Annuities - An Investment Tool

Chapter 3

Annuitization

  In this chapter we are going to be discussing annuitization options, when a policyholder should annuitize, bailout clauses and the exclusion ratio.

  Annuitizing may be simply defined as "contracting for a series of payments from an annuity."  It provides an even distribution of both principal and interest over a period of time.  Annuitization only subjects a portion of the amount withdrawn for that year for taxation.  There are three risks involved:

1. That the annuitant dies too early and/or selects the guarantee and does not receive back from the insurance company what they could have.

2. Once annuitization has been selected and the insurance company issues the contract and the policyholder has cashed the first check there is no turning back.

3. The amount of the check in a fixed annuity will be the same each month for the duration of the annuity.  If inflation increases at five percent a year, the dollars that the policyholder receives from the annuity will purchase five percent less each year than the     policyholder receives from the annuity contract.  This decrease in purchasing power will constitute a reduction in one's standard of living each year.  This can be a major risk for retirees.

  Annuitization is a process that the contract owner chooses to do.  The contract owner can choose to have the checks issued monthly, quarterly or annually.  The amount of the checks will depend on the competitiveness of the insurance company, the level of current interest rates, the amount of principal that is to be annuitized and the duration of the withdrawals.  We will discuss all four variable items.

  Competition between insurance companies can benefit the policyholder greatly.  The interest rate that companies will often differ.  The same is true with annuitization.  Some insurance companies may offer very attractive yields during the accumulation period but poor returns during annuitization (distribution).

  Current interest rates have an effect on the payout amount for obvious reasons.  The amount of the checks received upon annuitization of a fixed-rate annuity contract will be level; it will not go up or down with the interest rates, the stock market or the economy.  When the policyholder decides to annuitize all or part of the investment, the amount of the check will depend on the current interest rates.  If the insurance company can take the policyholder's money and invest it in a conservative manner, and it results in a high return to the company, a large portion of this could be passed on to the policyholder.  The insurance company or contract may give policyholder the choice to annuitize a portion of the annuity contract.  Though, this choice may not be wise because the insurance company may not be giving competitive interest rates for this service.

  It may sound as if the ongoing return is based on what happens to the invested funds later on; this is not true.  The amount of the check will always stay level. 

  The amount of principal that is going to be annuitized depends on how much the policyholder decides to annuitize.  The larger the amount of the capital that is to be returned to the policyholder, plus accumulating interest on the still to be dispersed amounts, the greater each check will be.

  The period of annuitization is the period of time, or duration, in which the contract owner wants the checks to be received.  For instance, a contract owner could choose a five year period.  What makes the duration a little tricky is that annuitization does not necessarily have to be for a specific number of years.

  Many people annuitize for three, five or ten years or longer period of time.  Others want an income stream that will last for the remainder of their life, or during the lifetime of two people. 

  Combining an annuity program with what is called Seven-Pay Life Insurance can be a powerful move.  The IRS will allow the policyholder to borrow money tax free from the cash value in a life insurance policy if certain conditions are met.   Basically, the owner of the insurance policy needs to make sure that insurance premiums are paid in over a minimum period of time, hence the "seven-pay test." 

  As long as the seven-pay test is met, the only other thing the contract owner of the insurance policy must be aware of is that they cannot cancel the policy or borrow all of its cash value.  If both of these tests are met, money can be borrowed freely from the insurance company every year indefinitely.

  Annuitization can work well in conjunction with seven-pay universal or whole life policies.  A seven-year "period certain" immediate annuity funding a universal life contract is a good option for anyone who has a lump sum ready to deposit, wants to take advantage of the seven-pay life insurance test for future tax-free liquidity and may also need a substantial death benefit.  The advantages of this combination include the policyholder making only one payment.  The exclusion ratio on the immediate annuity makes the distribution about 80 percent tax free and if the insured does it within the first six years, the beneficiary of the annuity receives the remaining payments.

  To make sure the life insurance policy is funded properly, the investor or policyholder will want to first make a lump-sum deposit into an annuity and request immediate annuitization over at least a five-year period.  Immediate annuitization means that premiums are being paid when they should be, directly to the insurance company.  This takes care of the seven-pay test and means that money can be borrowed from the life insurance policy tax free as opposed to tax deferred.

  Annuitization offers some great tax benefits.  The benefits, though, are not all considered to be tax free.  By using a combination of an annuity that is annuitized and having the payments set aside to pay for life insurance premiums, the investor can later take advantage of income that is 100 percent free of income taxes and receives some life insurance as a bonus.

  A policyholder will be able to add more money to the life insurance policy after the seven policy years.  With universal life, the policyholder can add some attractive riders to the policy, such as long-term health care, catastrophic illness, prime term, child or additional insured, and premium continuation for disability.

  It may also be possible to fund a final divorce or other legal action with an immediate annuity.  With a cash refund option, the cost would be only slightly higher than a life-only annuity option.  A cash refund option means that any undisbursed money will go to the beneficiary if the annuitant dies prior to a complete liquidation.

  Some employer provided retirement plans will not give the policyholder the choice of annuitization, but only the opportunity to choose among various types of annuity guarantees.  The policyholder would then have to consider the income generated by each choice or opportunity and then, adapt the income received to their personal situation.   In the decision making process, it may be wise to cross out the choices that the policyholder does not like first.  This may aide the decision making process.  Since each situation is different, so to the annuity chosen should meet the requirements of the family.  For instance, if one spouse is ill but the other is healthy, a joint-and-survivor option will work well.

  In deciding whether or not to annuitize or take a lump sum cash disbursement, the first step is to determine:

1. The amount of the payout,

2. What the lump sum cash disbursement could be used for, and

3. How much would be left to invest net after taxes.

  If the policyholder does not need the money, then rolling it into an Individual Retirement Account (IRA) may be wise.  It would conserve the principal from which a person could draw interest earnings while not annuitizing.  A person could then compare the income that would be generated from the earnings in the IRA funds to the income offered under the payout annuity arrangements offered by the employer.  The younger the policyholder is when they retire, the more likely they are to find that the interest earnings in an IRA are almost equivalent to the monthly income offered by the employer on an annuitized basis.  The amount of income generated in the annuitized basis should exceed what the policyholder is able to receive in an arrangement where they use only the interest on the capital sum, not the principal.  The annuity is making payments to the policyholder of both principal and interest.  If there is little difference in income, the fact that the rollover IRA not annuitized, conserves the principal.  This will give the policyholder some flexibility.

Why would a policyholder want to annuitize?

  They may be forced to do so if it was the only way to provide a sufficient income for the family's survival.  They may not be able to conserve the principal in a rollover IRA.  Of course, a policyholder would find it preferable to have a sufficient pension income, social security income and personal assets to prevent them from having to annuitize.  Annuitization puts the income at risk of being eaten up by inflation, having the principal forfeited to an insurance company because of premature death and it eliminates the possibility of changing the contract to suit the policyholder's future needs.

  If a policyholder chooses a rollover IRA and tries to survive on just the interest from the IRA, they may find that after a year or two the interest earnings are just not enough.  Because the policyholders are often older, it is highly likely that the income provided when they annuitize would be higher than it would have been when they originally retired.  Annuities are based on one's life expectancy and, as the policyholder gets older, the insurance company is able to pay more.  When dealing with immediate annuities the consequences of waiting are not detrimental as long as the contract owner was careful to conserve principal. 

  The decision to annuitize can be an emotional one.  It may be wise for the policyholder to seek objective counsel from a CPA, a financial advisor, attorney and of course, trusted insurance producers.

  A primary reason that people choose annuities is that the money grows and compounds on a tax-deferred basis.  Policyholders in annuities purchased before 1981 could choose to withdraw principal first and growth or interest later.  By utilizing such a strategy, no taxes were paid on any of the redemptions until such cumulative withdrawals equaled the contract owner's principal.

  Avoidance of income taxes can continue indefinitely.  The death of the annuitant would normally mean the annuity contract is terminated.  If, though, one spouse is named as both the contract owner and the annuitant with the other spouse named the beneficiary, the contract can continue.  The surviving spouse has the option of liquidating part or all of the investment without cost, fee, or penalty by either the IRS or the insurance company.  Withdrawals or a complete liquidation can trigger an income tax event to the extent that any money the survivor receives will be considered growth or interest.

  In the situation already presented, the surviving spouse does not have to terminate the annuity contract upon the death of the other spouse.  The remaining spouse can take over the investment and postpone any income tax event.  The annuity contract would then continue until death of the surviving spouse.  If the remaining spouse later remarries and names the new spouse as the beneficiary, the tax deferral could last until the death of both of these spouses.

  Upon the death of the final spouse, the non-spousal beneficiaries are entitled to the money.  These beneficiaries have four options.  They are:

1. Pay taxes immediately,

2. Make withdrawals during the next five years and pay taxes along the way,

3. Waiting up to five years, make a complete liquidation, and then pay taxes, or

4. Annuitize and pay some taxes with each withdrawal.

            If the fourth choice is exercised the beneficiary must choose annuitization within 12 months after the death of the surviving spouse.  Annuitization means that the beneficiary will receive specific amounts each month until their share, plus any accumulated growth or interest, has been completely withdrawn.  These withdrawals have certain tax benefits because the IRS considers a portion of each check to be a return of principal and therefore not taxable.

            Surrender charges equal costs to liquidate the account.  Surrender charges can be avoided if one of the following events occurs to the policyholder:

· Death,

· Disability,

· Annuitization,

· Taking withdrawals up to 10 percent a year, or,

· Waiting for the surrender period to end.

The Exclusion Ratio

Upon annuitization, an exclusion ratio is automatically determined.  The taxation of annuitized non-qualified annuity contracts is based on this ratio.  The IRS uses this ratio to determine the amount of each check received which is considered a return of capital and therefore not taxed.  The amount considered growth and/or interest is fully taxed.  The exclusion ratio varies depending on the life expectancy of the annuitant, based on mortality tables or the set number of years the contract owner chooses.  The longer the expected period, the smaller the exclusion ratio becomes.

  Since the policyholder directed the insurance company to distribute both principal and interest from the contract in a series of equal periodic payments, the basis (the original after tax investment) is paid out as a portion of each of those payments.  This portion is determined based on government tables and is not taxed.  It often represents 40 percent to 50 percent of the total periodic payment being received by the policyholder.  This percentage is found by calculating a ratio determined by the ratio of the original investment in the annuity contract over what the expected return is in total from the annuity contract.  If the policyholder outlives the annuity tables, there may come a time when they have received the entire cost basis back from the annuity contract.  If that time comes, all subsequent payments will be subject to ordinary income tax in their entirety.  This rule was incorporated in the Tax Reform Act of 1986 and applied to annuities that had not been annuitized as of January 1, 1987.  Annuity contracts that have been annuitized before that date enjoy the exclusion ratio for the rest of the annuitant's life and may continue to exclude the same percentage even after the annuitant's entire cost basis has been paid out.  The rule adds an additional income tax for senior citizens in their mid-eighties.  This hits them hard since inflation also eats away their retirement funds.

Bailout Provisions

  The bailout provision is very straightforward.  After the guaranteed interest rate period is over, if the renewal rate is ever less than one percent of the previously offered rate, the policyholder can liquidate part or all of the annuity, principal and interest without cost, fee or penalty.  This provision gives the policyholder the security of knowing that they will always be getting a competitive rate.  Under the Bailout Annuity, this provision can allow the policyholder versatility and forces the insurance companies to stay competitive - hopefully.

  As an example, if a contract owner was receiving a three year guaranteed rate of six percent, and at the end of those three years the new rate was 4.99 percent for the next three years.  The contract owner must decide whether or not to stay with that company.  They will want to investigate other companies.  If they decide to move the money, they have 30 to 60 days, depending on the company, to notify the insurance company that the contract owner will be terminating the contract.  They will then receive the principal plus the compounded annual interest for the three years.  The policyholder would be receiving this bailout because the renewal rate fell one percent lower than the previous locked-in rate.  If, though, the new interest rate offered was five percent, the policyholder would still decide whether or not to leave the money where it is at.  The difference is that if they chose to take the money, they would be subject to an insurance company back-end penalty.

  A free bailout provision is closely tied to the guaranteed interest rate provision of a fixed-rate annuity.  It can prove to be highly beneficial to the contract owner.

End of Chapter 3