- Flexible Premium—starts with initial investment and allows additions
• Most issuers have a maximum age for which they will issue a contract. This is typically between 75 and 90. Know your issuers!
• There are no sales charges assessed when a contract is purchased. However, most contracts have surrender charges (see below).
• Every contract is only as “sound” as the underlying issuer.
Annuity Terms
• Premium—the amount of money deposited into the contract.
• Annuitization—stream of income payments contracted with the insurance company.
Parties of the Contract
• Owner—This is the person or entity that owns the rights of the contract. They purchase the annuity and make the decisions about withdrawing money, who the beneficiary is, etc.
• Annuitant—The function of the annuitant is to determine the age upon which annuitization payments are based. Often the owner is also the annuitant.
• Beneficiary—The beneficiary receives the proceeds of the contract upon the death of the owner or annuitant. Some contracts are owner driven and some are annuitant driven. This means that the death of that particular party will “drive” the payout. If the same person, there should not be a problem. However, if the owner and annuitant are two different people, it is important to understand the provisions of the contract you recommend.
Surrender Charges
• Usually decline as contract ages.
• Typically range from 9% down to 0% over 10 to 5 years.
• Clients must be apprised of these charges prior to purchase.
Withdrawal Provisions of any Annuity Contract
• Annuities are designed as long-term investments. Typically insurance companies assess a surrender charge if money is withdrawn in the first several years of the contract, generally, six to eight years. Some companies offer ways to avoid or reduce surrender charges. For instance, they may allow the investor to withdraw 10% of the balance without charge or they may allow a withdrawal of the interest without charge. Each contract is different. Make sure you understand the provisions of each product you recommend and assure your customer also understands.
• To allow for tax deferral, all annuities are subject to a 10% penalty from the IRS if withdrawals are made prior to the age of 59 ½. This is in addition to the surrender charge so even if a surrender charge is waived, the customer will still be assessed the IRS penalty (there may also be “state tax” penalties). Be sure your client understands this before they purchase and/or withdraw income from the annuity.
• Any time a withdrawal of earnings is made from the contract, income taxes will be imposed. Annuities do not eliminate taxes, they just postpone them.
• Many contracts offer a Nursing Care Waiver/Hospitalization Waiver. Each waiver is unique in its requirements, but generally, access is allowed to portions of the entire contract value, free of surrender charges, if the annuitant or owner (dependent on the contract) meets certain medical criteria. This waiver applies only to the surrender charges from the company. Any other penalties or taxes may still apply.
• Bailout provisions allow a contract owner to forfeit a portion of interest for the ability to “bail out” or surrender the contract at the end of a year, and keep the entire contract value. Make sure you understand the provisions of the contract you are recommending.
Withdrawal Choices
• Once the investor has passed the surrender charge period and the age of
59 ½, they can basically do whatever they want to do with the contract.
- They can continue to accumulate earnings on a tax-deferred basis.
- They can withdraw any amount they want at any time or on a systematic basis. The decision to make withdrawals of this type is revocable. The investor can change their mind any time they want to.
- They can annuitize the contract. (See below)
Annuitization
• This is a process where the investor contracts with the insurance company to establish a steady income stream. This decision is irrevocable. Once the investor decides to annuitize, the decision cannot be changed.
• Annuitization payout choices:
- Life—This option allows the investor to receive a predetermined amount of money monthly until the annuitant dies. This is typically the highest payout option, but it has a risk. If the annuitant lives a long time, they are guaranteed to receive these payments for their lifetime. However, if they die shortly after the payouts begin, the insurance company keeps the rest of the money and the heirs will get nothing.
- Period Certain—This provision makes payments for a certain period of time (i.e. 10 years). At the end of that time period, the payments will stop. The risk here is if the person lives a long life, they will only receive the payments for that time period. However, if they die shortly after the payouts begin, their heirs will continue to receive the payments.
- Life and Period Certain—This is an option that seems very attractive for many investors since it combines the better of the two previously discussed choices. Here, the investor is guaranteed a lifetime stream of income. However, if they die shortly after the payouts begin, their heirs will continue to receive payments for the remainder of the period certain.
- Joint and Survivor—This option is usually only available to spouses. A monthly income is paid to two individuals. At the death of one, the survivor continues to receive payments until death. The continued payments are usually a pre-determined percentage less than the original installments.
- Designated Amount—Under this option, a specified amount is paid in each installment until the account balance has been eliminated. If the annuitant dies before everything is paid out, the heirs will receive the remaining installments.
Tax Considerations
• All withdrawals of earnings are taxable as ordinary income at the rate of the person making the withdrawals.
• Withdrawals from an annuity (with the exclusion of an annuitization option) will be treated as LIFO—Last In First Out. This means that the withdrawals will consist of earnings until all earnings have been taken. (Some very old annuities may still be considered under FIFO—First InFirst Out. This would allow the investor to withdraw the principal prior to taking the earnings. Very few of these annuities now exist.)
• Withdrawals under annuitization options receive some favorable tax treatment. The insurance company will apply a factor to the annuitization payments whereby a percentage of the withdrawal will be considered principal and a percentage will be considered earnings. The investor will only be taxed on the earnings.
• If an owner is unhappy with the contract or the insurance company, there are options for changing to another company. This is called a 1035exchange. It refers to the IRS code, which allows contracts to be exchanged between insurance companies without incurring a taxable event. However, it does not preclude the original issuing company from assessing surrender charges designated by the terms of the contract. 1035 exchanges should only be recommended to clients when there is a clear overall benefit to the investor, and all costs associated with the exchange must be carefully explained to the owner prior to effecting the exchange.
• In the 1980s, Congress decided that individuals with larger incomes who were also receiving social security benefits should be taxed on a portion of their benefits. At that time, up to 50% of the benefits could be subject to taxation. In 1994, that number was increased to 85%. In order to determine if benefits will be taxed, a formula is used. If income from all sources including half of social security benefits and income from tax-free sources reaches certain levels, there is a schedule for the percentage of social security benefits that will be subject to taxation. Because an annuity is tax deferred, the earnings are not added into the equation unless a withdrawal is made.
• Annuities avoid probate as long as a beneficiary is properly named. This allows the beneficiary to receive the proceeds of the contract without the expense and delay of probate.
Fixed Annuities
General Investment Features
• Contract issued by an insurance company with an interest rate guaranteed for a fixed period of time.
• Typically have a minimum rate guarantee below which subsequent rates may not fall.
• Rate guarantees can typically range from one to ten years.
• Some annuities offer additional features. Be sure you understand all the features of the product you are recommending.
- Bonus Annuities—These annuities typically pay a 1% bonus during the first year. It is important the investor understand there are a base rate and the bonus rate. Their renewal rate will be based on the base rate.
- Index Annuities—These annuities offer a rate that is based on a market index such as the S&P 500. This offers the investor the ability to have a guaranteed return and still participate in a strong market without taking the risk. Be sure your client fully understands how this product will be affected if they make withdrawals.
Surrender Charges
• Usually decline as contract ages.
• Typically range from 9% down to 0% over 10 to 5 years.
Tax Considerations
• Please refer to the “General” section on annuities.
Market Values
• Principal is guaranteed on fixed annuities. However, the guarantee is only
as strong as the financial strength of the issuer.
• Special Considerations
- Investors cannot withdraw prior to age 59 ½ without tax penalties. This may not be a suitable investment for young clients.
- Surrender charges must be understood.
- Fixed Annuities should not be described as similar to CDs.
- 1035 Exchanges are carefully monitored.
Fixed Indexed Annuities
(aka Equity Indexed Annuities)
General Investment Features
• They offer the traditional features of a fixed annuity (refer to Fixed Annuities section); however, provides the opportunity for index-linkedinterest crediting without giving up safety of principal.
• Fixed indexed annuities are tax-deferred annuities that offer minimum guaranteed interest rates and the ability to obtain a higher rate linked to one or more stock market indexes.
• The contract periods range from 5 to 12 years.
Surrender Charges
• Usually decline as contract ages.
• Typically range from 10% down to 0% over 12 to 5 years.
Tax Considerations
• Please refer to the “General” section on annuities
Market Values
• When the index increases, a portion of those gains is credited. When the index decreases, no interest is credited, but the account value does not decrease.
• Special Considerations
- Investors cannot withdraw prior to age 59 ½ without tax penalties.
- Surrender charges must be understood
- 1035 Exchanges are carefully monitored.
- Caps: Also known as “upper limits” on index linked interest earnings. Example: If a contract has a 12% cap, only 12% interest would be credited even if the underlying index generates earnings of 18%
- Participation Rate: Determines how much of the underlying index’s gain is used to calculate a FIA’s interest credit.
Example: Underlying index grows by 10% Participation rate = 70% Client’s contract would be credited with 7% (assuming no cap or annual contract fee)
Market Value Adjustment (MVA) Annuities
General Investment Features
• A MVA annuity pays a fixed rate of return. An adjustment is applied to the account value if the contract is surrendered prior to maturity.
• An annuity with a MVA usually pays a higher interest rate than one without this adjustment feature.
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