Annuities are considered a tax-deferred financial vehicle. That means that the interest growth is not
taxed until withdrawn. When funds are withdrawn,
part will be taxable (growth) and part will be non-taxable (principal).
An exclusion ratio is determined by the insurer
and represents the portion of the annuity that is capital and therefore not
taxed. In other words, it is the
principal that was deposited either in a lump sum or on an accumulation basis
that was taxed prior to deposit (after-tax dollars).
When
annuity withdrawals are requested the insurer figures the exclusion ratio by
using tables provided by the Internal Revenue Service (IRS). It is a formula that determines the amount
of each check that is considered to be either principal or interest. The interest is taxed, but the principal is
not because it is a return of capital.
The
exclusion ratio will vary depending upon the life expectancy of the annuitant,
which is based on mortality tables, or the set number of years chosen by the
contract owner for receiving payments.
The longer the expected period, the smaller the exclusion ratio will be.
Expected return is the projected
or assumed rate of growth. This amounts
to the total growth plus principal.
Once an expected return is determined, the percentage of the amount that
was invested in the contract is calculated.
Once this percentage is calculated, it is used each year to determine
how much of the annual payments will be classified as a return on capital, and
not taxed, and how much will be classified as growth, which will be taxed. Once the total of all payments representing
return of capital over the years equals the principal, then these tax-favored
payments end. Any future distributions
thereafter would be totally taxable.
In
variable contracts, the exclusion ratio could change almost every month, since
the performance of the stock and bond markets cannot be predicted.
An Example:
Marjorie invested $100,000 in a fixed-rate annuity. She needs as much current income as possible
for the next five years. She decides to
annuitize her contract and receive monthly checks. During the next 60 months, which is the five years, approximately
85 percent of each check she receives will be considered a return of capital
(the $100,000 deposited) and therefore not taxable. She paid the taxes as she earned the initial deposit, so that
represented after-tax dollars. The remaining approximately 15 percent is
considered income according to the IRS tables and will be taxed as ordinary
income. Once all of the initial
$100,000 deposit has been paid to Marjorie, all remaining checks will be
considered income and taxed at the rate she is taxed for ordinary income.
Only a small percentage of annuity owners actually annuitize
their investment. As a result, the
funds might remain in a tax-deferral state throughout their lives, with only an
occasional withdrawal being exposed to taxation. Since the account is tax-deferred, only if a withdrawal is made
will any taxes apply. If withdrawals
are never made, the account will eventually go to the listed beneficiary upon
the account owners death.
People often choose an annuity because of its tax-deferred
status. Since the majority of annuity
owners do not annuitize, tax-deferral becomes an important point since it allows
them to hold their cash asset without being penalized by taxation. If these same people purchased another type
of vehicle that was taxed, the growth would be affected by paying tax on it.
Compounding interest allows the principal and the accumulating
interest to earn additional interest.
Compounding interest is often figured using the Rule of 72. This is a quick and convenient way to
determine how something will multiply in value over time. It helps to determine how money will grow
with time.
Most of us figure dollar growth in terms of how long it takes to
double in value. This will depend upon
the rate of return. Obviously, the
higher the rate of interest, the faster the sum will grow. Dividing the rate of return into the number
72 will provide an approximate doubling rate.
Therefore it is called the Rule of 72.
If the growth is being reduced each year due to taxation, this
lessens the growth of the financial vehicle.
When taxes do not reduce the returns, the financial vehicle becomes
larger quicker.
Lets look at how tax deferral affects compounding interest:
If Gerald places $100,000 into both a
certificate of deposit and a fixed-rate annuity both earning 5 percent
interest, the initial growth will be identical. For simplicity sake, lets say the growth on each is an even
$500. Gerald is in a twenty percent tax
bracket, so the CD will be taxed $100.
The annuity will not because no funds have been withdrawn. That leaves a policy year-end balance of $100,500 for the annuity, but only $100,400
for the certificate of deposit. Since
compounding means that the interest earned in that first year will be earning
in the second year on, the annuity now has a larger amount earning interest
than does the CD. Within a few years
the annuity will certainly outpace the CD.
The bank will send Gerald a 1099 form each year on the interest
his CD has earned so that he may count it towards his income earnings for the
year. These earnings will count towards
his provisional income which will determine if he is going to pay taxes on his
social security benefits or not. Provisional
income consists of Geralds pension income + interest from the CD, his stocks,
and so forth +tax-exempt interest + 50% of his social security benefits.
Since the annuity interest is tax-deferred, it is not only an
advantage as far as growth is concerned, but also an advantage in that it will
not affect his social security earnings (unless he makes a withdrawal from his
annuity). Many financial advisors feel
that the lack of an effect on provisional income is a far greater advantage of
tax-deferral than the interest compounding.
As previously discussed, an annuity owner has several options
available when he or she is ready to receive distributions from their annuity:
In all of these options, the longer the potential payout period
may last, the lower the payment will be.
Obviously, the payment will also be based on the amount of money that
has been deposited. Dividing $100,000
over ten years will be different than dividing $50,000 over ten years.
Split Annuities are contracts that are
divided into two parts. One part is
distributed while the other remains intact earning interest. While the annuity can have either a fixed or
variable rate, the fixed rate can make the guarantee of complete restoration
within a set period of time. A Split
Annuity is for anyone who needs current income, needs a tax break, and wants
the guarantee at the end of a specific period of time. The amount received each month will change
with the securities investments that the policyholder selected. It is possible to choose a fixed rate
annuity if a person desires a specific amount payable.
The chief difference between a split annuity
and an immediate annuity is that the split annuity is designed to restore
principal. The immediate annuity only
capitalizes on the short-term performance.
Split annuities can be used as long-term investments, whereas immediate
annuities vary from a few years to a lifetime.
Split annuities can offer the policyholder guarantees in terms of
performance that the immediate annuity cannot unless a fixed rate option is
used.
In choosing a variable or fixed rate, one
should consider the market and the policyowner's goals. The variable rate cannot offer any
guarantees like the fixed rate ones.
However, the potential for return is greater on the variable rate
options.
As with all annuities, the distribution
amount is flexible prior to annuitization.
If the policyholder does not need as much income, the contract can be
changed. The same is true if the
policyholder decides they need more income.
They would then be weighing down the split annuity more heavily for
income as opposed to growth. Remember,
the policyholders only become locked in for the portion they annuitize.
Should the
Investor Annuitize?
The majority of individual
(non-qualified) annuities are never annuitized only about 25 percent
are. This is often a very personal
decision based on individual needs and circumstances. A primary downside to withdrawing funds from an annuity is the
way that growth is taxed as ordinary income.
There are no capital gains in annuities. This includes variable fund accounts. Only the portion that represents a return of the original
investment is non-taxable. If the owner
has not withdrawn the money from their account, when they die it will be
considered a part of the estate and subject to estate taxes. That does not mean it will go through
probate because it wont as long as a beneficiary other than the estate is
listed.
Annuities are designed to pay income to the annuitant during
their life. Therefore, if the
individual needs income it makes sense to annuitize. On the other hand, if the individual does not need income it
would make no sense to do so, since the growth would be taxable.
For qualified annuities, there may be little choice. Most require withdrawals at some determined
point at least age 70 . On the plus
side, one of the great features is knowing that income will be there each
month. Even if the owner is forced to
annuitize, there will be monthly income that they can count on possibly for
life if that option has been chosen.
There are positive and negative aspects to every investment
vehicle. What is appropriate for one investor may not be appropriate for
another. With that in mind, lets look
at what is commonly considered to be annuity advantages:
Those who buy fixed-rate annuities nearly always quote safety of
principal as a major concern. As the
saying goes Im not so concerned with a return on my money, as I am with the
return of my money.
Certainly the point of investing is to obtain growth, but in todays
economic marketplace many investors feel uncomfortable with financial
risk. Annuities guarantee 100 percent
of the investors principal. Few
investments give principal guaranteed at all
times promises. Only
accounts insured by the Federal Deposit Insurance Corporation (FDIC) gives the
same promise. A few others make similar
promises, but only if the investment is held to maturity. Variable annuity values can fluctuate and
may not be suitable for safety-conscience investors since principal is not
guaranteed on a day-to-day basis.
Variable annuities do guarantee principal through the guaranteed death
benefit.
Why the difference between fixed-rate and variable
annuities? In a fixed-rate annuity the
insurer does the investing, but in a variable product the investor decides
which type of portfolio to go into and with what dollar amounts. Therefore, there is the potential of loss
since risk is greater.
Virtually every state requires that insurers doing business in
their state participate in the legal reserve pool. If an insurer goes out of business, the
remaining insurers must assume the liabilities and obligations of the
now-defunct insurer. The liability
assumed by any one company depends on how much business it does in that
particular state. A company doing 15
percent of business in the state would assume 15 percent of the failing
companys obligations.
Rating services are not foolproof. There have been insurer failures that were not signaled by the
rating services. Even so, by comparing
the ratings of two or more services it is possible to gain good insight into an
insurers financial strength.
For the person investing in variable annuities, the rating of the
insurer has little bearing since the investment is not made in the company
issuing the annuity, but rather in other sub-accounts. It is the performance of those sub-accounts
that will determine the strength of the investment. They are buying securities that are issued by other entities
not the insurer.
Fixed-rate annuity investors will have their money commingled
with what is referred to as the insurance companys general account. The general
account is a pool of money from fixed-rate annuity investors and
other sources. The insurer then seeks
the highest return possible while still maintaining a high level of safety
(since they guarantee the principal and a base interest rate).
Participants in annuities bought before 1981 can chose to
withdraw principal first and growth second, but any purchased after that time
cannot. Even so, if withdrawals are
made at times chosen by the annuitant or contract owner, taxes can be
minimized.
Tax-deferred growth, a strong advantage for the annuity prevents
taxation until funds are withdrawn. The
owner of a non-qualified annuity can determine when that point in time is. Since the investment grows without taxation,
returns are greater than an account that loses money each year to taxes.
Most annuities are purchased by individuals aged 60 and
over. This may be due to the withdrawal
limitation of 59 but it is more likely due to the investors turning to safety
and repositioning previous accounts that carried higher investment risk. Many more older people buy annuities than do
younger ages. At younger ages,
investors are willing to take investment risks that they do not wish to take by
the age of sixty. By that point, safety
carries a high importance.
It seems like everywhere we look there is an article by someone
who professes to be an authority on annuities.
Some are for them; others are adamantly opposed to annuities. The truth usually lies somewhere in the
middle. While annuities have their
place in financial planning, annuities should never be the only plan. Rather they should be part of a diversified
financial strategy.
Basically, the disadvantages of an annuity consist of:
Annuities were intended to be retirement funds. Although they are not always used for that
purpose, that was the intent.
Therefore, the IRS intends for them to be used for retirement and they
encourage this by fining those who withdraw funds prior to age 59 . It is the assumption that no one will be
using the money for retirement prior to that age. No penalty will be imposed on the principal; its imposed on the
growth.
There are some exceptions to the IRS penalty:
It is important to realize that most contracts will look at the
annuitants death or disability, not the contract owners. The beneficiarys death or disability never
affects the contract, unless he or she is also the annuitant. In those contracts that are owner-driven the
death or disability of the owner would waive penalties.
A person of any age can purchase an annuity. Those under legal age would have to have
another person involved. However, since
they are geared with retirement in mind, few people under age 50 tend to
purchase them. That is unfortunate
since all of us will retire some day.
The younger we begin to save for retirement, the more secure that time
of our life will be.
Those under the age of 60 do save for retirement, but they are
more likely to save in ways that involve a higher level of risk, since they
have youth on their side. If their
stocks lose money, for example, a younger person has time on their side to make
it up. As they reach fifty and sixty,
their focus begins to change, looking towards more secure investments. At this time, they are likely to reposition
their assets to vehicles such as annuities.
Annuities grow tax-deferred not tax-free. Tax liabilities can be postponed and
passed on to the beneficiary if the account is never annuitized and funds are
never withdrawn. IRS will not tax the
principal even if it goes to the beneficiaries; it is the growth that is taxed.
Although annuitants can decide when they are taxed by waiting to
withdraw funds, at some point there will be taxes if they take out any growth
income. Probably the most often cited
disadvantage is the fact that the growth income is taxed at ordinary income tax
rates. Those who favor annuities point
out that this can be minimized by withdrawing at appropriate times, while those
who dislike annuities say there is never an opportune time to pay tax on
ordinary income. This debate is likely
to continue as long as annuities are offered for sale.
Insurers have surrender charges on annuities. The length of the charge will depend upon
the contract but they often remain with the contract for seven or eight
years. Annuitization will not be
affected by surrender charges (they will not be levied if the contract is
annuitized). Since most annuities do
not experience many withdrawals, except for the free ones that are not affected
by surrender charges, this does not seem to be an issue for most investors.
Disadvantages often mean misuse.
Any financial vehicle becomes a disadvantage if it is used
improperly. Annuities, like other
financial vehicles, must be fully explained, surrender values must be
completely discussed, and annuitization options must be understood by the
person buying it.
Some financial planners feel annuities should not be used for
IRAs because the IRA is already a tax-deferred vehicle. They reason that it makes no sense to use
one tax-deferred vehicle to shelter another.
Barry Perlman states that income deferral is utterly irrelevant if the
annuity is held as an IRA or retirement account. He states the IRA and retirement plan already provides for the
deferral and, in fact, distributions are governed by the provisions of Section
72 applicable to IRA retirement plans, not the general annuity provisions.
Finally, it would be impossible to overlook one major
disadvantage that occurs with annuitization: the potential loss of beneficiary
money. The theory behind lifetime
income is that the annuitant will live far longer than the insurer desires,
receiving far more than they ever paid in.
However, there are perhaps no better statisticians than those employed
by insurance companies. While people
certainly do fool them by living far longer than expected, most live within the
horizons projected by the insurers. Some
die far sooner than expected. If a
lifetime income annuitization has been selected, the insurer becomes the
designated beneficiary, receiving any unused portions of invested funds.
For all types of annuitization, there are fees involved. There are fees involved in the annuity even
if not annuitized, but investors should realize that all portfolios require
management and there is no free lunch.
The investor must pay the insurance company for the cost of selling the
annuity, setting up the account, collecting and investing the money during
accumulation periods, and paying the regular payments during the distribution
periods. Some financial professionals
write as though the insurers should be able to do all of this without cost, but
all types of investments have costs.
These expenses are required in all types of portfolios. For some mutual funds the annual expenses
can be as high as 10 percent when everything is added in. Those that are tax-deferred, like annuities,
will still end up with better returns than those that are not tax-deferred.
How does an annuity compare with other investments? For those that do not have the advantage of
tax-deferral, such as CDs, money markets, and savings annuities will grow much
faster due to the tax-deferral. Some
types of investments would be very difficult to compare to annuities. It would be virtually impossible to
adequately compare an annuity with a real estate investment, for example. The features of each are so different. One could say that the real estate
investment lacked liquidity, but that is not even necessarily true with todays
low real estate equity rates.
Investment Comparison
Chart:
|
|
Liquidity |
Tax
Advantages |
Probate |
Accelerated Benefit |
Returns |
|||||
|
Annuities |
10% yr* or annuitization |
Yes, tax Deferred |
Beneficiary designation |
Up to 25% For illness |
** Triple Compounding |
|||||
|
Certificates Of Deposit |
Only at maturity |
No, taxable in year
earned |
Beneficiary designation |
No |
Earnings to maturity |
|||||
|
Money Market |
Yes |
No, taxable in year
earned |
Beneficiary designation |
May withdraw |
No tax deferral |
|||||
|
Savings a/c |
Yes |
No, taxable in year
earned |
Beneficiary designation |
May withdraw |
No tax deferral |
|||||
|
Mutual Funds |
Must be sold |
No, taxable in year
earned |
Fully applicable |
No |
Earnings not guaranteed |
|||||
|
Stocks |
Must be sold |
No, taxable in year
earned |
Fully applicable |
No |
Earnings not guaranteed |
|||||
|
Bonds |
No |
Some are tax-exempt |
Fully applicable |
No |
Stated Returns |
|||||
|
Commodities &
Options |
Must be sold |
No, taxable in year
earned |
Fully applicable |
No |
Questionable |
|||||
|
|
Liquidity |
Tax
Advantages |
Probate |
Accelerated Benefit |
Returns |
|||||
|
Limited Partnerships |
No |
No |
Fully Applicable |
No |
Questionable |
|||||
|
Promissory Notes |
No |
No |
Fully Applicable |
No |
Individual to contract |
|||||
|
Real Estate Invt Trusts |
No, must be sold. |
Only the primary home |
Fully Applicable |
No |
Can be very good or bad. |
|||||
|
Viaticals |
No, must be sold. |
No |
Fully Applicable |
No |
No statistical
information available. |
|||||
|
* Some contracts may vary. It is always important to read contract terms. ** Triple Compounding is a term used to mean interest
earning interest. The first year
interest is applied. The next year will gain interest on the principal +
interest on first year interest and so on in successive years. |
||||||||||
|
|
Annuitization |
Terminal
Illness |
LTC Waiver |
Additional Contributions |
Free Look Option |
|||||
|
Annuities |
Yes |
Yes, Some contracts |
Yes, Some contracts |
Some, yes. Some, no. |
Yes |
|||||
|
CDs |
No |
No |
No |
No |
No |
|||||
|
Money Market |
No |
No |
No |
Yes |
Not Relevant |
|||||
|
Savings a/c |
No |
No |
No |
Yes |
Can close a/c if unhappy |
|||||
|
Mutual Funds |
No |
No |
No |
Yes |
No |
|||||
|
Stocks |
No |
No |
No |
May purchase additional
stocks |
No |
|||||
|
Bonds |
No |
No |
No |
No |
No |
|||||
|
Commodities &
Options |
No |
No |
No |
May purchase additional |
No |
|||||
|
Limited Partnerships |
No |
No |
No |
No |
No |
|||||
|
Promissory Notes |
No, except when set up as an
annuity |
No |
No |
No |
No |
|||||
|
Real Estate Invt Trusts |
No |
No |
No |
Some can |
No |
|||||
|
Viaticals |
No |
No |
No |
Some can |
No |
|||||
|
|
Transferability |
Creditor Protection |
|
Annuities |
Yes |
If properly set up, yes |
|
CDs |
No |
No |
|
Money Market |
Yes |
No |
|
Savings a/c |
Yes |
No |
|
Mutual Funds |
No |
No |
|
Stocks |
No |
No |
|
Bonds |
No |
No |
|
Commodities &
Options |
No |
No |
|
Limited Partnerships |
No |
No |
|
Promissory Notes |
Sometimes, yes |
No |
|
Real Estate Invt Trusts |
No |
No |
|
Viaticals |
No |
No |
Some of the investments listed in the grid above resemble
gambling more than they do investing.
For example, some so-called investments are pure speculation and include
such things as trading of futures, options, and commodities. These are derivatives,
meaning financial investments with value derived from the performance of
another security such as a stock or bond.
Options are likely to depend upon the short-term movements of a specific
security.
Real estate and stocks have historically produced comparable
returns. In some areas, real estate has
done especially well, but this can provide a false security. What goes up can also come down. No tax benefits are earned when accumulating
a down payment another drawback to real estate. For many, however, real estate has produced extremely good income
and investment return when sold many years later.
There is no particular investment that is always right for every
person. Each is an individual with
individual needs and circumstances.
Each annuity and other investment vehicle should be viewed from the
standpoint of the needs that exist for that person.
End of
Chapter Seven
United
Insurance Educators, Inc.