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Annuities

Annuities are one of the ways to receive income when you are retired. It is an agreement in which you (the annuitant) transfer property or assets to another person (the obligor) in return for regular payments to you.

Annuities are essentially insurance that can protect you from the risk of outliving your assets. One of the drawbacks of this security is that the return on investment of annuities is usually less than other investment choices, often referred to as opportunity cost.

Another drawback is that you purchase annuities from a life insurance or investment company. Setting up most annuities is expensive, those sold by traditional insurance companies through insurance agents even more so.

  • Most of the cost comes from commissions and fees from those involved, which may include property assessors, accountants, actuaries, and insurance agents.
  • The more professionals involved and the more complex the terms of the annuity, the more expensive the set-up charge. For example, calculating a variable annuity payment is much more complex than a fixed annuity payment and, therefore, more expensive. The cost will also increase for each rider/provision you add.
  • Increasing the number of guarantees/provisions/riders will also decrease payments.
  • Low-cost annuities may be available through financial companies.

The earnings from the annuity (capital gains, dividends, and interest) accumulate tax-free. You must be at least 59½ years old to begin withdrawals without penalties. Once this starts, you will get payments for a specific time, usually the rest of your life. How the withdrawals are taxed, how much can be invested, and how long you can defer withdrawals are based on whether the annuity was funded with pre-tax or after-tax dollars.

While your choices of annuities can seem quite complicated, it really comes down to choosing among multiple available options for funding, investing, withdrawing, and passing on your annuity.

There are seven major things that you can consider when you are choosing annuities.

  1. Funding — You can fund your annuity all at once or contribute over time with pre-tax dollars (Qualified Annuities) or after-tax dollars (Non-Qualified Annuities). Funding an annuity through an individual retirement account (IRA) or another tax-advantaged retirement plan may entitle you to a tax deduction for your contribution. Qualified Annuities have a funding limit, while Non-Qualified Annuities and Variable Annuities do not.
  2. Investment risk — Some annuities will give you some choice in the investments, either by letting you or your financial advisor pick some of the investments or determining the amount of risk you want to take, such as safe investments, aggressive investments, or a combination. Your money will get interest at a fixed rate in the accumulation phase.
  3. Beginning withdrawals — Your withdrawals from your annuity can usually begin after you reach 59½ years old. They can either be immediate or deferred. The choice frequently depends on your age, but also on whether investments have been previously taxed. You must begin to withdraw from qualified annuities by 70½ years old, while non-qualified annuities have no upper limit.
  4. Withdrawal amount — Your withdrawals can be fixed or change over time, as either variable or fixed-indexed.
  5. Withdrawal duration — You can choose to receive withdrawals until a certain total amount is reached, or spread out over your lifetime or a more limited time frame.
  6. Any additional protections you may want to add — This is usually done with riders or additional provisions.
  7. Using your annuity as an inheritance tool — You can have a joint annuity with your spouse or name beneficiaries for your annuity in case you die before the payout/distribution phase has ended. Though not common, joint and survivor annuities are possible. The annuitants are usually spouses and payments continue until the second spouse (survivor) dies. Since there is a chance that the annuity payments will continue for a longer time with a joint annuity, annual payments are generally smaller.

Like any insurance policy, you can add any number of provisions and riders to annuities. Like any provision and rider, you need to consider the chance of needing the protection and comparing the cost of adding the provision or rider to your annuity, adding them to a different type of insurance, or taking out a separate policy. There are provisions and riders that will protect you under a number of situations. They can be divided into living and death benefits.

  • Living benefit riders are any that apply to circumstances that may occur while you are alive and may include:
    • Increasing payments with inflation;
    • A minimal benefit if you have variable or indexed annuities that will protect you against any significant reductions in the payment amounts or value of the annuity due to market fluctuations;
    • Setting up specific payments, either monetary amount until the principle is gone or a specific percentage of the principle for the first few years;
    • Paying additional benefits if you need long-term care; and
    • Deferring surrender charges or accelerating payouts if you are diagnosed with a terminal illness or other qualifying life events such as becoming disabled, developing serious illness, or needing long-term care (hardship rider).
  • Death benefits are any that apply if you die before you have received all of your principal.
    • You can name beneficiaries or alternate annuitants.
    • They will receive any of the contract value, the amount of the premiums that have been paid, or other death benefit amount you specify.

Annuities are regulated by the Securities and Exchange Commission and the Financial Industry Regulatory Authority.

Annuity Funding

Annuities can be funded as lump sums and/or discrete payments (premiums) over time. The period over which you add funds to your annuity is known as the accumulation phase. Your choices will usually depend on circumstances.

  • If you are purchasing an annuity well in advance of retirement you will usually be adding to the annuity over time.
  • If you receive a windfall, such as a large lawsuit settlement or lottery win, you can use it to either purchase an annuity or add to an existing one.
  • Another reason for lump sum additions may be that you are approaching retirement age and want to convert some of your assets to retirement funds.

Whether the withdrawals are taxed, how much can be invested, and how long you can defer withdrawals are based on what the annuity was funded with.

Qualified Annuities

Qualified annuities are treated like tax-deferred (traditional) retirement plans. They may be purchased through an employer tax-deferred retirement plan or with money from a traditional IRA, 401(k), or another account that is tax deferred.

Unlike non-qualified annuities, qualified annuities have caps on how much money may be invested in them. These caps are governed by your income and whether you participate in other qualified pension plans.

When funds from a qualified annuity purchased with pre-tax dollars from a traditional IRA or other retirement account are distributed to you, the entire amount is taxable because taxes have not yet been paid on that money.

Non-Qualified Annuities

Non-qualified annuities are treated like Roth retirement plans and are purchased with after-tax dollars.  When money from a non-qualified annuity is withdrawn there are no taxes due on the principal, since the money has already been taxed. Income taxes are levied only on the earnings and interest.

The IRS determines which portions of a non-qualified annuity withdrawal are taxable by using a calculation known as the exclusion ratio. This ratio is based on the length of the annuity, the principal and the earnings.

If a non-qualified annuity is set up to pay you for your entire life, the exclusion ratio will take your life expectancy into consideration. This can be found in the Internal Revenue Service (IRS) life expectancy table.

Exclusion Ratio = Sellers Cost Basis ÷ Expected Return (IRC §72[b])

  • Expected Return = Annual Payment × Life Expectancy
  • Annual Payment = FMV of Property Transferred ÷ Present Value of Annuity Factor (1 – (1+r)-n/r: r is the expected interest rate and n is the number of years left in life expectancy)

The idea is to spread the total of the principal and earnings of the annuity in regular payments over your lifetime. If you live beyond your calculated life expectancy you have received the entire principle of the annuity.

If your predicted life expectancy is 90 years old the exclusion ratio will calculate how much of each payment from your non-qualified annuity will be considered taxable earnings until then. After the age of 90 you have received all of your principal and all of the payout amount from the annuity is considered taxable income.

Timing of Initial Withdrawal

When you begin getting payments it is called the annuitization phase. If you are over 59½ years old, this can start right away or be deferred. If you withdraw funds before this, called the surrender period, you will be subject to a surrender fee, unless you have a hardship rider. These fees can be 10% or more, although the penalty typically declines annually over the surrender period. 

Despite the surrender fees, you can consider this if you need cash for emergency situations, such as a terminal illness.

  • Most annuities allow you to withdraw 10% to 15% of the account for emergency purposes without penalty.
  • If you do not have a hardship rider, ask your employer if you can waive the penalty if you have a terminal illness for amounts above this. 

Immediate Withdrawal

If you begin receiving the income within a year of purchasing the annuity, it’s known as an immediate income annuity, also called a single premium immediate annuity (SPIA). Typically, you would purchase immediate annuities with a single lump sum payment if you were approaching retirement. Your payments can either be a fixed amount or a variable one, depending on your choice and the contract.

You might choose this type of annuity as you get close to retirement if you:

  • Have a one-time windfall such as an inheritance or lawsuit settlement; and/or
  • Want to take a portion of your retirement savings and buy the annuity as a way to supplement your income from Social Security and other sources.

Deferred Withdrawal

If the payout or distribution phase begins a year or more later, the income annuity falls into the category of deferred income annuity (DIA). Deferred annuities can be purchased three ways.

  • A lump sum – single premium deferred annuities (SPDAs). 
  • Multiple payments – flexible premium deferred annuities (FPDAs).
  • A combination of the two.

The income payments from a deferred annuity are typically higher than payments from an immediate annuity for two reasons.

  1. With a deferred annuity, your principal has time to accumulate before you start taking payments. 
  2. If you have life annuities, you will get payments for the remainder of your life. The longer you wait to receive payments, you will get fewer payments over a shorter time, resulting in larger individual payments.

Withdrawal Duration

The choice of duration of your payments is probably the most important choice when it comes to annuities, but it is the most difficult to anticipate. It all comes down to predicting your life expectancy, who is predicting it, and trying to make your annuity last until your death.

Life Option

A life option is the choice of getting payments from the annuity for the rest of your life, even if you live much longer than your life expectancy and get back more than you put in and earned. In this case your life expectancy is based on the IRS table.

Because you no longer have any basis in the annuity after your life expectancy:

  • Payments will now be considered gifts, requiring the obligor to pay gift taxes on the payments; and
  • The money will increase your taxable estate.

The risk of this option is that you will not receive the full value of the annuity if you die sooner than expected. Unless you have a death benefit, the company holding your annuity keeps the remainder of the account after your death. 

There may be three ways to reduce the odds of the company getting the rest of your annuity after your death. 

  1. You can create the annuity as a joint account with your spouse.
    • After you die, they will continue to receive payments until their death.
    • The monthly payments will be lower with a joint account since two life expectancies are taken into account.
  2. You can opt for hybrid annuity which combines a life annuity with a period certain annuity.
    • This is called an Income for Life with a Guaranteed Period Certain Benefit annuity (also referred to as “life with period certain”).
    • In this case, the period certain phase refers to the specific time frame during which your beneficiary will get the remainder of payments if you die.

  3. Add a Death Benefit provision or rider to your annuity contract which allows you to name a beneficiary for the remaining amount.

Period Certain

The choice of a period certain or income for a guaranteed period annuity allows you to decide when and how long to receive payments.

  • In some cases, you may be trying to base the decision on how long you think you will live.
  • The duration of this time frame will determine the monthly payment amount.
    • The typical choices are 10, 15, or 20 years.
    • The limited payout duration results in higher monthly payments than the life option.

The period certain option does not protect you from outliving your assets, if you do not have other assets to rely on once this happens. It may be the most useful if you use the annuity to fill the gap until another retirement income source matures.

This option has the risk of the company holding your annuity getting the remainder of your annuity if you die before the period ends, unless you have named beneficiaries to receive the payments until the end of the period.

Systematic Withdrawal Schedule

The systematic withdrawal schedule allows you to get payments from your annuity account in the amounts and with the payment frequency that you specify, until your account is emptied. As opposed to the period certain option, it is the payment that determines the duration of the payments.

Like the period certain option the monthly payouts are higher and you may be:

  • Trying to base the decision on how long you think you will live;
  • Using the annuity to fill the gap until another retirement income source matures; and/or
  • Running the risk of outliving your assets. 

Although there is a risk of the company getting the remainder of your assets if you die before the account is empty, unlike the period certain payment option you may be able to increase your payment amounts, especially if you have an emergency. This may allow you to empty the account before your death.

Lump Sum

If you have been building up your annuity for retirement, there is the option of getting the entire annuity as a lump sum payment.

  • You would get less money than if you received payment over time which would have included interest and capital gains. However, you could consider doing this if you think you can get a higher return on a different investment or develop a terminal illness and need the money.
  • You would pay income tax on the payment based on the nature of the annuity, qualified or non-qualified.
  • You would not have surrender fees if you did this after you are able to withdraw from the annuity, usually after reaching 59½ years old.

Amount of Withdrawal

Once you have decided to start your withdrawals and how long you want to get payments you must then figure out how much each payment amount will be. If you opted for specific withdrawal amounts, you would need to figure out how long you would be getting payments.

The company’s actuaries calculate your annual and taxable annual payment amount according to a complex formula that includes the duration of payment, payment amount choice (either as fixed or variable payments), the current dollar value of the account, your current age (the longer you wait before taking an income, the greater your monthly payments will be), the expected future inflation-adjusted returns from the account’s assets, and your life expectancy based on industry-standard life-expectancy tables.

Taxable Income Portion of Annuity Payment = Annual Payment – (Excludable Amount + Gain Amount)
Where:
Annual Payment = FMV of Property Transferred ÷ Present Value of Annuity Factor (1 – (1+r)-n/r:  r is the expected interest rate and n is the number of years until expected lifetime date)
Gain Amount = (FMV of Property – Property’s Basis [original cost of property]) ÷ Life Expectancy of Annuitant

Excludable Amount = Exclusion Ratio × Annual Payment

  • Exclusion Ratio = Sellers Cost Basis (difference between FMV and purchase price) ÷ Expected Return (IRC §72[b])
  • Expected Return of Annuity = Annual Payment × Life Expectancy

Spousal or other beneficiary provisions and riders are then factored into the equation. The more provisions and riders in the contract the more guarantees you have, the higher risk the insurance company will have, and the lower the annual payments.

This will be divided by the number of yearly payments. Most people choose to receive monthly payments, so the result would be divided by 12.

Annuities are available as fixed, indexed, or variable products. Each has a different risk associated with it, so choose the one that you are comfortable with. For indexed and variable payments, the amounts will be adjusted yearly based on the performance of the annuities investments.

Fixed Withdrawals

A fixed annuity payment is where you receive either a lump sum of money or the same amount for the remainder of the term of the annuity, whether you opt for the life option or period certain method. This fixed payment is based on the interest rate guaranteed at the time of purchase.

Fixed withdrawals provide a predictable source of retirement income during the terms of the policy.

  • You will receive that amount whether or not the company holding your annuity earns enough return on its own investments to support that amount. The risk is on the company, not you.
  • One drawback of a fixed payment is that if the investment markets do better than predicted, the company holding your annuity company, not you, will get the extra profits.
  • Another drawback is the lack of keeping pace with inflation. Your payment will lose spending power year after year as the cost of living increases. This would be especially difficult in a period of serious inflation.

As insurance products, your state’s department of insurance has jurisdiction over fixed annuities. Advisors have a license to sell fixed annuities, so make sure yours does. You can find contact information for your state’s insurance department on the National Association of Insurance Commissioners website.

Fixed-Indexed Withdrawals

Indexed annuity payments, also called equity-indexed or fixed-indexed annuities, are a form of fixed annuity but include the chance of a higher payment if the investment/stock markets indices, such as the S&P 500 do much better than predicted. You are guaranteed a minimum payment which will be higher if the annuity does very well, although there is a maximum payment. You are not at risk if the annuity does poorly, but the baseline amount may be lower.

Variable Withdrawals

A variable annuity is the riskiest choice for payments in that they will vary over time with the success of the annuity’s investments. As the value of a variable annuity grows or shrinks over time, so does the payment. The money could even be reinvested rather than used for payments in a given year. Some companies offer a guaranteed minimum income benefit option.

Transferring Annuity Funds

It may be possible to transfer your funds between annuities if you feel the need. There may be many reasons for this.

  • A new annuity can have a higher interest rate, lower fees, better investment options, or more features, such as an enhanced death benefit or guaranteed minimum income.
  • The annuity company may no longer be financially strong and you have a variable or indexed payment or are just concerned the company will fold and you will lose everything.

With non-qualified annuities (funded by after-tax dollars), you can transfer the funds between different kinds of annuities, such as fixed and variable, without facing an early-withdrawal penalty. These exchanges are guaranteed by Section 1035 of the Internal Revenue Code and are known as 1035 exchanges.

With qualified annuities (funded by pre-tax dollars), you can transfer the funds between different kinds of annuities, such as fixed and variable, but the transfers are limited to funds in the annuity that are considered tax-deferred. These are your contributions to an IRA or 401K, not the earnings.

Inheriting Annuities

If desired, you may use your annuity as an inheritance tool. As mentioned above, you can name beneficiaries for annuities if you die before the end of the annuity period.

  • In many cases this has already been accounted for by making it a joint and survivor annuity where the payments remain the same until your surviving spouses death.
  • Even if you have not, most of the time the surviving spouse will be the beneficiary.
  • Beneficiaries may be your children or other family members that cannot be part of a joint annuity. 

The payment method may be determined by the company holding your annuity or they may offer your beneficiaries choices similar to yours when you first opened the annuity.

  • A lump-sum payment of the remaining value of the annuity to invest as your beneficiary sees fit. They will pay tax based on the nature of the annuity.
  • A stretch distribution payment option allows your beneficiary to take what is remaining in the annuity and make a non-qualified annuity and stretch the annuity payments out over the rest of their life.
    • Their life expectancy is used to calculate the minimum amount the beneficiary must withdraw each year.
    • They have the option of removing the remaining value at any point.
  • The five-year payment option gives your beneficiary up to five years to withdraw the rest of the annuity contract. This can be done with a combination of smaller incremental payments and one final, lump-sum payment at the end of the five years.
  • The spousal distribution payments makes your surviving spouse the new annuity owner. The payout amount and frequency are the same as they were when you established the annuity.
  • The annuitized payment option must be selected within 60 days.
    • You elect to have the annuity paid out over time, but you set the conditions to fit your preferences or needs.
    • Once the schedule is chosen, you can’t change it.

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