Questions – Immediate Annuities

Questions - Immediate Annuities
by Steve Goodman

CPA, MBA – President & Chief Executive Officer

Contact Steve today for more info.

Which companies offer immediate annuities?

Many different companies offer immediate annuities, so be sure to get quotes from at least five different carriers.

What’s the difference between a life only annuity, a life annuity with a period certain, a period certain annuity, and a life annuity with an installment refund? How do the payment amounts differ and what are the different tax consequences?

There are key differences between these types of immediate annuities that you should be aware of. Here’s a simple explanation:

  • A life only annuity pays you money until you die.
  • A life annuity with period certain pays you money until you die or until a predefined period of time has expired, whichever is greater.
  • A period certain annuity pays you money for a predetermined period of time.
  • A life annuity with installment refund pays you money until you die while guaranteeing that you receive back all of your principal if you die prematurely.

Life only annuity pays out the greatest amount because you are taking the greatest risk.

If an annuity is purchased outside of a retirement plan — or in other words, as a non-qualified annuity — what portion of the payment is tax-free? And after how many years is the full payment taxable?

If an annuity is purchased outside of a retirement plan, a portion of the payment is considered an exclusion rate, as calculated by an insurance company. That portion is tax-free, with the balance taxed as ordinary income. Once you receive annuity payments where the cumulative exclusion rates equal your original principal, the full payment is taxed as ordinary income.

Why are insurance carrier ratings from S&P, Moody’s, Duff & Phelps and Weiss important?

It’s critical that you work with a high-quality insurance company. An annuity is a long-term liability on the part of the insurer so you want to be sure the company will be around for the long haul. Therefore, make sure you compare the ratings of various companies to determine their quality.

What protection (if any) does my State Insurance Department provide if the insurance carrier goes out of business?

Every state offers different protections if insurance companies go out of business. Check with your state insurance department about your state’s protections.

Do annuities provide an inflation adjustment? If so, what options are available?

Most insurance companies offer annuities in which payments increase each year based on a selected inflation factor — usually 2% to 5%. The higher the inflation factor, the lower the initial annuity payment will be.

If I die before receiving back my original investment, what are the tax consequences?

It will depend, in part, on the settlement option selected. Assuming that an annuitant dies once the annuity has commenced to pay out, the tax consequences are all dependent on the settlement option. Assume you had selected a period certain, say lifetime with a minimum 10-year payout, or a spousal last to die option and the spouse survives you. The payments would continue as contracted. As always, the return of the investment portion of each payment is not taxable while the earnings portion is taxed at ordinary income rates.

The present value of any payments not received when you die will be added to your taxable estate.

Should you have selected your lifetime settlement option and died before receiving your original investment in full, your payments will cease, no payments will be made your beneficiaries, and no tax adjustment is necessary.

How are annuity income and principal taxed?

If you withdraw money from an annuity, these funds are subject to ordinary income taxes above your cost basis. Also, you’ll receive no additional tax benefit by holding a deferred annuity in a traditional IRA or qualified retirement plan. Ironically, though, the majority of variable annuity assets in recent years have been held in qualified retirement plans. This means that many investors are paying extra for tax-deferred status that they already enjoy. Keep in mind that if you are considering holding an annuity in a taxable account, you may face early withdrawal penalties if you take withdrawals before reaching age 59½.

You should discuss the tax treatment of an annuity in more detail with your tax advisor.

When I die, what impact will the annuity have on my survivors?

Many factors other than the guaranteed minimum death benefit will influence how your annuity will impact your survivors. For example, most annuities do not receive a step-up in cost basis when you die, which could create a larger tax burden for your beneficiaries. Also, any capital gains in a variable annuity are passed through to beneficiaries as ordinary income, so if your beneficiaries are in a high tax bracket, an annuity may not help them taxwise.

Will the insurance company selling me the annuity be able to make good on its promises?

The main factor here is the insurance company’s credit rating. This will give you the most objective information to determine the likelihood that you will receive your promised annuity benefits in the future.

Insurance companies are rated by rating agencies such as AM Best, Fitch, Moody’s and Standard and Poors. Be wary of buying an annuity from a salesperson who is unable to provide an insurance company rating.

People should investigate state agencies that guarantee all annuities other than variable annuities.

Is the annuity adjusted for inflation?

Inflation can erode the value of your annuity over time, so inflation adjustment is important. Many annuity providers offer automatic cost-of-living adjustment (COLA) as a standard feature to protect you against inflation. This will result in lower payments in the early years but a larger payment over the long run.

What is the exclusion ratio and how does it work?

This is the percentage of lifetime payments that are not considered income for federal tax purposes on annuities purchased with after-tax dollars.

Can an annuity cover both me and my spouse?

Annuitants must select a payout option as the annuity is set to begin issuing payments. If you select a spousal last to die payment option, an annuity can provide payments beyond the lifetime of one of the couple. Should an annuity holder die during the accumulation phase (before the payouts commence on a deferred annuity), the annuity can cover the spouse assuming the spouse is the beneficiary of the annuity.


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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