The material presented may contain concepts that have legal, accounting and tax implications. It is not intended to provide legal, accounting or tax advice, you may wish to consult a competent attorney, tax advisor, or accountant.
Note: Any reference to the word guarantee is based on the claims paying ability of the underlying insurance company.
An annuity is a contract issued by an insurance company. It is a unique financial product that provides tax deferral of interest and capital gains and the option (if funds are annuitized) of a guaranteed monthly income for life. Although annuities can serve various needs, the primary purpose of an annuity is that of a retirement vehicle for the annuitant, the person who will usually receive the annuity benefits. The annuity is an attractive retirement vehicle because the money accumulating in an annuity, grows on a tax deferred basis. There are two parts to an annuity: the accumulation phase and the distribution phase.
After accumulating money in an annuity it is not mandatory that the annuitant exercise the annuitization option and relinquish control of his or her cash value and enter into the annuity distribution phase, the annuitant can simply cash out of his or her annuity.
The Accumulation Phase
- During the accumulation phase, the fund grows tax deferred, it does not grow tax free. If the annuity was not purchased as part of a qualified retirement program such as an IRA, 401(k), TSA, or 457 plan, income taxes are paid on the earnings when money is ultimately paid out. If the annuity is part of a qualified plan the entire fund is subject to income taxes as it is withdrawn.
- Surrender charges for early withdrawals.
- If you withdraw money from your annuity before age 59 ½ it is called a "premature distribution" and is subject to an additional 10% IRS penalty.
- If a premature death should occur, the accumulated funds within the annuity are transferred to the named beneficiary, avoiding probate costs.
- Annuities can vary by payment mode and are available as "single premium" (purchased with one-time payment) or "flexible premium" (purchased with recurring periodic payments). They also vary by timing of the annuity income and may be available as a "deferred annuity" (which means that annuity income payments are deferred until later) or as an "immediate annuity"(which means that annuity income starts immediately).
- For fixed and indexed annuities there is safety of principal and earnings.
- Variable products are subject to mortality and expense charges and administrative fees not typically found with other investments.
- Fixed annuities
- Variable annuities
- Indexed annuities
In a fixed annuity, the insurance carrier:
- Declares a current rate of interest for a specified time period. Once the time expires the company will set a new rate which may be higher or lower than the original rate.
- Guarantees a minimum interest rate of return which is specified in the contract, and at no time may the current or renewal interest rate fall below it.
- Guarantees the principal.
A variable annuity has two types of accounts:
In a fixed account, principal and interest are guaranteed by the insurance company. Interest rates are usually guaranteed for one year but can be longer.
In a variable account, the annuity owner bears the investment risk. Policy values vary directly with market performance and may result in a loss of principal and prior earnings. Earnings are tied directly to the performance of various underlying investment vehicles which are available within the variable annuity and are selected by the owner.
Note: Variable annuities are sold by prospectus. You should consider the investment objectives, risk, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity or from your financial professional. You should read the prospectus carefully before you invest.
An Indexed Annuity has interest rates that are linked to growth in the equity market as measured by an index such as the S&P 500. The FIA owner enjoys the upside potential of equities but is not exposed to downside risk if the annuity is held to term. Subject to fixed minimum guarantees, the value of an FIA can only increase due to market growth ‐ it will never decline due to market movement. There are many variations in product design. No two of the FIAs are exactly alike, and some are very different from each other. However, all the various types fall into three general categories: annual reset, point-to-point, and annual high-water mark with look-back. The following is a simple definition of each. Please call us if you would like to know more.
Annual Reset - Also known as the annual ratchet design, the annual reset design resets the starting index point annually. It also credits index increases (interest) annually and compounds annually.
Point-to-Point - The point-to-point design measures the change in the index from the start of the term to the end of the term.
Annual High-Water Mark with Look-Back - The annual high-water mark with look-back can be viewed as a variation on the point-to-point design, except that it measures the index from the start of the term to the highest anniversary value over the term.
* Some annuities allow the insurance company to change participation rates, cap rates or spread/asset/margin fees either annual or at the start of the next contract term. If an insurance company subsequently lowers the participation rate or cap rate or increases the fees, this could adversely affect an investor's return. Therefore, a prospective investor must carefully review his or her contract in order to examine these issues.
- Withdrawals may be made at any time. However, the withdrawal may be subject surrender charges and if done before age 59 ½ there will be a 10% IRS penalty. Some contracts allow an annual 10% withdrawal free of surrender charges.
- The owner may pre-authorize a systematic periodic withdrawal plan. The owner of the contract instructs the company to withdraw a percentage or a level dollar amount from the contract on a monthly, quarterly, semiannual, or annual basis.
The Distribution Phase
As part of the distribution phase, the owner has two options, he or she can withdraw money (either in a lump sum or elect a systematic withdrawal plan) or annuitize (purchase an annuity pay out plan).
When the owner annuitizes the funds he or she purchases an annuity pay out plan. In a Fixed and in an Indexed Annuity the owner purchases a monthly income that will be paid to him or her until death. It is a guaranteed income that will not change. In a variable annuity, the owner has an option to do the same or transfer all or part of the contract to one or more of the sub-accounts that are available, and annuitize those funds. The funds that are annuitized in the separate accounts produce an income that will change from month to month based on the performance of the sub-account that the funds are placed in.
Annuity Pay Out Plans
Life Only - Periodic monthly payments to an annuitant for the duration of his or her lifetime and then ceases. It is for a lifetime, the annuitant cannot outlive the payments. The payments are determined at the time of purchase and are based on age and sex.
Life with 10 years certain - Payments will be made for at least ten years, regardless if the annuitant lives for the entire ten years. If the annuitant dies during the ten-year period the remainder of the ten-year payments will be made to a beneficiary. If the annuitant lives longer than ten years he or she will continue to receive payments for his or her lifetime. The guaranteed monthly payments will be less than "life only."
Life with 20 years certain - Payments will be made for at least twenty years, regardless if the annuitant lives for the entire twenty years. If the annuitant dies during the twenty-year period the remainder of the twenty-year payments will be made to a beneficiary. If the annuitant lives longer than twenty years he or she will continue to receive payments for his or her lifetime. The guaranteed monthly payments will be less than "life only", and "Life with 10 years certain."