Annuities

ANNUITIES

An annuity is a contract between an individual and an insurance company, in which the individual agrees to pay a certain amount of money, either in a lump sum or in regular payments, in exchange for a guaranteed stream of income in the future. Annuities can be a valuable tool for retirement planning, as they provide a steady source of income for the rest of the annuitant's life. In this write-up, we will explore the different types of annuities, their advantages and disadvantages, and factors to consider when purchasing an annuity. 

Annuities can be 

Qualified: A qualified annuity is an annuity contract that is purchased with pre-tax dollars, typically from a tax-qualified retirement account such as an IRA, 401(k), or 403(b) plan. The funds used to purchase the annuity have not been taxed, which means that the annuitant will pay taxes on the distributions when they begin receiving income from the annuity.

Qualified annuities are subject to the same distribution rules as the retirement account from which the funds were withdrawn. For example, if the annuity is purchased with funds from a traditional IRA, then the annuitant must begin taking required minimum distributions (RMDs) from the annuity starting at age 72 (or age 70 ½ for those who turned 70 ½ before 2020). RMDs are calculated based on the annuitant's life expectancy and the account balance.

One benefit of purchasing a qualified annuity is that it allows the annuitant to continue deferring taxes on the funds until they are withdrawn. This can be particularly beneficial for individuals who are in a lower tax bracket during retirement than they were during their working years.

Non-Qualified: A non-qualified annuity is an annuity contract that is purchased with after-tax dollars, meaning that the funds used to purchase the annuity have already been taxed. Because the annuitant has already paid taxes on the funds used to purchase the annuity, they will not be subject to taxes again when they receive distributions from the annuity.

Non-qualified annuities are not associated with any tax-qualified retirement accounts, such as an IRA, 401(k), or 403(b) plan. This means that there are no required minimum distributions (RMDs) associated with non-qualified annuities, and the annuitant can continue to defer taxes on the earnings until they begin receiving income from the annuity.

Non-qualified annuities can be a useful tool for individuals who have already maxed out their contributions to tax-qualified retirement accounts or who are looking for additional retirement income sources. They can also be a good option for individuals who are looking for a way to defer taxes on their investment earnings.

Regardless of how it is set up, you cannot take distributions from an annuity prior to age 59 ½ without being penalized an early withdrawal fee of 10% from the IRS. That is true for all annuities, except Single Premium Immediate Annuities (SPIAs).

Cash value from a life insurance policy can be rolled over into an annuity contract without creating a taxable event. This is called a 1035 Exchange. Note that it is not allowed the other way around. Annuity cash value cannot have a 1035 exchange into a life insurance contract.

 There are 3 Main Types of Annuities based on returns:

• Fixed Annuities: Fixed annuities provide a guaranteed fixed interest rate for a specific period of time, typically one to ten years. After the initial period, the interest rate may be adjusted based on the prevailing market rates. Fixed annuities are less risky than variable annuities because the interest rate is guaranteed, and the principal is not exposed to market volatility. .

• Indexed Annuities: An indexed annuity combines features of both fixed and variable annuities. The rate of return on the annuity is based on the performance of a stock market index, such as the S&P 500. However, the annuitant is guaranteed a minimum rate of return, regardless of how the index performs. This type of annuity is a good choice for individuals who want the potential for higher returns but also want some protection against market downturns. .

• Variable Annuities: Variable annuities allow you to invest your money in different types of investments, such as stocks, bonds, or mutual funds. The returns on variable annuities depend on the performance of the underlying investments. While variable annuities offer the potential for higher returns, they also carry more risk than fixed annuities. 

Annuities can be further broken down into two main categories: Deferred and Immediate.

•  Deferred Annuities

This is an annuity that begins payments to an annuitant after a specified period of time following the initial purchase. A deferred annuity can be funded with installments or it can be a one-time Single Premium ("lump-sum'] contribution.

• Immediate Annuities

An immediate annuity is an annuity that is purchased with one Single Premium ("lump­ sum'J contribution and income payments begin usually within 30 days.

Stages of Annuity

•  Accumulation Phase

This is the period of time that an annuitant makes contributions to the annuity to build up the cash value. The more contributions that are made to an annuity during the Accumulation Phase, the more income will be received by the annuitant during the Annuitization Phase. The longer an annuitant postpones income payments by going into the Annuitization Phase, and the longer the Accumulation Phase is, the more income will be received by the annuitant.

•  Annuitization Phase

When an annuitant decides to begin income payments, he enters the Annuitization Phase, sometimes referred to as the Payout Phase. An annuitant can receive income payments in different ways:

 Life Only Option

This option typically has the highest payout because the payout is based solely on the life of the annuitant. When the annuitant dies, no further payments are made.

Joint and Survivor Option

This option will continue to make income payments to the spouse upon the death of an annuitant. The income payment will be less than the Life Only Option because the income calculation is based on the life expectancy of both spouses.

Period Certain Option

This option will ensure that the income payments from an annuity will pay for a guaranteed number of years, even if the annuitant dies during the period. When this happens, payments will continue to a named beneficiary. Common periods to select are 10, 15 and 20

years.

Life with Period Certain Option

This option is similar to the Period Certain Option, however if the annuitant lives past the chosen Period Certain, the income payments will continue for as long as the annuitant lives.

Net Refund Option

Upon the death of an annuitant, this option will pay a named beneficiary the difference between what was already paid out to the annuitant and the total amount that the annuitant originally paid in premiums. This is sometimes called a Cash Refund Annuity, a Pure Life Annuity or a Straight Life Annuity.

Annuities can be a powerful financial tool when used properly. It is the "opposite" of life insurance. With life insurance, you are betting that you will die too soon. With an annuity, you are betting that you are going to live too long.

Unlike a life insurance policy, annuities can be an option for a Qualified Plan rollover. Moreover, Qualified Annuities can be converted into a Roth IRA which can help put a person on the road to a tax-free retirement. The annuitant would have to pay taxes on the rollover, so a careful review with a financial professional would be required in order to determine the feasibility and suitability of such a move.

TAX TREATMENT

Annuities are classified as either qualified or non-qualified, which determines the amount of taxable income from the annuity. Non-qualified annuities are purchased with after-tax personal funds and are not held in retirement accounts like IRAs. Although the growth in a non-qualified annuity is tax-deferred, the income received from it is partially taxable.

Each payment from a non-qualified annuity comprises a non-taxable return of principal and a taxable gain until you receive back your contribution(s). Once you have received the equivalent of your contribution(s), 100% of the annuity's income will be taxable.

Qualified annuities are bought with pre-tax dollars, such as contributing pre-tax funds into a traditional IRA and purchasing an annuity with those dollars. Therefore, none of the money in a qualified annuity has yet been taxed. Consequently, when you receive income from a qualified annuity, 100% of the payment(s) will be taxable.

Unlike non-qualified annuities, a qualified annuity must follow the IRS's required minimum distribution (RMD) rules, which means you must start taking at least a minimum amount of withdrawal when you turn 73 years old (in 2023).

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