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Frequently Asked Questions |
| General questions a client might ask. |
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| What is an Annuity? |
An annuity is a long-term (often 5 years or more), interest-paying contract offered through an insurance company. An annuity can be “deferred” as a means of accumulating income while deferring taxes, or it can be “immediate” and pay you an income now and as long as you live.
The Opposite of Life Insurance
Annuities are sometimes described as the opposite of life insurance. Annuities protect you from living too long, while life insurance protects you from dying too soon. With an annuity, the financial risk of “living too long” is transferred to the insurance company.
A Lifetime Income
With the average retirement period lengthening, annuities are increasing in importance. Only annuities can pay you an income you can’t outlive, even after all the money you put into the annuity has been exhausted. Therefore, annuities can help you manage your cash flow, and provide a safe and competitive means to accumulate funds.
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| What are the different types of annuities? |
This guide explains major differences in different kinds of annuities to help you understand how each might meet your needs. But look at the specific terms of an individual contract you’re considering and the disclosure document you receive. If your annuity is being used to fund or provide benefits under a pension plan, the benefits you get will depend on the terms of the plan. Contact your pension plan administrator for information.
Single Premium or Multiple Premium
You pay the insurance company only one payment for a single premium annuity. You make a series of payments for a multiple premium annuity. There are two kinds of multiple premium annuities. One kind is a flexible premium contract. Within set limits, you pay as much premium as you want, whenever you want. In the other kind, a scheduled premium annuity, the contract spells out your payments and how often you’ll make them.
Immediate or Deferred
With an immediate annuity, income payments start no later than one year after you pay the premium. You usually pay for an immediate annuity with one payment.
The income payments from a deferred annuity often start many years later. Deferred annuities have an accumulation period, which is the time between when you start paying premiums and when income payments start.
Fixed
During the accumulation period of a fixed deferred annuity, your money (less any applicable charges) earns interest at rates set by the insurance company or in a way spelled out in the annuity contract. The company guarantees that it will pay no less than a minimum rate of interest. During the payout period, the amount of each income payment to you is generally set when the payments start and will not change.
Variable
During the accumulation period of a variable annuity, the insurance company puts your premiums (less any applicable charges) into a separate account. You decide how the company will invest those premiums depending on how much risk you want to take. You may put your premium into a stock, bond or other account, with no guarantees, or into a fixed account, with a minimum guaranteed interest. During the payout period of a variable annuity, the amount of each income payment to you may be fixed (set at the beginning) or variable (changing with the value of the investments in the separate account).
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| Why should I buy an annuity? |
| To properly position annuities and make appropriate product choices, the annuity buyer (and seller) must understand that, first and foremost, these are long-term planning products suitable for those with long-term investment horizons (usually 5 years or more). For most, the need annuities address is retirement. With few exceptions, they are inappropriate or inefficient for other needs or other objectives. |
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| What questions should I ask an agent (or company)? |
The NAIC* recommends you ask the following questions of your agent or the insurance company…
- Is this a single premium or flexible premium product?
- What type of annuity is this? (i.e. Fixed, Equity indexed, Variable…)
- What is the initial interest and how long is it guaranteed?
- Does the initial rate include a bonus rate and how much is the bonus?
- What is the guaranteed minimum interest rate?
- What renewal rate is the company crediting on annuity contracts of the same type that were issued last year?
- Are there withdrawal or surrender charges or penalties if you want to end your contract early and take out all of your money? How much are they?
- Can you get a partial withdrawal without paying surrender or other charges or losing interest?
- Does the annuity waive withdrawal charges for reasons such as death, confinement in a nursing home or terminal illness?
- Is there a market value adjustment (MVA) provision in the annuity?
- What other charges, if any, may be deducted from the premium deposits or contract value?
- If you pick a shorter or longer payout period or surrender the annuity, will the contract value or the way interest is credited change?
- Is there a death benefit? How is it set? Can it change?
- What income payment options can you choose? Once you choose a payment option, can you change it?
*The National Association of Insurance Commissioners (NAIC) is an association of state insurance regulatory officials. This association helps the various state insurance departments to coordinate insurance laws for the benefit of all consumers.
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| What charges might be subtracted by the insurance company from the earnings? |
The annuity is typically sold as a back-end loaded contract. As such, no fees are deducted at the time of the product’s purchase. If the contract owner purchases a flexible premium annuity, there may be some annual fee for the administration of these small premium amounts.
Some might argue that surrender charges can be considered fees. However, surrender charges in an annuity contract are usually limited in their duration and almost always guarantee not to invade principal. This is significantly different from other investments, such as a CD that has a revolving surrender charge or a bond that has asset value fluctuation.
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| What about taxes on my earnings? |
Taxation of Annuity Income
Income received from a nonqualified annuity under a structured annuitization option is taxed in accordance with the exclusion ratio. The exclusion ratio treats each annuity payment as part principal and part interest, thereby excluding a portion of each payment from tax and taxing a portion. The exclusion ratio is the “investment in the contract” (i.e., total premiums paid) divided by the “expected return” (i.e., total amounts to be received). If the expected return is not based on a life expectancy – as would be the case with a fixed term of years option, for example – it is calculated simply by adding the total amounts to be received. If the expected return is based on a life (or joint life) expectancy, certain IRS-prescribed tables and multipliers are used to determine the total expected return.
Taxation to the Beneficiary at the Annuitant’s Death (Post-Annuitization)
In cases where an annuitant owns a term certain or refund annuity and dies after payments begin but before receiving the full amount guaranteed, the balance is paid to a designated beneficiary. In these cases, the amounts paid to the beneficiary – whether as a single payment or in installments – are received tax free until the sum of all payments that were excluded from tax exceed total premiums invested. After that, any amounts the beneficiary receives are fully taxable.
Taxation to the Beneficiary at the Annuitant’s Death (Pre-Annuitization)
In cases where the owner is the same as the annuitant, what happens at the annuitant’s death is governed by the rules applicable at the owner’s death. In cases where the annuitant is different from the owner and the annuitant dies first, federal tax law does not require that taxes be paid unless the contract terminates, which many do. However, recent clarification on this issue by Congress and the IRS has given insurers confidence to design contracts that survive the death of a nonowner annuitant by naming a new annuitant. Often this is the owner or contingent annuitant.
One important exception to this occurs when the owner is a “non-natural” person, such as a trust. In these situations, the death of the annuitant results in exactly the same tax treatment as the death of an owner.
Taxation to the Beneficiary at the Owner’s Death
For contracts in deferral, federal tax law requires that any gain in the contract be recognized and consequent taxes paid whenever the owner dies. This is also true in the event of multiple owners when any owner dies. Therefore, most annuity contracts provide for payment of the death benefit to the beneficiary at the time of the owner’s death. This means that the beneficiary will be responsible for income taxes on the contract’s gain.
Taxation of Annuity Withdrawals and Distributions
There are a number of ways for contract owners to access the values in their annuities other than through annuitization. These options include systematic withdrawals, loans and full or partial surrenders, all of which can be utilized before an annuity’s maturity date. However, current tax laws are such that any of these distribution options may create a taxable event
For annuities purchased before August 14, 1982, the general rule regarding cash withdrawals, amounts received as loans or amounts received on surrenders is that they are tax free until they equal the contract owner’s basis or investment in the contract. After that, they are fully taxable as income. These annuities are given “first-in, first-out” (FIFO) treatment.
Annuities purchased on or after August 14, 1982, the general rule regarding these same kinds of distributions is that they will be treated first as fully taxable interest payments and only second as a recovery of non-taxable basis. These annuities are given “last-in, first-out” (LIFO) treatment.
Penalties for Early Distributions or Withdrawals
To promote the use of annuities as retirement plans and to discourage their use as short-term tax-sheltered investments, a 10% penalty is imposed on “premature” distributions, or those taken before the contract owner’s age 591/2. Therefore, an individual who, at age 54, withdraws a sum of $5,000 from his or her annuity will have to pay a current tax plus a $500 penalty as well, to the extent the withdrawal is attributed to interest earnings. No penalty is imposed for distributions taken:
- After age 591/2;
- In the event of disability;
- In the event of death; or
- As part of a series of substantially equal payments taken over life expectancy.
Estate Taxation of Annuities
If the contract owner dies during the deferral period (prior to annuitization), the entire account value of the annuity is included in his or her gross estate for purposes of determining the estate tax. If the contract owner dies after annuitization has begun and payments continue to a beneficiary (under period certain or survivor annuity), then the present value of those future payments is included in the contract owner’s gross estate. If the annuitization election is the life-only option, then there is no value for estate tax purposes, since payments cease at the contract owner’s death.
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| Is this a single or flexible (multiple) premium contract? |
| You pay the insurance company only one payment for a single premium annuity. You make a series of payments for a multiple premium annuity. There are two kinds of multiple premium annuities. One kind is a flexible premium contract. Within set limits, you pay as much premium as you want, whenever you want. In the other kind, a scheduled premium annuity, the contract spells out your payments and how often you’ll make them. |
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| How is an annuity different from a CD? |
Assume an individual has $100,000 to invest and is considering an annuity or a CD. He or she is a 40% (combined state and federal) taxpayer. The following shows how tax deferral gives the annuity a significant advantage over the CD.*
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Certificate of Deposit |
Annuity |
| Before-tax yield: | 6.50% | 6.50% |
| After-tax yield: | 3.90% | 6.50% |
| 1 year | $103,900 | $106,500 |
| 5 years | $121,081 | $137,009 |
| 10 years | $146,607 | $187,714 |
| 15 years | $177,514 | $257,184 |
| 20 years | $214,937 | $352,365 |
*Both investments assume the same rate of return over 20 years and annual compounding. After 20 years, the annuity value after taxes is $251,419.
Differentiating Annuities and CD’s
In the past, many comparisons have been made between certificates of deposit (CDs) and annuities. Some of these comparisons are fair and accurate; some are not. Let’s try to set the record straight.
A CD is a time deposit insured by the FDIC guarantee that protects such bank assets with a limit of $1 million. Certificates of deposit should be viewed as short-term investments in that their yields are based on short-term assets. While maturities typically extend out to 5 years, most CD customers elect one-year or three-year time horizons. The earnings on CDs are taxable unless the product is held in a qualified account. Finally, CDs carry a loss-of-interest penalty that extends for the full term of the contract if it is cashed in before it matures.
An annuity is not a short-term investment. It rewards the buyer who commits to tax deferral and that reward is more dramatic every year. The annuity is not guaranteed by the FDIC, but there is no limit in terms of protection by the insurance company. The annuity has a finite period during which surrender charges apply. Unlike CDs, annuity monies are invested by the insurer for 6 to 10 years, depending on the terms of the contract. The annuity offers liquidity in addition to tax deferral through free withdrawals, loans and surrender charge waivers under certain circumstances. Finally, whereas the value of a CD could be part of the owner’s estate at death, the annuity passes outside of probate to the named beneficiary (assuming the beneficiary is an individual, not the estate).
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| Can I move my annuity to another insurance company without penalties? (1035 Exchange) |
A section 1035 exchange (1035 refers to tax code number) is a tax-free method of exchanging an existing life insurance or annuity policy for a new policy with a different company. This procedure is often exercised when it is beneficial for the policy owner to move to a more favorable contract that offers rates or features they don’t currently have.
Keep in mind that while the IRS recognizes this as a tax-free move, there may be a “back-end” surrender charge from the insurance company before the exchange takes place if the existing annuity is still within the surrender charge schedule.
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| What if I die before receiving any income? |
Taxation to the Beneficiary at the Annuitant’s Death (Post-Annuitization)
In cases where an annuitant owns a term certain or refund annuity and dies after payments begin but before receiving the full amount guaranteed, the balance is paid to a designated beneficiary. In these cases, the amounts paid to the beneficiary – whether as a single payment or in installments – are received tax free until the sum of all payments that were excluded from tax exceed total premiums invested. After that, any amounts the beneficiary receives are fully taxable.
Taxation to the Beneficiary at the Annuitant’s Death (Pre-Annuitization)
In cases where the owner is the same as the annuitant, what happens at the annuitant’s death is governed by the rules applicable at the owner’s death. In cases where the annuitant is different from the owner and the annuitant dies first, federal tax law does not require that taxes be paid unless the contract terminates, which many do. However, recent clarification on this issue by Congress and the IRS has given insurers confidence to design contracts that survive the death of a nonowner annuitant by naming a new annuitant. Often this is the owner or contingent annuitant.
One important exception to this occurs when the owner is a “non-natural” person, such as a trust. In these situations, the death of the annuitant results in exactly the same tax treatment as the death of an owner.
Taxation to the Beneficiary at the Owner’s Death
For contracts in deferral, federal tax law requires that any gain in the contract be recognized and consequent taxes paid whenever the owner dies. This is also true in the event of multiple owners when any owner dies. Therefore, most annuity contracts provide for payment of the death benefit to the beneficiary at the time of the owner’s death. This means that the beneficiary will be responsible for income taxes on the contract’s gain.
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| Can a business own an annuity? |
| With certain exceptions, if the owner of the annuity is not a natural person, the annuity does not provide income tax-deferral on accumulations. The major exceptions to the non-natural person rule are a trust acting as agent for a natural person, a qualified plan, or the estate of a deceased owner. |
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| Can I have an annuity in my IRA? |
The term ‘qualified’ does not specifically refer to the annuity itself, but rather to whether the annuity is being used as part of a retirement plan that is considered ‘qualified’ under certain sections of the Internal Revenue Code.
Annuities can be purchased to fund tax-qualified retirement plans. They can also reduce your current taxable salary, accumulate funds tax-deferred and increase your after-tax retirement income.
Individual vs. Employer Sponsored Retirement Plans
A retirement plan can either be funded directly by you (like the Traditional and Roth IRAs) or it can be sponsored by your employer (like a 401(k) or SEP). These qualified retirement plans are different because each are authorized under different sections in the Internal Revenue Code and are subject to their own rules and regulations.
Why Have a Qualified Annuity?
Some have asked “Why choose an annuity to fund a qualified plan that is already enjoying tax-deferred accumulations?” When you compare the features and benefits associated with fixed and variable annuities against other traditional retirement funding vehicles, it seems obvious why annuities are a competitive and logical choice…
...Fixed Annuities as Qualified Plans
Fixed annuities offer many benefits that alternative vehicles, like CD’s, do not. For instance, fixed annuities…
- Offer free withdrawal privileges*
- Offer the option to receive an income that can’t be outlived
- Tend to credit higher interest rates than CD’s
...Variable Annuities as Qualified Plans
- Variable annuities offer many benefits other vehicles, like mutual funds, do not. For instance, variable annuities…
- Offer free withdrawal provisions
- Offer the option to receive an income that can’t be outlived
- Provide a guaranteed death benefit, an, in some cases, may offer a “stepped up” death benefit that locks in investment gains every few years*
- Offer the option to choose many different fund companies within one product*, providing full diversification
- Provide the ability to move among fund families at no charge and with no tax consequences
*Subject to company specific product restrictions
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| What happens when I take withdrawals out of my annuity? |
If you need access to your money, you may be able to take all or part of the value out of your annuity at any time during the accumulation period. If you take out part of the value, you may pay a withdrawal charge. If you take out all of the value and surrender, or terminate, the annuity, you may pay a surrender charge. In either case, the company may figure the charge as a percentage of the value of the contract, of the premiums you’ve paid or of the amount you’re withdrawing. The company may reduce or even eliminate the surrender charge after you’ve had the contract for a stated number of years. A company may waive the surrender charge when it pays a death benefit.
Some annuities have stated terms. When the term is up, the contract may automatically expire or renew. You’re usually given a short period of time, called a window, to decide if you want to renew or surrender the annuity. If you surrender during the window, you won’t have to pay surrender charges. If you renew, the surrender or withdrawal charges may start over.
In some annuities, there is no charge if you surrender your contract when the company’s current interest rate falls below a certain level. This may be called a bail-out option.
In a multiple-premium annuity, the surrender charge may apply to each premium paid for a certain period of time. This may be called a rolling surrender or withdrawal charge.
Some annuity contracts have a market value adjustment feature. If interest rates are different when you surrender your annuity than when you bought it, a market value adjustment may make the cash surrender value higher or lower. Since you and the insurance company share this risk, an annuity with an MVA feature may credit a higher rate than an annuity without that feature.
Be sure to read the Tax Treatment section and ask your tax advisor for information about possible tax penalties on withdrawals.
Free Withdrawal
Your annuity may have a limited free withdrawal feature. That lets you make one or more withdrawals without a charge. The size of the free withdrawal is often limited to a set percentage of your contract value. If you make a larger withdrawal, you may pay withdrawal charges. You may lose any interest above the minimum guaranteed rate on the amount withdrawn. Some annuities waive withdrawal charges in certain situations, such as death, confinement in a nursing home or terminal illness.
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| How often should I review my annuity contracts? |
It’s a good idea to review your annuity as your contract anniversary date approaches. You may reach an anniversary when the surrender charge schedule ceases, at which point you can move to a more beneficial product (if available) without being penalized by the existing insurance company. Even if the existing contract is within the surrender charge period, it still might be beneficial to take the penalty and move to a better product if it offers certain features that the existing annuity does not. Meeting with an agent for your review can help in determining if it’s best for you to stay with what you have or move to a better product depending on your situation and goals.
A variable annuity may require more attention (or review) than a fixed annuity. A fixed annuity has minimum guarantees and/or an annually declared interest rate, so there is much less maintenance. A variable annuity, however, has underlying subaccounts that fluctuate in value. Most variable annuities allow you to re-allocate your funds amongst these subaccounts with little or no fee (up to certain limits), so perhaps a quarterly or semi-annual review would be more appropriate.
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