Advisor's Guide to Annuities, 5th Edition

By John L. Olsen

Written in plain English, the latest updated, revised, and expanded edition of The Advisor’s Guide to Annuities covers both the technical details of how various types of annuities operate, as well as the broader questions about how and when they should be used in clients’ financial plans. No other resource provides such a deep and independent-minded look at the structure, costs, benefits, and risks that come with all types of annuities. This comprehensive, single-volume guide supplies: - Clear and concise descriptions of every type of annuity - In-depth discussions of the direct and secondary issues surrounding the use of annuities, including income and estate tax consequences as well as concerns for annuity owners and beneficiaries - Detailed explanations of annuity-specific terminology, which empowers advisors and clients to understand exactly how an annuity will function and enables comparison of similar products from different companies - Sound advice from industry-leading authors which helps advisors avoid common mistakes and ensures that the choices offered are truly in the best interests of clients Highlights of the 5th Edition: - Detailed discussion of qualified vs. nonqualified annuities - Exploration of planning opportunities presented by Deferred Income Annuities (DIAs) or “longevity annuities” and QLACs - In-depth discussion about the impact of the DOL Fiduciary Rule on advisors and consumers - Advice and analysis of the impact of partial withdrawals - Updated tax info, including info on QLACs - New material on “managed volatility” indices used in indexed annuities - New ways to use variable annuities as an investment vehicle, including new “fee only” variable annuities that can be sold under the Fiduciary Rule. Written by two of the foremost experts in this field, The Advisor’s Guide to Annuities, 5th Edition, is designed specifically to help you make the most of all the opportunities—and avoid complications—in this active and ever-changing area .

• Language: English
• Publisher: The National Underwriter Company
• Release date: May 27, 2017
• ISBN: 9781945424540

Book preview

THE NATIONAL UNDERWRITER COMPANY

a division of ALM Media, LLC

THE ADVISOR’S GUIDE TO ANNUITIES, 5th EDITION

John L. Olsen, CLU®, ChFC®, AEP®

Michael E. Kitces, MSFS, MTAX, CFP®, CLU®, ChFC®, RHU, REBC, CASL

Written in plain English, the book you hold in your hands covers both the technical details of how various types of annuities operate, as well as the broader questions about how and when they should be used in clients’ financial plans. No other resource provides such a deep and independent-minded look at the structure, costs, benefits, and risks that come with all types of annuities.

The fully updated 5th Edition of The Advisor’s Guide to Annuities includes:

•    Clear and concise descriptions of every type of annuity

•    In-depth discussions of the direct and secondary issues surrounding the use of annuities, including income and estate tax consequences as well as concerns for annuity owners and beneficiaries

•    Detailed explanations of annuity-specific terminology, which empowers advisors and clients to understand exactly how an annuity will function and compare similar products from different companies

•    Sound advice from industry-leading authors, which helps advisors avoid common mistakes and ensures that the choices offered are truly in the best interests of clients

Highlights of the 5th Edition

•    Detailed discussion of qualified vs. nonqualified annuities

•    Exploration of planning opportunities presented by Deferred Income Annuities (DIAs), or longevity annuities, and QLACs

•    In-depth discussion about the impact of the DOL Fiduciary Rule on advisors and consumers

•    Advice and analysis of the impact of partial withdrawals

•    Updated tax info, including info on QLACs

•    New material on managed volatility indices used in indexed annuities

•    New ways to use variable annuities as an investment vehicle, including new fee only variable annuities that can be sold under the Fiduciary Rule

Written by two of the foremost experts in this field, The Advisor’s Guide to Annuities, 5th Edition, is designed specifically to help you make the most of all the opportunities—and avoid the pitfalls—in this active and ever-changing area.

To place additional orders for The Advisor’s Guide to Annuities, 5th Edition, or any of our products, or for additional information, contact Customer Service at 1-800-543-0874.

Related Titles Also Available:

•    Tax Facts on Investments

•    Tax Facts on Insurance & Employee Benefits

•    Tax Facts on Individuals & Small Business

•    The Tools & Techniques of Trust Planning

•    The Tools & Techniques of Estate Planning

•    The Tools & Techniques of Estate Planning for Modern Families

•    The Tools & Techniques of Financial Planning

•    The Tools & Techniques of Life Insurance Planning

•    The Tools & Techniques of Income Tax Planning

•    The Investment Advisor’s Compliance Guide

•    The Advisor’s Guide to the DOL Fiduciary Rule

•    Social Security & Medicare Facts

•    Field Guide: Estate & Retirement Planning, Business Planning & Employee Benefits

•    Facilitating Financial Health

5th Edition

The Advisor’s Guide to Annuities

John L. Olsen, CLU®, ChFC®, AEP®

Michael E. Kitces, MSFS, MTAX, CFP®, CLU®

The Advisor’s Guide Series

ISBN 978-1-945424-54-0

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. – From a Declaration of Principles jointly adapted by a Committee of The American Bar Association and a Committee of Publishers and Associations.

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Dedications

John L. Olsen

To Katherine, who continues, even after 44 years, to put up with more than she should. Without her unflagging support, I could not have written even one book.

Michael E. Kitces

To my friends and family, and especially my wife Ellie, for their understanding, patience, and support while I pursue my passion for financial planning.

Acknowledgments

Any book, even one by a single author, is invariably the product of many minds. The authors have been blessed by the willingness of friends and colleagues to share their insights with us and our readers. We wish to acknowledge the help of Jack Marrion, Steve Leimberg, Wade Pfau, Ben Baldwin, Gary Mettler, Jay Adkisson, Tom Hegna, Stan Haithcock, Sheryl Moore, and Moshe Milevsky. Our very special thanks to Jim Dobler and the folks at Cannex and Curtis Cloke and the folks at the Thrive Income Distribution System for giving us access to their superb tools and for their much-appreciated advice. We’d also like to thank Kelly Maheu of National Underwriter Company for her willingness to support another edition of this book.

John L. Olsen, CLU, ChFC, AEP

Michael J. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL

About the Authors

John L. Olsen, CLU, ChFC, AEP, is a financial and estate planner practicing in St. Louis County, MO. John has been involved in the financial services industry since 1973. In addition to providing insurance and estate planning services to his own clients, John works with other advisors on advanced cases and product selection. In 2016, John established Olsen Annuity Education, a fee-only firm offering education, training, consulting services, and expert witness services relating to annuities.

John is a past president of the St. Louis chapter of the National Association of Insurance and Financial Advisors, past president of and the Estate Planning Council of St. Louis, a former Board member of the St. Louis chapter of the Society of Financial Services Professionals, and a member of the Editorial Advisory Board of Tax Facts. He is a highly sought-after speaker, having given presentations on financial, insurance, retirement, and estate planning and other topics to many industry groups. John can be reached at:

Olsen Annuity Education

www.olsenannuityeducation.com

131 Hollywood Lane

Kirkwood, MO 63122

[phone]

[e-mail]

Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, is Director of Wealth Management for Pinnacle Advisory Group, a private wealth management firm located in Columbia, Maryland. In addition he is the co-founder of the XY Planning Network and New Planner Recruiting, the former practitioner editor of the Journal of Finanical Planning, the host of the Financial Advisor Success podcast, and the publisher of the leading finanical planning industry blog Nerd’s Eye View through his website Kitces.com, dedicated to advancing knowledge in financial planning.

Michael is extremely active at both the local and national level in the financial planning profession, serving on numerous boards and task forces. He is also a member of the Editorial Review Board for the Journal of Financial Planning, a commentator on retirement distribution and retirement planning issues for Leimberg Information Services Inc., and a co-founder of NexGen, a community of the next generation of financial planners that aims to ensure the transference of wisdom, tradition, and integrity, from the pioneers of financial planning to the next generation of the profession. For his active work in the profession, Michael was one of the 2010 recipients of the Financial Planning Association’s Heart of Financial Planning awards for his dedication to advancing the financial planning profession. In addition, he has variously been recognized as financial planning’s Deep Thinker, a Legacy Builder, anInfluencer,aMover & Shaker, and a Rising Star in Wealth Management by industry publications.

Michael welcomes your questions, comments, or inquiries at:

Michael Kitces

PO Box 2231 Reston, VA 20195

[phone]

[e-mail]

About the Publisher

Kelly B. Maheu, J.D., is Vice President in charge of the Practical Insights Division of ALM Media, which produces National Underwriter’s professional publications. Kelly has been with National Underwriter since 2006, and has served as the Managing Director of National Underwriter’s Professional Publishing Division as well as performing editorial, content acquisition, and product development roles.

Prior to joining The National Underwriter Company, Kelly worked in the legal and insurance fields for LexisNexis®, Progressive Insurance, and a Cincinnati insurance defense litigation firm.

Kelly has edited and contributed to numerous books and publications including the Personal Auto Insurance Policy Coverage Guide, Cyberliability and Insurance, The National Underwriter Sales Essentials Series, and The Tools & Techniques of Risk Management for Financial Planners.

Kelly earned her law degree from The University of Cincinnati College of Law and holds a BA from Miami University, Ohio, with a double major in English/Journalism and Psychology.

About the Editor

Jason Gilbert, J.D., M.A., is an assistant editor with the Practical Insights Division of The National Underwriter Company, a division of ALM Media, LLC. He edits and develops publications related to tax and insurance products, including titles in the Advisor’s Guide and the Tools & Techniques series of investment and planning products. He also develops content for National Underwriter’s other financial services publications and online products. He has worked on insurance and tax publications for more than nine years.

Jason has been a practicing attorney for more than a dozen years in the areas of criminal defense, products liability, and regulatory enforcement actions. Prior to joining National Underwriter, his experience in the insurance and tax fields has included work as a Westlaw contributor for Thomson Reuters and a tax advisor and social media contributor for Intuit. He is an honors graduate from Wright State University and holds a J.D. from the University of Cincinnati College of Law as well as a master’s degree in Economics from Miami University in Ohio.

Editorial Services

Connie L. Jump, Manager, Editorial Operations.

Emily Brunner, Editorial Assistant.

Table of Contents

Chapter 1: Basics of Annuities

Chapter 2: Taking Money from an Annuity Contract: Distributions As an Annuity

Chapter 3: Taking Money from an Annuity Contract Using Withdrawals

Chapter 4: Optional Benefits in Variable and Fixed Index Annuities

Chapter 5: Taxation of Annuity Benefits During Owner’s Lifetime

Chapter 6: Taxation of Annuity Death Benefits

Chapter 7: Basic Costs of Annuities

Chapter 8: Fixed Index Annuities

Chapter 9: Deferred Income Annuities (Longevity Annuities)

Chapter 10: Exploring the Benefits and Challenges of Immediate Annuitization

Chapter 11: The Variable Annuity as an Investment

Chapter 12: Annuities and Trusts

Chapter 13: Annuities in Estate Planning

Chapter 14: The Great Annuity Debate: Are Annuities Good or Bad?

Chapter 15: Recent Developments and Trends in the Annuity Landscape

Chapter 16: Summary: The Annuity as a Planning Tool

Chapter 17: Annuities in a Fiduciary Future

Appendix A: Actuarial Tables for Taxing Annuities

Appendix B: Examples of Exclusion Ratio Calculations

Appendix C: Internal Revenue Code Sections

Appendix D: FINRA RULE 2330 for Recommended Purchases of Exchanges of Deferred Variable Annuities

Appendix E: Iowa Insurance Bulletin 11-4

Index

Basics of Annuities

What is an Annuity?

The term annuity simply means a series of regular payments over time, in which the principal (the amount invested) and earnings (interest) are both amortized over the payout period. However, when most people use the term annuity, they’re referring, not to that stream of income, but to a contract or policy, issued by an insurance company, providing for payment of that stream of income—by the annuity issuer (an insurance company) to the owner, over a specified period or for the life of an annuitant (see Parties to the Annuity Contract below). These contracts, called commercial annuities¹, are what we will be talking about throughout this book.

Types of Annuity Contracts

Classifying things into types is always a tricky business. Consider a red Chevrolet Corvette. What is it? Well, that depends upon the type or types of classifications we’re using. It’s a motor vehicle. But what kind of motor vehicle? Well, it has four wheels, so that we can use that classification to make clear that it’s not a motorcycle (which uses two or three wheels). It’s also a car (as opposed to a truck). And a kind of car called a sports car as opposed to, say, a station wagon. (Are there still station wagons?) And this one is red, so it’s not blue or black or some other color.

The problem with assigning only one category to anything is that readers sometimes think that this fully describes that thing. But it never does. The car in question is a car and a sports car and red and a Chevrolet (it’s not a Ford or any kind of foreign car) … We mention this because annuities are complex because there are several different types and subtypes, designed to do very different things. Understanding that any one annuity contract may be described accurately by several different lables is essential to an understanding of how it works. So, let’s get started.

It is possible to divide all annuity contracts into different types using four different parameters:

1.    How is the annuity purchased?

2.    When do regular annuity payments are commence?

3.    How are contract values and premiums invested?

4.    How is the contract taxed?

1. How is the Annuity Purchased?

Using this parameter, there are two kinds of annuity contracts: (1) Single Premium, and (2) Flexible Premium.

A single premium annuity² is a contract purchased with a single payment, or premium. No further premiums are required, or even allowable. By contrast, a flexible premium annuity is purchased with an initial payment (to establish the contract) and allows for a series of premiums that may be paid whenever, and in whatever amount, the purchaser wishes, subject to policy minimums and maximums.

There is very little difference, if any, in the important policy provisions, guarantees, and payout options of the two types, and their tax treatment is identical. The significant distinction is simply that in some instances, contracts offered as single premium do not allow additional contributions under the original contract’s terms—instead, additional money must be deposited to a new annuity contract.

2. When do Regular Annuity Payments Commence?

Using this parameter, there are three kinds of annuity contracts: (1) the Immediate Annuity, (2) the Deferred Annuity, and (3) the Deferred Income Annuity (DIA), sometimes called the Longevity Annuity.

The Immediate Annuity

An immediate annuity is one in which regular income (annuity) payments must be made to the owner³ commencing within one year of purchase. Other labels sometimes used to describe an immediate annuity are payout annuity or income annuity.

•    Immediate annuities are always purchased with a single premium.

•    Immediate annuities have only one phase—the payout (or annuity) phase. There is no accumulation phase. Immediate annuities are all about income.

•    The duration of annuity payments will depend upon the annuity payout option chosen. In the next chapter, we’ll look at those options in detail.

A question often asked by those considering purchase of an immediate annuity is "Can I get at the rest of my money (the excess of the premium paid, over the regular annuity payment) if I need it? The answer is generally NO". This is because the purchase of an immediate annuity amounts to an irrevocable exchange of the single premium for a stream of income which will persist for the entire payout period chosen. There is no rest of my money because the premium was exchanged for that annuity income. Once annuity payments begin, many contracts allow for no commutation or changes.

That said, some newer contracts allow for some modifications after income payments begin. For example, a contract may permit the owner to accelerate future annuity payments by taking a larger than usual payment (extra cash for an emergency, for example), with the understanding that future annuity payments will all be reduced. Often, this option is available only for a limited period following the annuity starting date. A few contracts allow the owner to undo the annuity by taking a lump sum in lieu of all future payments.

The Deferred Annuity

A deferred annuity is one in which annuity payments may be deferred until later than one year after purchase—perhaps much later. The life of a deferred annuity is divided into two phases:

1.    The accumulation phase. This is the period extending from purchase of the contract until annuitization. Annuitization is the exercise by the owner of a contractual option to receive regular annuity payments, in accordance with an annuity payout option (see the section entitled Types of Annuity Payouts). Deferred annuity contracts typically require annuitization by some specified date or age by specifying a maximum Annuity Starting Date (ASD) or Maturity Date (e.g., policy anniversary following annuitant’s age eighty-five, or annuitant’s age eighty-five). Newer contracts may permit further deferral of annuitization provided the request is received within a specified period of time prior to the maturity date.⁴

2.    The distribution phase. This is the period from annuitization until the annuity payments cease which may be at the end of the annuitant’s life or after a specified number of years (see the section entitled Types of Annuity Payouts).

Note: It is essential that the advisor understand the difference between an annuity contract’s Maturity Date, which is the maximum Annuity Starting Date (i.e., the date by which annuity payments must commence, absent an election to defer annuitization), and when annuitization is permitted under that contract. In January, 2005, a class-action lawsuit was filed alleging unsuitability, asserting that the deferred annuity purchased by a senior citizen allegedly did not permit annuity payments to begin until the annuitant’s age was 115. However, it appears that age 115 was the contract’s Maturity Date, and annuity payments under the contract could have started at any time the owner wished to annuitize. In fact, a late maturity date is a benefit, allowing an owner to keep the contract in the accumulation phase as long as possible, if that is his/her wish.

As we have noted, there is no accumulation phase in the life of an immediate annuity, as annuity payments typically commence shortly after purchase, and must, by definition, commence within one year. Annuities that are in distribution phase (i.e. deferred annuities that have been annuitized and all immediate annuities) are said to be in payout status.

The Deferred Income Annuity (DIA)—the Longevity Annuity

A third type of annuity (using the parameter of when annuity payments begin), often called a longevity annuity, first appeared in the marketplace in 2007. It is similar to an immediate annuity in that it provides only for income (usually for life); there is no accumulation period. Unlike an immediate annuity, the longevity annuity income does not commence within one year of purchase; rather, it is deferred on until a future date, which is typically an advanced age such as age eighty-five. See Chapter 9 for a detailed discussion of longevity annuities.

Chart of Annuity Types

The chart below shows the types of annuities organized in terms of when income may or must commence.

3. How are the Contract Value and Premiums Invested?

Using this parameter, there are two types of annuity contracts: (1) Fixed, and (2) Variable.

Fixed Annuities

A fixed annuity (either Immediate, Deferred, or Deferred Income) is an annuity in which the contract value is measured in dollars. A variable annuity (either Immediate or Deferred) is one in which the contract value is measured in terms of units—either accumulation units or annuity units, depending upon whether the contract is in the accumulation phase or the distribution phase. The value of both units can, and probably will, vary each business day, according to the investment performance of the separate accounts⁵ chosen by the contract owner. We will look at how accumulation units and annuity units work shortly. First, however, let’s understand the basic investment difference between fixed and variable annuities.

There are three types of fixed annuities: (1) Fixed Immediate Annuities, (2) Fixed Deferred Annuities, and (3) Fixed Deferred Income (or Longevity) Annuities.

The Fixed Immediate Annuity

The Fixed Immediate Annuity provides for a stream of income of a known amount. This amount will either remain level or will increase in accordance with a cost of living adjustment if that option was chosen at purchase. The annuity payout options are described at length in the next chapter.

The Fixed Deferred Annuity

There are two types of fixed deferred annuities: (1) The Fixed Declared Rate Deferred Annuity, and (2) the Fixed Indexed Deferred Annuity (or Fixed Index Annuity).

The Fixed Declared Rate Deferred Annuity

The Fixed Declared Rate Deferred Annuity is sometimes referred to imprecisely as the fixed deferred annuity, because this type of fixed deferred annuity has been around for a very long time (whereas index annuities emerged only in the late 1990s). How it operates can be seen from its name. It’s a fixed annuity (valued in fixed units—dollars—rather than in variable units that can change value over time. It’s a deferred annuity, so annuity payments need not commence in the first year. And declared rate tells us how the interest will be credited. The issuing insurer will declare periodically, usually each year, what the interest rate will be for that contract for the next interest rate crediting period (usually one year).

Almost all fixed declared rate deferred annuities offer both a guaranteed minimum interest rate (guaranteed for the life of the contract) and a current interest rate, which is the rate declared periodically, never to be below that guaranteed rate.

Some declared rate fixed annuities guarantee the current rate for more than one year. These Multiyear Guarantee Annuities (MYGAs) typically have surrender charge periods equal to the interest rate guarantee period, so that at the end of the interest rate guarantee, the buyer may surrender the contract without charge, or renew it at whatever the renewal interest rate is for the next period.

The Fixed Index Annuity

The Fixed Index Annuity (sometimes called the Equity Index Annuity) is a fixed deferred contract (so it’s valued in dollars, not variable units and annuitization may be deferred) in which credited interest is calculated by reference to (or linked to) an external equity index, such as the S&P500® (although newer contracts offer interest linking to other indices, such as the NASDAQ®, Dow-Jones Industrial Average®, or other stock or bond indices). Index annuities are discussed in detail in Chapter 8.

The Fixed Deferred Income Annuity

The fixed deferred income annuity (or longevity annuity) is discussed at length in Chapter 9.

It is essential for the advisor to understand that the guarantees in fixed annuities are only as good as the ability of the issuing insurer to pay them.

Variable Annuities

There are two kinds of variable annuities: (a) Immediate, and (b) Deferred.

The Immediate Variable Annuity

An immediate variable annuity, like its fixed cousin, must begin payouts within one year of purchase. The duration of payouts depends upon the payout option chosen (see the next chapter for details on how these options work). The amount of each year’s payments will vary, however, with the investment performance of the subaccounts chosen. These work just like the subaccounts in variable deferred annuities and are, with most insurers, the same ones. The variation in annual payments and the amount of the first payment is described in The Accumulation Phase in the next section.

The Deferred Variable Annuity

Like the deferred fixed annuity, this contract has two phases.

The Accumulation Phase

In the accumulation phase of a variable deferred annuity,⁶ each premium payment purchases, after applicable contract charges are deducted, a number of accumulation units for each investment subaccount chosen by the contract holder.

Example: Mr. Jones has chosen five investment subaccounts from among those available in his variable deferred annuity. He has directed that each premium payment⁷ be allocated to these accounts as follows:

The accumulation unit values of these accounts on the day his premium is received are set forth in the table below, along with the changes in the subaccounts that will coccur when Mr. Jones makes a premium payment of $1,000 with $14 in applicable contract charges.⁸

Accumulation unit values can, and often will, change each day according to the investment performance of the subaccounts, just as the net asset value of a mutual fund share does. However, there is a significant difference between the pricing of annuity accumulation units and that of mutual fund shares. When a mutual fund declares a dividend or capital gains distribution—through the realization of dividends or capital gains income by the fund—and the shareholder has elected to reinvest such distributions, additional shares are purchased for his account, and the price of all shares of the fund is reduced to reflect the distribution. If the shareholder has elected not to reinvest such distributions, he receives cash, and the share price is reduced. By contrast, when a dividend or capital gain is realized by a variable annuity subaccount, the value of the accumulation unit is increased reflecting the dividend or gain received, but the number of units remains the same.

Investment Subaccounts

One of the main advantages of investing in a variable annuity is the access it provides to diversified investment types. The first variable annuities offered relatively few investment choices, and the choices were often limited to proprietary accounts; that is, accounts managed by the insurance company that issued the annuity, or a subsidiary. Newer contracts, by contrast, offer subaccounts representing a wide variety of asset classes,⁹ managed by a variety of money management firms. Typically, the contract owner is permitted to choose several subaccounts,¹⁰ and to make exchanges among them, reallocating existing contract values, and to reallocate ongoing contributions without charge.¹¹ Moreover, exchanges among subaccounts in a single contract are not taxable events for income tax purposes. These investment management features, together with features such as automatic portfolio rebalancing and dollar cost averaging from the annuity contract’s fixed account¹² to the variable subaccounts, make the modern variable annuity a robust and powerful investment management tool.

The Distribution Phase

In the distribution phase, fixed annuities—either immediate contracts or deferred contracts that have been annuitized—provide a regular income by application of a chosen annuity payout factor to the amount that is converted to an income stream. For example, if Mr. Smith purchases a fixed immediate annuity for $100,000 or annuitizes a fixed deferred annuity having an annuity value of that same amount, and if he elects a Life & 10 Year Certain payout arrangement, and if the annual annuity payout factor for that option, for his age and sex, is 5.67, his annuity payments will be $5,670 per year from that point until the later of his death or the expiration of ten years. Similarly, if he elects to annuitize a variable deferred annuity on a fixed annuity payout arrangement¹³, and if the total value of the accumulation units in his contract, at the time of annuitization, is $100,000, he will receive that same income, assuming the same annuity payout factor.

If the annuity payout is to be on a variable basis, however, the amount annuitized (either a lump sum, in the case of an immediate variable annuity, or, in a deferred variable annuity, the current value of the accumulation units the owner wishes to annuitize¹⁴) is not converted to a fixed income stream by applying an annuity payout factor. Instead, the purchase payment or amount annuitized is used to buy a certain number of annuity units.¹⁵ The process works as follows:

•    First, the payment, or annuitization amount, is reduced by any contract fee applicable and by any state premium tax due, and allocated to the investment subaccounts chosen by the contract owner.

•    Next, the insurance company computes an initial income payment amount for that portion of the purchase payment or annuitization amount allocated to each subaccount, using (a) the age and sex¹⁶ of the annuitant and (b) an Assumed Investment Rate (AIR). Many variable annuity contracts allow the purchaser to choose among several AIRs (e.g., 3 percent, 4 percent, 5 percent, and 6 percent). The higher the initial AIR chosen, the higher the initial variable income payment will be.

•    Finally, the initial income payment is divided by the value of the annuity unit for each subaccount chosen. The result is the number of annuity units of that subaccount which will be purchased by that payment. Subsequent annuity payments will increase or decrease in proportion to the extent to which the net investment performance, after application of the separate account charges, of the chosen variable subaccounts exceeds or lags the AIR.

4. How is the Contract Taxed?

Using this parameter, there are two kinds of annuity contracts: qualified and nonqualified.

The first term refers to contracts that are purchased by employer-sponsored retirement programs such as a 401(k) plan. Contributions to and distributions from such plans are subject to special tax rules (which vary somewhat with the type of plan). Nonqualified annuity contracts, by contrast, are purchased with regular, nondeductible dollars outside of these retirement plans.

Actually, the first term (qualified annuity) is a bit of a misnomer. Strictly speaking, qualified plan refers only to employer-sponsored plans that qualifies for special tax treatment under Sec. 401 of the Internal Revenue Code. This includes 401(k) plans, of course, but it does not include IRAs, which are, by definition, individual plans. That said, many of the tax provisions governing qualified plans are similar or even identical to the rules governing IRAs. Contributions may be either deductible or nondeductible and distributions are subject to the rules set forth in Sec. 401(a)(9) of the Internal Revenue Code and the relevant Regulations.

In common usage, an annuity contract used to fund an IRA (either Traditional or Roth or a SEP-IRA) is called a qualified annuity and the money in it is called qualified money (as distinguished from the money in a nonqualified annuity (which is called nonqualified money).

Why are we bothering you with this rather muddy technicality? Because the tax treatment that applies to qualified annuities is governed by the rules of the type of plan (e.g., 401(k), IRA, etc.) and is not the same as the tax rules governing nonqualified annuities. In our discussion of annuity taxation, we will be focusing almost exclusively on the tax rules governing nonqualified contracts. The distribution rules governing an annuity contract held inside an IRA are almost always identical to those governing any other investment property held in that same type of IRA. The very few exceptions will be noted in the chapters on annuity taxation.

Parties to the Annuity Contract

There are four parties to a commercial annuity contract.

1.    The insurance company is the party that issues the policy, and is obligated to keep all the promises made in it. (Only insurance companies can issue annuity contracts).

2.    The annuitant is the individual—and it must be an individual, a human being—who may or may not also be the owner of the policy. The age and sex¹⁷ of the annuitant determine—for life annuities—the amount of each annuity payment. The annuitant is merely the measuring life for purposes of annuity payment calculations. He or she has NO rights in the annuity contract as annuitant.

3.    The beneficiary is the party who will receive any death benefit payable under the annuity, whether as a lump sum or by a continuation of annuity payments upon the death of the primary annuitant. However, not all annuities will have a beneficiary because if payments cease at the annuitant’s death, there is nothing for a beneficiary to receive. In most cases the beneficiary has no other rights, unless the beneficiary is named irrevocably.

4.    The owner is the individual or entity—it need not be a natural person—that has all ownership rights in the contract, including the right to name the annuitant and beneficiary, to elect commencement of annuity payments, and to surrender the contract. Occasionally, advisors will suggest that a nonqualified annuity¹⁸ be owned jointly; usually when the owners are a married couple. As will be discussed in Chapter 6, this arrangement can produce unexpected problems, and should be avoided unless the client and advisors are aware of and accept the implications of such ownership.

Endnotes

1.      There are annuities that are not commercial annuities, including private annuities and charitable gift annuities. We will not be discussing these in this book.

2.      We used the term annuity here but clearly meant annuity contract. We’ll do this throughout the book for the sake of brevity, but when we are specifically referring to the stream of income, we’ll make that clear.

3.      Insurance companies will usually agree to issue annuity checks directly to a nonowner annuitant if requested to do so by the owner (but the tax liability will be the owner’s).

4.      Such deferral may require the insurance company’s approval.

5.      These are also referred to as investment subaccounts.

6.      As we have noted, there is no accumulation phase in a variable immediate annuity.

7.      After deduction for contract charges.

8.      We have illustrated four decimal places precision for units purchased and three decimal places for unit values in this example. Some insurers use greater precision and some use less.

9.      Asset classes are investment types having distinct risk/return characteristics, such as U.S. Large Cap Growth Stocks, Foreign Stocks, U.S. Real Estate, U.S. Long Term Government Bonds, etc.

10.    Some contracts require a minimum initial and/or ongoing contribution per subaccount.

11.    Most contracts impose a maximum on the number of exchanges permitted per month and may levy a charge for additional excess exchanges. These restrictions are generally in place to prevent active trading using the investment subaccounts, but are not intended to restrict normal occasional trading and rebalancing.

12.    The fixed account in a deferred variable annuity typically guarantees a minimum interest rate and may offer a guaranteed duration for the current declared interest rate. In addition, the principal—including all prior credited interest—is typically guaranteed against loss.

13.    All variable deferred annuity contracts permit annuitization on either a fixed or variable basis; fixed contracts offer only fixed annuitization.

14.    Nearly all variable deferred annuities permit partial annuitization. Others require that the entire value of the contractholder’s accumulation units be annuitized.

15.    Some variable annuity literature describes this process as a conversion of the existing accumulation units to annuity units.

16.    If the annuity uses unisex annuity factors, the sex of the annuitant is not considered. Most commercial annuities use sex-distinct factors. Unisex factors are most often seen in contracts used to fund qualified retirement plans, where sex-distinct factors in such an employment context are considered to impose potentially unlawful discrimination.

17.    As was noted, some annuity contracts are unisex; most, especially those that are nonqualified, are sex-distinct, in which the annuity payout factors for males are different from (and lower than) those for females (because females generally live longer than males of the same age).

18.    As noted earlier, this means an annuity purchased with after-tax dollars purchased outside an IRA or tax-qualified plan.

Taking Money from an Annuity Contract: Distributions As an Annuity

There are two ways of taking money from an annuity contract. The first is to take regular annuity payments, in accordance with an annuity payout option. The second is to take a distribution in any other way (via partial withdrawals or a full policy surrender). In this chapter, we’ll look at taking distributions as an annuity.

What does that mean, as an annuity? As we mentioned in Chapter 1, an annuity is, in current usage, a stream of income over a specified length of time (which might be the lifetime of the annuitant or annuitants or a set period of years), in which the principal (the amount to be annuitized) and any interest earnings are amortized over the period, such that no value remains in the contract at the end of the annuity payout period. Amounts received this way (technically referred to as amounts received as an annuity) are taxed differently from amounts received any other way (which distributions, as you might expect, are called amounts not received as an annuity). We’ll discuss those different tax regimes in the chapters on taxation. In this chapter, we’ll deal simply with the different annuity payout options that are available in annuity contracts.

These different options are available either in an immediate annuity contract (in which case, the payout option is chosen at the time of contract purchase) or in a deferred annuity contract (in which case, the payout option is chosen at the time of annuitization; it need not be chosen at the time of contract purchase).

Types of Annuity Payouts

The chart below shows the various payout methods for an immediate annuity or a deferred annuity to be annuitized using the regular payout options.

Period Certain

The Period Certain annuity does not guarantee that payments will persist for life, but, rather, for the duration of the period chosen. Thus, a 30 Year Period Certain payout will make level payments for thirty years. If the annuitant dies during that period, payments will persist (for the remainder of the thirty year period) and be paid to the annuitant’s beneficiary. Payments will cease at the end of the period, whether the annuitant is still living or not.

Note: It is very important that beneficiaries, and contingent beneficiaries be designated at the time of annuity purchase, and updated when necessary. In a Period Certain annuity or a life annuity with a refund feature, if the annuitant dies during the payout period and there is no valid beneficiary designation on file with the insurer, payment will be made to the estate of the owner. Thus, to ensure that money will go to the people I want it to go to, beneficiary and contingent beneficiary¹ designations need to be kept up to date.

Life Contingent Options

Life Only (also known as Life Only—No Refund)

Payments will be made until the annuitant’s death, at which point the contract will expire without value.

Note: In the Life Only arrangement where two annuitants are named, the amount of annuity payments may not remain level throughout the payout period. The following variations are typically available on a life annuity.

Life & 100 Percent Survivor

The amount of annuity payments will remain level until the last annuitant’s death.

Life & Percentage Survivor

The amount of annuity payments will remain at the initial level so long as both annuitants are living. On the death of either annuitant, payments to the surviving annuitant (for his/her lifetime) will be reduced to a specified percentage of the original amount.

Example: Joint & 2/3 Survivor. The original annuity amount is $1,000 per month. At the death of either annuitant, payments of