Market Recovery Program
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Appendix E
Annuity features, in general
The focus of this book is the market recovery program. Although part of that mandate includes a discussion and description of tax-deferred annuities, they have purposely not been given as thorough a treatment as the subject warrants.
Annuities deserve a book of their own and, indeed, there are many available. Although the reader is encouraged to peruse them, here is a summary of some of the benefits of annuities in general. Again, as counseled previously, if the reader is interested in purchasing and including an annuity as part of his investment portfolio he is advised to seek the counsel and advise of a licensed insurance agent.
Qualified and non-qualified
Annuities can be qualified or non-qualified.
Qualified annuities are held in qualified retirement accounts such as a 401(k), I.R.A., or 403(b).
Non-qualified annuities are purchased outside of qualified retirement accounts and are paid for with after-tax dollars.
Tax-deferral
Whether qualified or non-qualified, all annuities grow tax-deferred. That is, no taxation occurs until distribution (i.e. withdrawal) occurs.
The full benefit of an annuity’s tax-deferral may be inherited upon death by a spouse who may continue the annuity ownership as if the original owner. Non-spouse beneficiaries do not have access to this feature, although some aspects of tax-deferral continue (see below under “Taxation“).
Taxation
Qualified annuities are taxed like any other investment within a qualified plan: upon distribution.
Non-qualified annuities are only taxed on that portion of the total value that is more than the sum-total of the premiums paid into the annuity. This is because investments (i.e. premiums) in non-qualified annuities come from after-tax dollars. There is no requirement to distribute at any time from a non-qualified annuity.
Distribution for the purposes of taxation on non-qualified annuities is on the LIFO basis: Last In, First Out. That is, the portion of the annuity that represents growth or interest, which is taxable, is considered to be distributed (i.e., withdrawn) first. There is no income tax on distributions that represent the funds originally invested which come out last.
Depending upon the size of one’s estate at death, there may be estate tax on the entire value of an annuity.
Although there are exceptions, there is a 10% tax penalty for withdrawals prior to age 59 ½.
There are separate rules for non-spouse beneficiaries regarding the time frame for liquidating an inherited annuity. Generally speaking, non-spouse beneficiaries have two options:
1) Commit to an irrevocable lifetime annuity based upon the life expectancy of the beneficiary; or
2) Withdraw the amount within 5 years of December 31st of the year of the owner’s death.
Surrender charges
Annuities usually carry surrender charges for withdrawals over the allowed amount.
Surrender charges usually are highest in the beginning years and decline over the course of the contract, by year. There is usually a sliding scale for each contract year that provides for a percentage that will be held back and forfeited.
As a general rule, the owner can take up to 10% of an annuity’s value penalty-free each year.
Surrender charges may be increased or decreased by a Market Value Adjustment (MVA). There is an inverse relationship between interest rates and bonds: as interest rates increase, the price of bonds decrease; and vice-versa. Because insurance companies invest much of the funds they receive from annuity purchases in bonds, premature surrender of annuities may require the insurance company to sell bonds that they had invested in with the money they received from the purchaser of the annuity in order to provide the funds to pay out. This may incur a loss (or, possibly, a gain) from that sale if interest rates changed significantly from the time the annuity was purchased. If there is an MVA it would then either increase or decrease surrender charges.
Taxation of Social Security benefits
Social Security benefits are taxed according to a formula that includes income from various sources: the more income in a given taxation year, the more of the benefits that are taxed. The formula includes distributions from annuities but doesn’t include tax-deferred growth in either qualified or non-qualified annuities.
This can be a tax saving for individuals that are using funds to purchase non-qualified annuities from sources that generate income which is included in the formula. For example, interest on Certificates of Deposit (CDs) is taxable in the year earned regardless of whether the owner uses that interest or not and this interest income is included in the Social Security formula. If one were to use the funds from a CD for the purchase of an annuity, the interest earned that would otherwise have been taxed and included in the formula will not be once the funds are transferred out of the CD and in the annuity.
Safety and guarantees
There are various legislated and insurance industry protections for funds invested with insurance companies. And, as previously discussed, regulation often requires state departments of insurance approval before an insurance company may use written or oral language such as “guarantee” before doing so. Consult your local insurance agent as to the particulars.
Probate
Proceeds from an annuity to a beneficiary upon death is usually protected from probate, an often difficult and expensive process.
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