Introduction to Annuities

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by Steve Goodman

CPA, MBA – President & Chief Executive Officer

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Choosing an Annuity

Annuities can be useful for creating retirement income by providing a “check for life.” There are many different types of annuities, including the following:

A single premium immediate annuity, or SPIA

This is the most common type of annuity. Once the premium is paid, the annuity will provide a consistent stream of income, usually paid monthly. Keep in mind that once you pay the premium, you can no longer access these funds, regardless of your financial situation.


Several factors will affect how much income you may receive from an SPIA, including your age and gender, current interest rates and which settlement option you choose. The younger you are, the lower monthly income payments will typically be since the insurer assumes you will live longer and collect payments over a longer period of time.


Men usually receive higher payouts than women at similar ages because, statistically speaking, men don’t live as long as women. Since insurers invest premiums in the bond market, income payouts will be lower if current interest rates are low.


There are several different settlement options you can choose from, including the following:

Lifetime Income — You will receive monthly income payments until you die. You can choose a joint and survivor settlement option in which income payments will be made to a survivor after you die. With this option, though, your monthly income payments will be lower.

Period Certain — You will receive monthly income payments during a guarantee period that you choose. If you die before the end of the guarantee period, your beneficiary will receive the remaining income payments.

Period Certain and Lifetime Income — You will receive monthly income payments during a guarantee period that you choose. If you live longer than the guarantee period, you will still receive monthly income payments until you die. If you die before the end of the guarantee period, your beneficiary will receive the remaining income payments.

Cash Income and Lifetime Income — You will receive monthly income payments until you die. If you die before you’ve received the equivalent of your premium payments in income, your beneficiary will receive the difference in a single lump-sum payment.

Installment Refund and Lifetime Income — You will receive monthly income payments until you die. If you die before you’ve received the equivalent of your premium payments in income, your beneficiary will receive the difference in regular monthly income payments.


Tax Considerations of SPIAs

If SPIA income payments continue after you die, the payments will be included in your estate. The present value of payments to your beneficiaries will be included in your taxable estate. However, if your spouse receives the income payments, they could be sheltered from estate taxes by using the marital deduction.


If the total of income payments you receive from an SPIA exceeds the premiums you paid, the difference will be taxable as ordinary income. There is an IRS formula to determine how much periodic income will be subject to tax based on life expectancy. This formula calculates an exclusion ratio that excludes a portion of income payments from taxation, treating them instead as a return of the premium paid [basis].


Keep in mind that the exclusion ratio does not apply to SPIAs purchased with qualified funds — in this scenario, all payments are treated as taxable income. SPIAs held in qualified retirement plans (like IRAs) could be protected from creditors depending upon state rules, while SPIAs purchased with nonqualified funds are protected from creditors in some states.

Potential Drawbacks of SPIAs

Two potential drawbacks of annuities are the loss of control over funds and the effect of inflation on future income payments. Due to the loss of control over funds, it’s usually wise not to invest all of your money in an SPIA. It may also be a good idea to buy several different SPIAs from different insurance companies to increase diversification, perhaps laddering your investments by purchasing annuities with different terms.


SPIAs can be purchased with cost-of-living adjustments. To obtain this type of inflation protection, you’ll generally pay a higher premium or receive lower initial payments. For the same payment amount, annuities with cost-of-living adjustments generally provide for lower initial payments in exchange for higher payments in future periods. Those who live longer than average can significantly benefit from these adjustments.

Single Premium Deferred Annuities (SPDAs)

Unlike SPIAs, Single Premium Deferred Annuities, or SPDAs, provide income later in life, rather than immediately. With SPDAs, a single initial premium payment is made. SPDAs are usually classified based on how earnings are calculated during the accumulation phase or the period of time when income is not needed.


If you die during the accumulation phase, the death benefit — or premiums paid fewer withdrawals plus earnings — is included in your taxable estate. If the SPDA has been annuitized, the estate tax rules for SPIAs apply. Premiums paid can be returned to you tax-free, while investment gains are taxed at ordinary income rates if they are paid out. Earnings held inside the SPDA grow tax-deferred. Withdrawals from SPDAs before age 59 ½ may be subject to a 10% penalty unless they are made due to death or disability.


If the balance of the SPDA is annuitized (or paid out over time), the income treatment is the same as with SPIAs. If the policy is surrendered or funds are withdrawn (either partially or totally) from the SPDA, withdrawals are recognized on a Last-In-First-Out (LIFO) basis. The first monies withdrawn in the case of withdrawal are the earnings within the annuity. These withdrawals are taxed at ordinary income rates. Amounts distributed after earnings have been paid out are considered a tax-free return of premium. Scheduled annuity distributions are not taxed on a LIFO basis. The initial payments are primarily a return of capital. No income tax is due on the return of capital portion of an annuity payment.


The main type of SPDA is a fixed annuity, which pays a fixed return for a fixed period of time based on the initial premium amount. A basic fixed annuity has a term of three to 10 years with a guaranteed return during the first year only — after this, the insurer determines the rate of return. Some basic fixed annuities provide a guaranteed minimum annual return after the first year along with a high bonus return during the first year. These policies usually feature higher surrender charges that extend over a longer period of time.


Another type of SPDA is a multi-year guaranteed annuity, or an MYGA, which offers a fixed rate of return every year. Premiums can be withdrawn at any time, subject to surrender charges that decrease over time. However, you may be able to withdraw up to 10% per year without paying a surrender charge. Due to surrender charges, MYGAs should usually be viewed as long-term investments.

Fixed Index Annuities

This type of annuity pays returns based on the performance of a market index. The S&P 500 is the primary index used by most issuers. Fixed index annuities generally offer guaranteed minimum annual returns. If the index is flat or loses money, you will not suffer a loss and will receive the guaranteed minimum return. Offsetting this downside protection is a cap on the return and a participation rate that may limit your potential gain. Most annuities include a participation rate of less than 100%. A 70% participation rate will limit the annuitant’s gain in a market that rises 10% in one contract period to 7%. Additionally, many contracts will contain a cap that limits the maximum upside in any single contract period.

The index’s performance period is usually one year, starting with the annuity inception date. Or, a point-to-point annuity measures performance periods anywhere from one year to the life of the annuity. Fixed index annuities are not credited with dividends because the insurer doesn’t own the securities but is investing with the goal of replicating an index’s returns.


Like MYGAs, fixed index annuities should usually be viewed as long-term investments due to significant surrender charges. Also, the equity-based rate of return might only be applied if the contract remains in full force until maturity; otherwise, the surrender value could be based on just a minimum guaranteed rate. Laddering may also be a viable strategy when buying a fixed index annuity.

Variable Annuities

With this type of annuity, you can invest funds in sub-accounts, which include both stock and bond mutual fund options. Your money may grow, or you may suffer loss, depending on how your investments perform, but there are no caps on your gains so you receive the full benefit of market growth, fewer fees.


Most variable annuities include living benefit riders, which provide income for life-based on the annuity’s benefit balance. Initially, this is equal to the premiums paid plus a bonus percentage annually — it will increase over time but is decreased if you make withdrawals. Living benefit riders may enable you to invest some of your money more aggressively since you’ll still receive a check for life even if your investments decline in value.


The two types of living benefit riders are Guaranteed Minimum Income Benefit (GMIB) and Guaranteed Minimum Withdrawal Benefit (GMWB) riders. Each provides lifetime income based on the benefits balance. With a GMIB, the benefits balance must be annuitized, while with a GMWB, you can receive income based on the benefits balance. How much income will depend on your age when you initiated payments.


Subaccount investment options may be limited to GMIBs and GMWBs. For example, there may be limits on the percentage that can be invested in equities or the insurer may change the allocation toward a heavier concentration in fixed-income investments due to market volatility.

Variable annuities may include significant fees that must be paid for via the annual return. These typically include an annual contract fee, mortality and expense fee, contract administration fee, rider fees, and asset management fees. The higher the fees, the higher the return needs to be to offset them and still increase the account balance.


Variable annuities may be appropriate for both qualified and nonqualified accounts. While tax-deferred compounding already applies to money in qualified accounts like IRAs and 401(k)s, the income guarantees may make variable annuities a good choice for qualified accounts. Required minimum distributions (RMDs) can usually be made from variable annuities without surrender charges. Withdrawals made from variable annuities held in qualified accounts are taxed at ordinary income tax rates.


When you die, your beneficiary will receive the account balance. This will be included in your taxable estate, but it won’t be subject to a step-up in basis. Your beneficiary will inherit the funds at your basis and be taxed on withdrawals above the basis.


CPA, MBA – President & Chief Executive Officer

About Steve Goodman

For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.

He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.

Email Steve today for the business succession planning you deserve.

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