An annuity is an investment option that many people find difficult to understand and frequently turn to their tax professional for financial planning advice. The purpose of this article is to offer a basic explanation of the annuity.
The annuity is basically an insurance product that pays out income, which is frequently used as part of a retirement strategy or other long-term financial strategy. Annuities are generally used as a vehicle to provide a steady stream of income for a period of time.
1. An annuity is a contract between the issuer (generally an insurance company), the owner (the individual purchasing the annuity contract), the annuitant (the person whose life will be used in the measuring the payment period) and the beneficiary (the person who will receive the death benefit when the annuitant dies, if there is a death benefit). In most cases, an individual is both the owner and the annuitant of the contract.
Simple Annuity
2. The annuity contract is based on the owner making either a lump-sum payment or a series of payments to the issuer (i.e. insurance company) in exchange for the issuer agreeing to later make periodic payments to the designated person (generally the annuitant) that can begin either immediately or within a year of the purchase (thus called an immediate annuity) or at some future date (thus called a deferred annuity). Annuity pay-outs are based on a variety of factors, including age, gender, investment amount, and type of pay-out. An annuity has two phases: an accumulation period and a payout period.
In its simplest form, the annuity contract would provide for a payment period based on the annuitant’s life and have no provision to make any payments after his/her death. If the annuity does not have a death benefit, then there is a risk to the owner and annuitant that the annuitant will not live long enough to receive a return of the amount invested. For the issuer (the insurance company) there is a risk that the annuitant will live well beyond what the actuarial tables predict and they will have to make payments indefinitely.
3. However, most annuity contracts are more complicated than the described simple annuity. Many annuity contracts are based on more than one life, perhaps both spouses or have a provision to guarantee a payment will be made for a minimum period of time (such as 10, 15 or 20 years). Some annuity contracts will provide for variable payments, although the most common seem to provide for a fixed payment.
Longevity Annuity
4. Another type of annuity that has become available is called a longevity annuity. This product was designed to provide protection against the annuitant outliving his income. This product is also known as an advanced life delayed annuity. This type of annuity is a deferred annuity contract which provides for a late life starting point, such as the annuitant turning 80 or so, and provides for a payment for the remaining life of the annuitant. The later you choose to begin your payments, the larger your payments will be. The longevity annuity generally does not have a fixed payment period and often does not have a death benefit. In fact, many of these contracts provide for no payment to anyone if the annuitant dies before the start date.
5. The next aspect of an annuity is to understand that premium dollars will be invested during the accumulation phase. There are generally three types of annuities — fixed, indexed, and variable. In a fixed annuity, the issuer (the insurance company) agrees to pay you no less than a specified rate of interest during the time that your account is growing.
With an indexed annuity, the issuer will base your account on an investment return that is based on changes in a specific index, such as the S&P 500 Composite Stock Price Index.
A variable annuity is an annuity contract for which the investment returns will fluctuate and the principal value, when redeemed, may be worth more or less than the original investment. In this annuity, you may choose from a range of different investment options such as mutual funds. The value of the annuity and your future benefit will vary depending on the performance of the investment option you selected.
6. A variation of the fixed, indexed and variable annuity is known as a modified guaranteed annuity. This annuity is designed to offer predictable earnings for a selected guarantee period, such as five, seven, or ten years. They can be attractive to investors who want returns without the uncertainty of the equities markets.
7. Now to the tax treatment - annuities are afforded special rules by the IRS. Similar to retirement-styled assets like IRAs and retirement plans, annuities are tax-deferred. This means that you do not pay taxes on the income inside the annuity during its accumulation phase. When you take your distributions from the annuity, it will be taxed to you as ordinary income and you do not get the preferred capital gains treatment of any of the internal accumulation.
8. Generally, annuity payments are treated in part as a return of capital and part income. This taxation of income for an annuity is allowed only for individuals. Thus, if the owner is an entity (e.g., corporation, employer, or trust), the distributions from the contract each year are taxable as ordinary income. However, these non-individual owners would enjoy the tax-deferred growth built up during the accumulation period of the contract. Another difference is that any death benefit from an annuity is taxable income to the beneficiary, and is not afforded the tax-free treatment that life insurance enjoys.
9. You may also transfer your money from one investment option to another one within the annuity without paying tax at the time of the transfer. There is a tax-free exchange available under Section 1035 if you exchange one annuity for another annuity. For exchanges occurring after 2009, no gain or loss will be recognized on the exchange of (1) an annuity for a qualified long-term care contract, (2) a life insurance contract for another life insurance contract, (3) a qualified long-term care contract for another qualified long-term care contract, or (4) a life insurance contract for an annuity contract.
10. And finally, distributions before age 59 ½ may be subject to a 10% premature distribution penalty (additional tax). Variable annuities are not subject to the mandatory distribution rules beginning at age 70 ½; however, many annuity contracts require the owner to begin annuity payments by a certain age.
11. Premiums you pay to purchase the annuity, however, are not tax deductible like an IRA contribution. On the bright side, because they are not tax deductible, there is not a limit on how much you can invest in an annuity.
12. An item that may cause confusion is that sometimes an annuity is purchased inside an IRA, 401k, 403b or other qualified retirement plan. When this is the case, the rules related to the applicable retirement plan take precedence over the annuity tax rules.
13. One key characteristic of an annuity is the surrender charge. The "surrender charge" is a penalty you must pay if you withdraw the funds from an annuity during the initial few years of the contract. This time period varies and is identified in the annuity contract but is generally the first four to eight years.
14. Overall, it is important to understand that the annuity is a contract between the issuer and the owner. By its nature, it is more complicated that buying a CD or investing money in a mutual fund. Because it is contractual in nature, it is important that the financial planning professional help their client understand the contract terms. As with any financial product, there are times when an annuity is the appropriate solution, and just as can be said for most other investment vehicles, it is not the answer to every financial need of the individual.
Jerry Love, CPA, is the sole owner of Jerry Love CPA, LLC in Abilene, TX. Contact him at
Comments powered by CComment