Life Insurance & Personal Protection Strategies
Annuities
Accumulating sufficient assets for retirement has become a daunting task. Pension plans and social security funding are often inadequate sources, and the distributions necessary to secure a comfortable retirement often fall short of what is needed. Annuities are versatile financial products that can be designed to both accumulate and/or distribute monies for the self-funding of your retirement needs. Depending on your goals, annuities can be designed for the accumulation of funds on a tax deferred basis, and/or the systematic distribution of funds to last for your lifetime or for a custom designed, fixed period of years. When lifetime distribution has been selected, no other product can guarantee that the owner will receive a continuous flow of income for as long as he or she lives. Options may allow for the inclusion of additional persons for joint monetary distribution for lifetime or fixed time periods, with additional features that may include the selection of beneficiaries should one pre-decease the completion of an annuity’s distribution plan. Purchasing an annuity can offer the peace of mind that a fixed income is waiting for you so that you can live life while spending your money each year, while the insurance company takes on the longevity risk of you potentially outliving your income.
Types of Annuities
There are several types of annuities which have been designed for various purposes and needs. Some annuities are designed simply as vehicles which can be used to accumulate funds on a tax deferred basis, without the intention of ever “annuitizing” the funds contained within. Since annuitization is the process of distributing the accumulated funds over a fixed period of time or over one’s lifetime, one may decide to simply utilize the accumulated funds outright, or simply bequeath the accumulated funds to one’s beneficiaries. Alternatively, if one desires to additionally use an annuity as a “distribution vehicle”, this allows much greater versatility for retirement funding needs. The process of“annuitization” converts an existing accumulation of funds into an actuarially determined series of income payments to be paid over a designated period of time, and or life.
· An Immediate Annuity - is a type of annuity that is designed “exclusively” to distribute a series of payments to the owner or annuitant, where these payments are to begin “almost” immediately (or up to a year) from when the owner has deposited a lump sum of money with an insurance company, to achieve the purpose of receiving lifetime, joint-lifetime, or payments to be received over a specific and designated timeframe. Typically, Immediate Annuities are funded with a single premium.
· A Deferred Annuity - is a type of annuity that is designed to first “accumulate” its funding over a long period of time by receiving fixed interest or investment income, generally remaining in the accumulation stage for five to ten years. The contract owner may fund a deferred annuity with a single lump-sum deposit or with a series of deposits over time and will generally incur a surrender charge if they withdraw funds from their annuity contract before a certain time period elapses. The great advantage of the deferred annuity over other financial products is that the funds within the contract grow on a tax deferred basis. At the end of the “accumulation period”, the owner can generally 1) withdraw the funds in whole or in part, 2) continue to leave the funds in the contract to further accumulate, or 3) annuitize the contract in whole or in part.
· A Deferred Income Annuity - is a type of annuity that is generally funded with a single immediate premium (as opposed to a longer accumulation period of five to ten years), where the period prior to annuitization can be anywhere from 10 to 20 years, and where no interest or investment income is credited to the account. The guaranteed income stream is actuarially pre-determined from the start of the contract and is a way of putting money away to guarantee a specific amount of retirement income at a designated time in the future. Often renewal interest rates are guaranteed to remain above a certain pre-established floor.
Interest Crediting to Annuity Contracts
During the accumulation period, most traditional fixed annuities provide for minimum interest crediting rates that are initially fixed for one or more years but may be re-adjusted after the end of the guarantee period. Index annuities are another form of fixed annuity where there is no specifically declared interest rate, but interest is credited based on the performance of a market index such as the S&P 500 or the Russell 1000. There are generally protections built into the crediting mechanism that provide interest rate floors which help protect the contract owner. Traditional fixed or indexed annuities mostly rely on more conservative underlying investments such as certificates of deposits or government bonds to generate interest that is credited to their contracts. Alternatively, “Variable Annuities” do not provide any guarantees as their underlying investments in stocks, bonds, and money market funds are similar to mutual funds, whose performance can vary and impact the underlying contract values both unfavorably as well as favorably. Variable Annuities are considered to be “securities” as well as insurance products, subject to federal and state securities regulations as well as state insurance laws and must be sold with a prospectus. As such, we do not represent the sale of variable annuities, and will refer your interest to a registered broker should you have an interest in this type of product.
Parties to the Annuitant Contract
Owner – is the party that applies for the annuity and decides who the annuitant(s) and beneficiaries are, can make withdrawals, liquidate the contract before the annuitization date, determine the beginning annuitization date, annuitization period, can change beneficiaries and even assign the contract to a new owner. The owner is also responsible for tax liability on withdrawals and payouts. It is important to note that once annuitization begins, the contract is converted into a “liquidation” or distribution mode, and the rights of the owner to make changes to the contract are terminated.
Annuitant – is the person whose life is considered a “measuring stick” for purposes of figuring out the payout of the annuity contract. An annuity can be owned by one person, or two people (joint annuity), however, regardless of whether it is owned by one or two people, the distribution or “annuitization” of that annuity can be over one life (single life annuity) or two lives (joint and survivor annuity). The amount of the distribution is an actuarial computation. The annuitant is often the same person or persons (usually spouses) as the owner of the annuity contract.
Beneficiary – is the person (or persons) that are designated to receive an annuity contract’s death benefit proceeds should the annuitant(s) die before either 1) The annuity’s accumulation period ends prior to annuitization of the annuity contract, or 2) the annuitant dies before the full contract’s values have been fully annuitized (distributed). With regard to annuities that have already begun the process of annuitization, not all annuities will have a death benefit; it depends on the type of contract purchased. Why would the purchaser of an annuity not opt for a death benefit to one’s heirs should they die during annuitization? One reason would be if the owner did not have any beneficiaries. Another reason is financial; not selecting a death benefit generally results in a greater distribution payout over the life of the owner/annuitant. If selected, the value of the death benefit for a traditional fixed annuity is typically the contract’s accumulated value at the time of death. For a Variable annuity, the death benefit is usually the greater of the accumulated values or the sum of all premiums paid less withdrawals. It is important to note that annuities are contracts, and as such, are not subject to probate. If no beneficiary is named, and a death benefit needs to be paid out, it will become part of the annuity owner’s estate.
The Insurer – An annuity is issued by an insurance company, which invests the premium payments, and pays out the benefits and distributions. It is the insurance company that stands behind any guarantees provided by the annuity contract. Annuities are not guaranteed by the FDIC, SIPC, or any other federal agency.
SurrenderCharges
Most annuities impose a surrender charge if a contract is cashed out or withdrawals are made during the accumulation period. Typically, this surrender charge is in force within the first five, eight, or ten years, depending on the contract. Notwithstanding the above, surrender charge–free withdrawals are often allowed on a limited annual basis as a percentage of the premiums invested, or as a percentage of accumulated values. Typically, 10% of a contract’s accumulated values may be withdrawn on an annual basis without incurring a surrender charge, should it be allowed by contract. Usually, the only other waivers allowed for not incurring a surrender charge, would be certain allowed crises, varying by contract. Such crises could include death, disability, unemployment, hospitalization, entry into a nursing home, terminal illness, or required minimum distributions (if the annuity funds a qualified plan or IRA). It is important to note that even though a withdrawal may not incur a surrender charge, such withdrawals are subject to ordinary income tax, and if taken prior to age 59 ½, also subject to a tax penalty.
What are the Distribution Options for Annuitization?
Typically, the available income streams are as follows:
· A set period of years (known as a term certain payout)
Payouts can be made i.e. for 15, 20, or 25 years without regard to life contingency. At the end of the term, payments cease, however if the annuitant dies during the term, payouts will continue to a named beneficiary until the end of the term.
· For the life of the annuitant (a straight life payout, after which payments cease)
· For the lives of two joint annuitants (a joint and survivor life payout)
Income payments to the surviving annuitants can be structured to a percentage of the original income stream i.e.: 100%, 75%, 50%.
· For the life of the annuitant, but for no less than a certain number of years (life with term certain payout i.e. 5, 10, 15, or 20 years)
· For the life of a joint and survivor with term certain. Income is paid out to the second annuitant for the longer of:
The second annuitant’s life or
A specified term (5, 10, or 20 years)
· For life with a refund feature (installment or cash) – income is paid for the life of the annuitant but with the guarantee that if the annuitant dies before receiving the full amount ofthe premiums that were paid in, the remaining principal amount will be paid to a named beneficiary, either as a lump-sum cash payment or installments.
The income stream consists of both principal and interest that was credited during the accumulation period. By operation and law, all annuities must provide for the option of annuitization. For Immediate Annuities and Deferred Income Annuities these types of annuities must be annuitized after the accumulation period. For certain other annuities like Fixed Deferred Annuities, Indexed Deferred Annuities, and Variable Deferred Annuities, one can utilize these annuity types as merely “accumulation vehicles”, without having to ultimately enter the annuitization or distribution process. These are important choices to make when deciding which type of annuity to purchase.
Payout Choices to Make
Amount to be annuitized – one must decide what portion (if not all) of your accumulated values to annuitize. Amounts not annuitized can be left to further accumulate on a tax deferred basis for future distribution or annuitization or can be taken presently in a lump sum. Some policies offer a “commutation feature”, which allow for the acceleration of payouts once the annuitization process has begun. These types of withdrawals may allow for a limited percentage (i.e. 10 or 20%) of the value of the future income stream, or potentially a 100% payout of the present value of the future income stream. If elected, this would reduce or terminate any remaining guaranteed income payments that were originally determined at the start of the annuity.
Systematic Withdrawal Option
With the exception of immediate annuities and deferred income annuities which require annuitization, an alternative for those who do not want to annuitize their contracts allows contract holders to implement what is called “systematic withdrawals”, which is a program of planned or discretionary distributions over a period of years or even lifetime (using a GLWB-Guaranteed Lifetime Withdrawal Based Calculation-at an increased price). Contract funds could be depleted, so this method doesn’t generally give the owner the full guarantee of lifetime income, or a guarantee of providing an inheritance to one’s heirs. This method does, however, leave contract holders with more control over their account values. Another negative to using systematic withdrawals is that each withdrawal is fully taxable as it is considered a withdrawal of solely interest earnings as opposed to a combination of both principal and interest (as in annuitization). Withdrawals will be considered fully taxable until all interest previously earned has been depleted. Additionally, if withdrawals begin before the owner’s age of 59 ½, they may also be subject to a 10% penalty. The key to consider is that many annuities do provide the flexibility of deciding how much of their accumulation value to annuitize, leave to further accumulate, or withdraw in order to provide the most favorable plan for the owner.
Inflation Adjustments – are features that may be available in order to allow a fixed payout to keep up with the increase in the cost of living. Unless one’s expenses are fixed over the long term, it is an option worth considering. Typically, those payouts with an inflation feature start out lower than a comparable payout without an inflation increase, however while the former payout increases each year, the latter will not. There is an inflection point where the payout with an inflation guard will surpass the fixed payout and continue to increase each year.
Taxability of Distributions – One advantage of annuitization is that each payment consists of both a principal and an interest component. Only the interest component is subject to tax as the principal portion was already taxed prior to have being contributed as premiums to the annuity contract.
Deferred Income Annuities vs. Immediate Annuities
Deferred Income Annuities are designed to purchase a retirement stream of income, TODAY, to be paid in the future – i.e. deferral period of 13 months to 15, 20, 25 years, when you are ready for retirement. The average deferral period is generally about ten years. The difference between a DIA and a basic deferred annuity is that the DIA does not have an accumulation period, and no interest is credited during the period up to retirement distributions (annuitization). It simply provides for an actuarial determination of what lump sum is needed today, to produce a known and guaranteed income stream payable in the future. DIA’s also provide the option of funding this product with multiple premium payments made over the deferral period. The owner of a DIA who anticipates this future stream of payments cannot outlive the planned income stream. Payout annuitization options for DIA’s are similar to other types of annuities, i.e. life only, period certain, life with period certain, life with refund, and joint life with survivor benefits. The payout rate is generally expressed as a percentage of the contracts invested premiums or as a percentage of accumulated assets. Where multiple premiums are allowed, each additional premium has its own payout rate and will purchase a specific amount of guaranteed future income at the insurer’s then-current rates. The negative to a DIA, is that the owner typically will have no access to the annuity’s funds during the period prior to annuitization, unlike that of a basic deferred annuity product. One of the big positives of purchasing a DIA is that the cost of the purchase is typically much less as compared to an immediate annuity for the same projected income stream, generally because they may factor in a higher rate of return than other fixed interest rate products that are comparatively available at time of purchase. Another positive of DIA’s generally include optional features offering a death benefit during the deferral period, prior to the annuitization or annuity start date. This death benefit feature can be purchased at a cost, and typically offers either 1) a full return of the premiums paid, or 2) an amount equal to the premium paid compounded at a specific elected rate of return. Alternatively, the owner can decide Not to elect a death benefit during the deferral period. An important comparison of DIA’s to a basic fixed deferred annuity is that the payout rate of the DIA (usually expressed as a percentage of accumulated assets) can be determined at contract purchase, vs. the fixed deferred annuity, whose payout rate cannot be determined until the contract is annuitized. (Remembering that DIA’s must be annuitized vs. the fixed deferred annuity where annuitization is optional.) Additionally, at contract purchase, DIA’s also offer options to increase the annual payouts based on a fixed percentage, i.e. 1 ,3 or 6% or tied to increases in the Consumer Price Index or a COLA option (Cost of Living Adjustment).
Immediate Annuities, on the other hand, also purchase a lifetime stream of income, however, the premium deposit is generally made within a month or so of when the distributions are ready to begin. The main difference between the DIA and an Immediate Annuity from the Insurer’s standpoint is that the Insurance Company has time to invest the premium money from a DIA, but no time to invest the money from an Immediate annuity. Because of this difference, assuming the same amount of premium deposit for both, will result in a higher income stream resulting from a DIA vs. an Immediate Annuity.
Special Annuities
A Qualified Longevity Annuity Contract (QLAC) – is a “qualified” version of a Deferred Income Annuity (DIA), that is used in conjunction for planning with retirement accounts. As initial background, the Internal Revenue Service requires that mandatory distributions are to be made from retirement accounts subject to certain rules. Such accounts include Traditional IRA’s (not ROTH IRA’s), including SEP IRAs, and SIMPLE IRAs, as well as most defined contribution plans such as 401(k) plans, 403(b) plans, and 457 (b) plans. (consult your CPA for individual guidance). Defined Benefit plans are not allowed to be used. Participants of qualified work-place retirement plans, such as 401(k) or profit-sharing plans, who are less than 5% owners of their plan sponsoring business, can delay making distributions from their plans, until they retire. Otherwise, such 5% or greater, work-place plan owners, and other retirement account owners must begin distributions, for the year they turn age 73, and more specifically, by at least no later than April 1st of the following year. These distributions are known as “Required Minimum Distributions” or RMD’s, and the second RMD must be taken by December 31 of the next year (the same year as the delayed first distribution), and by each December 31st thereafter. These RMD’s were designed to prevent taxpayers from perpetually delaying the taxation of their qualified retirement funds (which were never taxed), and to force them into distribution. (with resulting income taxation). The amount ofthe RMD is calculated by dividing the account balance in the qualified plan bythe owner’s life expectancy as of the current RMD year. If a person has multiple plans, the RMD calculation must be made for each plan. The total RMD can be distributed from any one plan or allocated amongst all of them. It should be noted that the RMD is a minimum amount required; one can always distribute more than the RMD requirement. The penalty for Not distributing the RMD is 25% ofthe amount that should have been distributed but was not.
Solving for a Retirement Income Problem
What if you have attained the age of 73 with retirement savings in a qualified plan, but would prefer saving those monies for later retirement years instead of being forced to begin distributions to avoid an RMD penalty? A Qualified Longevity Annuity Contract or QLAC is a type of deferred income annuity (fixed annuity only), authorized by Treasury Regulations in July 2014, that allows your IRA and qualified retirement funds to be directed into this financial vehicle, to allow future income distributions to be made after the age of 73, without violating the RMD regulations. This delay in future income distributions allows for greater accumulation growth of those funds on a tax deferred basis, until a date that is no later than the first day of the month following the QLAC owner’s 85th birthday. Annuitization of that QLAC can start earlier, but no later than that date. Delaying a portion of qualified retirement funds from being subject to RMD, reduces the amount of distributions and the corresponding income tax that goes with it. A QLAC can be purchased before as well as after age 73, so very often, a QLAC is purchased earlier, at the point of retirement i.e. age 65 or 66, where the QLAC is funded by an existing retirement account upon retirement.
· The limitation for the amount of premium that can fund a QLAC is $ 200,000 per person (indexed for inflation). It is important to note that if a QLAC is funded excessively, that excess must be repaid in cash and the correct RMD must be re-calculated by December 31st of the next year, otherwise, the entire annuity contract (not just the excess portion) will cease to be a QLAC as of the date the excess premium was made.
· QLAC’s do not provide withdrawal of commuted benefits during the accumulation period.
· Income payouts for the annuitization of a QLAC must be for life, which meet the minimum distribution requirements. Period-certain payouts are not allowed.
· All payouts from a QLAC are fully taxable at ordinary income tax rates.
· QLAC’s generally offer a “Return of Premium” (ROP) option that may be elected, which returns the difference between the total premium paid in, and the amount of distributions paid out. This is unique as the ROP option is effective during both the accumulation period as well as the distribution period. The ROP is made as a lump sum to the beneficiary no later than December 31 of the year following death of the QLAC owner. Election of an ROP option will reduce the benefit paid to the contract owner, however the additional premium involved for its cost may be well worth the price. As an alternative to a lump sum ROP distribution, some contracts offer an annuity benefit to the beneficiary, however, different percentages of the original annuity apply, based on the age of the beneficiary at the start of that distribution.
· QLAC’s can provide for cost-of-living adjustment options (COLA) at an additional premium cost. Similar to nonqualified annuities, initial distributions begin lower, and then increase over a period of years.
· The insurer must provide an annual report to the IRS and to the QLAC owner.
Taxation of Annuity Income
Contributions by the owner of premium dollars into a non-qualified annuity contract are considered to be the “principal” that make up the funding of the annuity contract. These non-qualified monetary contributions were previously taxed. When funds are deposited, any accumulated interest and growth is not taxable while it is held in the annuity contract. The advantage of the annuity is given the same growth rate, the accumulated funds in the annuity contract will always be greater than the after-tax accumulation of a comparable non-tax advantaged product.
Distributions classified as a “Withdrawal” from an annuity – are treated on a last-in/first out (LIFO) basis. In other words, all withdrawals are completely taxable at ordinary income tax rates to the full extent of any interest that has accumulated within the contract. Once withdrawals have exhausted any accumulated interest in the contract, any remaining distributions would not be taxable because they would be considered a withdrawal of principal. An exception to this rule would apply to annuity contracts purchased prior to August 14, 1982 (TEFRA), only because those contracts utilized a “First in First Out” (FIFO) treatment where principal was deemed to be withdrawn first, and then interest accumulations.
It is important to note that any taxable withdrawals (non-principal withdrawals) made before an owner turns age 59 ½, are subject to a 10% penalty, in addition to being taxed at ordinary income tax rates. If an annuity owner dies, it is important to note that any death benefit distributions made to a beneficiary will not be subject to the 10% early withdrawal penalty if the annuity owner died prior to reaching age 59 ½. Other exemptions to this rule also include the disability of the owner, or if the annuity owner decided to take a distribution through a series of substantially equal payments over his/her life expectancy. (or the joint life expectancy of the owner and beneficiary).
Hybrid Long-Term Care Annuities – is a special type of non-qualified annuity which allows for withdrawals to be made for the payment of a long-term care insurance rider. Such withdrawals for this purpose will not be subject to taxation.
Taxation of Annuitized Income
When a non-qualified annuity owner decides to “annuitize” their contract at the conclusion of their accumulation period, unlike a “withdrawal”, each annuity income payment distribution consists partly of interest earnings, and partly of original principal contribution. Annuity payments are taxed so that principal is excluded, and only the interest portion of the distribution is taxed. This is computed through an exclusion ratio as follows: The premium Invested in the contract / the Expected Return. While the premium invested is net of any withdrawals, the Expected Return is calculated by multiplying the fixed monthly payout by the number of periods for which the monthly payout is to be paid. If payout is to be made for life, then we would utilize the IRS life expectancy tables to determine the appropriate time period. Note that if one lives beyond the IRS expectancy tables, then any future income would be considered 100% interest and fully taxable.
The exclusion ratio outlined above is applied until all premiums paid into the contract have been returned to the annuitant. At that point, any remaining annuity payments will consist of interest, and will be fully taxed at ordinary tax rates.
If an annuity is only partially annuitized (i.e. part of the annuity is maintained in accumulation mode), taxation will be allowed for the annuity portion using an exclusion ratio so long as the annuitization period is at least ten years or lifetime.
Taxation of Annuities Upon Death of the Owner
When the owner of an annuity dies prior to their contract being annuitized, and the contract provides for a death benefit to be paid to the beneficiary, the amount distributed is taxable to the beneficiary to extent that the death benefit exceeds the amount of premiums invested into the contract. For purposes of Estate Taxation of the Annuity owner, the general rule is that upon the death of an annuity owner, the full current value of the annuity is included in the owner’s estate if the owner dies prior to contract annuitization. If the owner dies after annuitization has begun, the amount included in the owner’s estate and subject to Federal Estate Tax, is equal to the present value of the future payments.
Death Benefit Options to a Beneficiary for a Non-Qualified Annuity
· Lump Sum Benefit
· Annuitize the benefit over the beneficiary’s life (this option is taxed in accordance with the exclusion ratio)
· Take the benefit fully within five years of the owner’s death.
· If death of the owner occurs after a contract has begun the annuitization process, the beneficiary can receive the remaining payments tax free until the original premium investment in the contract has been distributed. After that, any remaining distributions are fully taxable to the beneficiary.
Special Spousal Continuation Option - If a spouse is the sole beneficiary, they can elect to treat the contract as their own, and either:
· Continue to hold and accumulate the contract values on a tax deferred basis until surrendered.
· Take withdrawals.
· Annuitize the contract.
· Receive the death benefit within five years or over his/her life expectancy.
Note: The 10% premature distribution penalty is waived regarding distributions to a beneficiary, even if the deceased owner was younger than 59 ½.
Balanced Considerations for Retirement Planning
To achieve the ideal balance for a comfortable retirement, one must consider having:
1) A certain amount of liquid assets for unexpected and/or large cash outlays.
2) A balanced investment portfolio to provide for both a hedge against inflation and for future long-term savings.
3) A source of guaranteed income from which to pay basic and continual expenses. These sources commonly consist of Social Security, pension or employer sponsored defined contribution plans, and annuities.
The ultimate objective for retirement is to design a plan where you can first offset your fixed expenses with a guaranteed income stream (such as your social security and pension income), and then provide for additional guaranteed income from which you can pay for discretionary spending to enjoy and live life, without worrying about outliving your income. Annuities can serve as a lifetime spending vehicle to provide for such a goal.
