Annuity Overview

Annuities play a very important role in retirement planning, enabling you to save money and taxes while eliminating the fear that you will outlive your savings. Basically an annuity is an investment contract or policy between you and an insurance company. There are many kinds of annuities - some tailored for income, some for future growth, and some as savings vehicles depending on your exact income and investment needs.

Two Main Annuity Types: Immediate and Deferred

With an immediate annuity, your income payments start right away (technically, anytime within 12 months of purchase). You choose whether you want income guaranteed for a specific number of years or for your lifetime. The insurance company calculates the amount of each income payment based on your purchase amount and your life expectancy.

A deferred annuity has two phases: the accumulation phase, where you let your money grow for a while, and the payout phase. During accumulation, your money grows tax-deferred until you take it out, either as a lump sum or as a series of payments. You decide when to take income from your annuity and therefore, when to pay the taxes. Gaining increased control over your taxes is one of the key benefits of annuities.

The payout phase begins when you decide to take income from your annuity. For most people, this is during retirement. As your needs dictate, you can take partial withdrawals, completely cash-out (surrender) your annuity, or convert your deferred annuity into a stream of income payments (annuitization). This last option is essentially the same as buying an immediate annuity.

Immediate Annuities

Single Premium Immediate Annuities (SPIAs) are purchased by a single deposit. They usually start making regular monthly payments to you immediately after the date you make that deposit. The key ingredient for an immediate annuity is the exchange which takes place between the insurance company and the buyer. The company promises to pay a monthly income for the life of the annuitant and the buyer gives up his rights to ever receiving his deposit back in a lump sum. Once an immediate annuity makes its first payment, it generally cannot be cashed in.

An immediate annuity can be purchased with funds from a variety of possible sources, such as: a maturing Certificate of Deposit (CD); monies which have accumulated in a Deferred Annuity account (see below); or funds from a tax-qualified defined benefit or profit-sharing plan, or from an IRA account.

Why should I consider buying an Immediate Annuity? What are its advantages to me?

Immediate annuities provide many advantages to the buyer, such as: (1) Security-the annuity provides stable lifetime income which can never be outlived or which may be guaranteed for a specified period; (2) Simplicity-the annuitant does not have to manage his investments, watch markets, report interest or dividends; (3) High Returns-the interest rates used by insurance companies to calculate immediate annuity income are generally higher than CD or Treasury rates, and since part of the principal is returned with each payment, greater amounts are received than would be provided by interest alone; (4) Preferred Tax Treatment-it lets you postpone paying taxes on some of the earnings you've accrued in a "tax-deferred" annuity when rolled into an immediate annuity (only the portion attributable to interest is taxable income, the bulk of the payments are nontaxable return of principal); (5) Safety of Principal-funds are guaranteed by assets of insurer and not subject to the fluctuations of financial markets; and (6) No sales or administrative charges.

SPIAs are particularly suitable for providing income in the following situations: (1) Retirement from Employment; (2) Terminal Funding or Pension Terminations (including deferred commencements); (3) Retired Life Buyouts; (4) Professional Sports Contracts; and (6) Credit Enhancement and Loan Guarantee Transactions.

Forms of an Annuity

In its simplest form-the Straight Life or Non-refund immediate annuity-payments are guaranteed over the lifetime of one person. This form of annuity insures the recipient against outliving his financial resources and is an important instrument in planning for retirement. Given a fixed deposit amount, the monthly payments which derive from a "Life" annuity are always greater than those derived from other forms of immediate annuity, such as the "Life with Period Certain" annuity, or the "Joint and Survivor" annuity. The insurer of a single life annuity calculates its obligation only until the last regular payment preceding the annuitant's death. With other more extended forms of annuity, the insurer calculates its risk over a longer period than the one life expectancy, and reduces accordingly the monthly payment amount. However, because the payments on a single life annuity expire when you do, selecting this form of annuity is, in a sense, a bet that you expect to live longer than the average person.

When you extend the range of a life annuity by continuing payments to a second person ("Joint and Survivor" annuity) or for a guaranteed minimum period of time ("Period Certain" annuity), the extra coverage may reduce the monthly payment by about 5% to 15%. Several situations where these "extended" forms of immediate annuity would be most suitable are: (1) when the income needs to be guaranteed over the lifetimes of a husband and wife ("Joint and Survivor" annuity); (2) when payments must continue for a specified period (e.g. 5 or 10 years or more) to a designated beneficiary ("Certain and Continuous" annuity); or (3) when the annuitant wants to make sure that, if he should die before his full investment has been distributed in monthly payments, an amount equal to the balance of the deposit continues to a named beneficiary ("Installment Refund" annuity).

Immediate Annuity Definitions

Funds That Purchase an Immediate Annuity
Source of Funds - Qualified vs. Non-Qualified

The term Qualified (when applied to Immediate Annuities) refers to the tax status of the source of funds used for purchasing the annuity. These are premium dollars which until now have "qualified" for IRS exemption from income taxes. The whole payment received each month from a qualified annuity is taxable as income (since income taxes have not yet been paid on these funds). Qualified annuities may either come from corporate-sponsored retirement plans (such as Defined Benefit or Defined Contribution Plans), Lump Sum distributions from such retirement plans, or from such individual retirement arrangements as IRAs, SEPs, and Section 403(b) tax-sheltered annuities, or Section 1035 annuity or life insurance exchanges. Generally speaking, insurance companies use male/female (sex-distinct) rates to price qualified annuities in situations where the purchaser and/or owner is a corporation. When the annuity is being purchased by an individual, annuity rates are generally unisex. Some states, however, require that unisex rates be used for all qualified annuities.

Non-qualified immediate annuities are purchased with monies which have not enjoyed any tax-sheltered status and for which taxes have already been paid. A part of each monthly payment is considered a return of previously taxed principal and therefore excluded from taxation. The amount excluded from taxes is calculated by an Exclusion Ratio, which appears on most annuity quotation sheets. Non-qualified annuities may be purchased by employers for situations such as deferred compensation or supplemental income programs, or by individuals investing their after-tax savings accounts or money market accounts, CD's, proceeds from the sale of a house, business, mutual funds, other investments, or from an inheritance or proceeds from a life insurance settlement. While most insurance companies apply their male/female (sex-distinct) tables to non-qualified annuities, some states require the use of unisex rates for both males and females.

Deferred Annuities

What is a Deferred Annuity?

A Deferred Annuity, also referred to as a tax-deferred annuity, is a contract between you and an insurance company for a guaranteed interest bearing policy with guaranteed income options. The insurance company credits interest, and you don't pay taxes on the earnings until you make a withdrawal or begin receiving an annuity income. Your annuity contract earns a competitive return that is very safe.

Tax-Deferred?
Tax-deferred means postponing your taxes on interest earnings until a future point in time. In the meantime you earn interest on the money you're not paying in taxes. You can accumulate more money over a shorter period of time, which ultimately will provide you with a greater income.

Savings Advantages
Many people today are using tax-deferred annuities as the foundation of their overall financial plan instead of certificates of deposit or savings accounts. Although CD's and Annuities are very similar there are significant differences between the two. The most important difference is that annuities allow for the deferral of the taxes due on the interest earned until the interest is withdrawal! By postponing the that tax width a tax-deferred annuity, your money compounds faster because you can earn interest on dollars that would have otherwise been paid to the IRS. Later, if you decide to take a monthly income, your taxes can be less because they will be spread out over a period of years. Like Certificates of Deposits, annuities have a penalty for early surrender, however most annuity contracts have a liberal "free withdrawal" provision.

Tax Advantages
You pay NO taxes while your money is compounding. You can also pay a lower tax on random withdrawals because you control the tax year in which the withdrawals are made, and only pay taxes on the interest withdrawn, Tax deferral gives you control over an important expense - your taxes. Any time you control an expense, you can minimize it. The longer you can postpone this particular expense, the greater your gain when compared to the gain you would make with a fully taxable account.

The Tax-Deferred Advantage
To illustrate the increased earnings capacity of tax-deferred interest, compare it to fully-taxable earnings. $25,000 at 6.0% will earn $1,500 of interest in a year. A 28% tax bracket means that approximately $420 of those earnings will be lost in taxes, leaving only $1,080 to compound the next year. If these same earnings were tax-deferred, the full $1,500 would be available to earn even more interest. The longer you can postpone taxes, the greater the gain.

Safety
Your tax-deferred annuity is safe. A qualified legal reserve life insurance company is required to meet its contractual obligations to you. These reserves must, at all times, be equal to the withdrawal value of your annuity policy. In addition to reserves, state law also requires certain levels of capital and surplus to further increase policyholder protection. Legal reserve refers to the strict financial requirements that must be met by an insurance company to protect the money paid in by all policyholders. These reserves must be at all times, equal to the withdrawal value (principal plus interest less early withdrawal fees, if any) of every annuity policy. State insurance laws also require that a life insurance company must maintain certain minimum levels of capital and surplus, which provide additional policyholder protection.

No More 1099's
There is no withholding tax while your annuity is compounding; it is completely tax-deferred. If you request a distribution (random withdrawals or annuity income), taxes will be withheld - unless you elect differently. Your election not to withdraw can be made at the time you make your request. Because the interest is tax-deferred, it is not necessary to issue a From 1099 while your money is compounding. Only when your interest is distributed (withdrawal or annuity income) will a Form 1099 be sent, reflecting the amount of interest actually received.

When Does My Money Mature
An annuity policy does not "mature" like a bond or certificate of deposit. Both your principal and interest will automatically continue to earn interest until withdrawn or you reach age 100. You can let your money continue to grow, make withdrawals, or begin receiving an annuity income at any time.

What is the Penalty Tax and When Does it Apply?
An IRS penalty tax, currently 10%, will be payable on any withdrawal of interest or qualified premium made prior to age 59 1/2.

Avoid Probate
If a premature death should occur, the accumulating funds within your annuity may be transferred to your named beneficiaries, avoiding the expense, delay, frustration and publicity of the probate process. Like most assets, the annuity is part of your taxable estate. Your heirs can chose to receive a lump sum payment, or a guaranteed monthly income.

Equity-Indexed Annuities

Stock Market Growth With No Market Risk

With an Equity-Indexed Annuity, your return is tied to the increase in one of several stock market indexes, such as the S&P 500. However, if the stock market goes down, you do not lose any of your money. In fact, most Equity-Indexed Annuities will even GUARANTEE you a minimum annual return (typically 3%), even if the index you invested in goes down the entire time you are invested.

An Equity-Indexed Annuity is a great place to protect the money you've saved in your CDs, money market accounts, IRA accounts, etc. Or perhaps as an alternative for the money you currently have invested in stocks and mutual funds. Equity-Indexed Annuities can greatly improve your earnings potential, while at the same time keep your principal safe from market fluctuation.

Additionally, Equity-Indexed Annuities are a good option for people who already own annuities and have seen their interest rates drop substantially. Many people do not realize that you can easily trade-in an older, possibly under-performing annuity for one that better suits your needs. This exchange can be accomplished with no out-of-pocket expense or current taxes to pay!