IRA under the required minimum distribution rules. Required Minimum Distribution: Mandated regular IRA distributions that must meet a required minimum amount and be made beginning by a required beginning date. Generally, these distributions must begin following the IRA owner’s age 70 ½ and must be made at least annually over the life or life expectancy or the IRA owner. Rollover: Method for moving moneys to another IRA Plan, or qualified moneys to an IRA plan moneys to another IRA. The distribution is made to the account owner and must be placed in the new plan within sixty days of the distribution or the distribution will be taxable. No more than one rollover may be taken from an IRA plan every twelve months. Roth IRA: An IRA plan available starting in 1998. Qualified distributions are received tax-free from the plan. Contributions are not deductible. Roth IRA moneys grow tax-deferred while in the plan. Certain distributions are includible in income and may be subject to additional taxation. Self-Directed IRAs: IRA plans accepting a large variety of products and allow the IRA owner to direct the transactions within the plan. Single Premium contribution only.
Annuity:
Annuity
that
accepts
the
opening
State Guaranty Association: Association governed by individual state regulations. Insurance companies that are members of a state guaranty association are liable for contractual obligations to policyholders if another member is unable to meet them.
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Surrender Charge: Percentage charge assessed on withdrawals from an annuity that exceed the penalty-free withdrawal amount and are within the surrender charge period. The surrender charge period begins from the date of contribution, or from the opening date of the contract and continues for a specified period of time. Systematic Withdrawals: Annuity feature wherein regular payments are made, but are not an annuity payout option. Tax-Free 1035 Exchange: IRC Section 1035 regulates the exchange of a life insurance contract, endowment contract or annuity contract for an annuity contract without tax consequences. Transfer: Method for moving IRA moneys to another IRA plan. The account values are distributed directly to the new plan trustee. There is no limit on the number or frequency of transfers Variable Annuity: Annuity that allows the purchaser to allocate contributions to a variety of sub-accounts which generally provide variable, rather than fixed, return to a customer. Variable Income Annuity: Annuitization or immediate income option guaranteeing the number of units paid in each periodic payment. Since unit values may fluctuate, the variable income payments may also fluctuate.
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