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Written by: Jerry Love, CPA

Published: 14 November 2012

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 This email address is being protected from spambots. You need JavaScript enabled to view it..

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Written by: Jerry Love, CPA

Published: 10 August 2012

It seems that one topic that is on the forefront of every small business owner's mind this summer is what impact will the Obama Care legislation have to their bottom line. 

Without any question, health care costs are skyrocketing. One possible alternative for a small business to address the health care mandate is to use the Health Savings Account (HSA). Health Savings Accounts are really pretty simple: it is a savings account for your medical expenses. An HSA is a tax-advantaged account that's paired with a high-deductible health plan (HDHP).

In 2003, Congress created the Health Savings Accounts to allow individuals who are covered by HDHPs to receive tax-preferred treatment of money set aside for medical expenses. The HSA was part of a larger agenda to promote consumer-directed or consumer-driven health care. HSAs have been promoted by companies and the government as a way to help control health care costs, because consumers will spend their health care dollars more wisely when they are spending their own money.

In an article written by John K. Iglehart, he points out how vastly different Americans are in our health care expenditures than other countries: (http://content.healthaffairs.org/content/24/4/902.full), " The United States always leads all nations in the amount of money it spends on health care, and explanations abound about why. Truth to tell, there is no constituency with any real influence that favors constraining these expenditures."

Fundamentally, the Health Savings Account provides coverage much like traditional health insurance, but it can save you money in three ways. 

1) HSA plan premiums are expected to be lower, because the coverage is the HDHP and historically these plans have not seen as large of rate hikes as seen in other health plans, 

2) You get a tax deduction (above the line like an IRA) when you fund the HSA and,

3) Any funds left in the HSA at the end of the year can grow with tax-free earnings to accumulate for later years when your health care needs may be greater during retirement.

Essentially, Health Savings Accounts are like a personal savings account earmarked for health care expenditures.  And as long as the money is used for health care expenses, the distributions are tax free.

Many believe that the HSAs are a key shift that can help reduce the growth of health care costs for both individuals and small business. HSAs shift responsibility for health care to the individual for much of the routine care expenditures. Proponents believe this shift makes the individual more aware of the costs of health care. Further, HSAs encourage the individual to save for future health care expenses. An HSA allows the individual to receive needed care without a gatekeeper to determine what benefits are allowed and makes the individual more responsible for their own health care choices. It is also believed that as an individual takes more responsibility for paying for their health care, it will increase the efficiency of the health care system. And finally, those providing medical care will have an incentive to lower their rates, because they're competing for consumers' business.

An HSA is a tax-exempt trust or custodial account that you set up with a qualified HSA trustee to pay or reimburse certain medical expenses you incur. No permission or authorization from the IRS is necessary to establish an HSA. The funds contributed to an account are not subject to federal income tax at the time of deposit. 

Among the advantages of HSAs over the Flexible Spending Accounts (FSA) are that unlike FSAs, HSAs do not have a "use it or lose it" provision and the HSA funds remain in your account at the end of the year to accumulate tax free year after year until withdrawn. If your health expenses are relatively low, you may be able to build up a significant balance in your HSA over time. You can even let your money grow until retirement, when your health expenses are likely to be substantial.

Individuals who are covered by HDHPs are eligible to contribute to an HSA. An HDHP is "catastrophic" health coverage that pays benefits only after you've satisfied a high annual deductible. In 2012, a qualifying HDHP (1) has an annual deductible of at least $1,200 for individual coverage or $2,400 for family coverage (unchanged from 2011), and (2) limits annual out-of-pocket expenses (e.g., co-pays, deductibles) to $6,050 for individual coverage or $12,100 for family coverage.

Because the individual is paying a greater portion of their own health-care costs with higher deductibles, in most cases they will pay a much lower premium than for traditional health insurance. The theory is that the individual would then contribute the premium dollars they save to their HSA. Contributions made to an HSA that do not exceed the maximum limit are tax deductible on the individual's federal income tax return.

For tax year 2012, the contribution limits are $3,100 ($3,250 in 2013) for individual coverage or $6,250 ($6,450 in 2013) for family coverage. This annual limit applies to all contributions, whether made by the individual or the employer. The taxpayer may also be eligible to make "catch-up contributions of $1,000 to their HSA if they are 55 or older.

Because the HSA is an "individual plan" much like an IRA, it is "self directed". Thereby, the individual has the discretion to direct how the funds are invested subject to the investment options offered by the qualified trustee or custodian. Any interest and investment earnings in the HSA grow tax-deferred until withdrawn, and will not be taxed when withdrawn if used to pay qualified medical expenses.

Distributions for nonqualified expenses are considered taxable income and are subject to an additional 20 percent penalty tax if withdrawn prior to age 65. After age 65, the funds can be withdrawn penalty-free for any reason but the money withdrawn, which is not related to medical expenditures, is subject to tax.

Qualified medical expenses are health-care expenses, as defined by Internal Revenue Code 213(d). These include laboratory fees, prescription and nonprescription drugs, dental treatment, ambulance service, eyeglasses, and hearing aids, as well as many other health care expenses. HSA funds may also be used to cover health insurance deductibles and co-payments. Although funds cannot be used to pay regular health insurance premiums, money can be withdrawn to pay for specialized types of insurance such as long-term care or disability insurance. IRS Publication 502 contains a list of allowable expenses.

HSAs encourage people to save for their future medical expenses. They also provide an incentive for people to take more care in making medical decisions, instead of agreeing to any and all proposed tests and treatments regardless of their medical benefit, since it’s their money on the line.

Jerry Love, CPA, is the sole owner of Jerry Love CPA, LLC in Abilene, TX. Contact him at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Written by: Jerry Love, CPA

Published: 17 February 2012

One thing that anyone active in a tax practice understands is that you must adapt to an ever-changing environment. One huge change over the last century is how the average worker’s retirement is funded while at the same time the life expectancy has significantly increased. The combination of these two elements is a major financial planning topic for the CPA to address with all of their clients because a large majority are reaching retirement age without adequate savings.

When this country was founded and the most common way of life revolved around the family farm and agriculture when 90% of the work force was agricultural, retirement meant living with the family members who had taken over the farm. As we read the accounts of those years, we come to understand that life was hard and life expectancy was not very long. 

In 1776 life expectancy was 35 years. In 1900, just more than a century later, the life expectancy had risen to 49 years and only 38% of the US work force was agricultural. By comparison in 1960 only 8.3% of the US work force was agricultural and medical science was beginning to show significant strides as life expectancy was recorded at 69.8 years. Today, in the US the average life expectancy is 78.7 years (women’s life expectancy is approximately 80 years).

Parallel to this rise in life expectancy was a transformation of how the average worker’s retirement was funded. As America became an industrialized country and the work force moved from the farm to the factory, companies began to provide lifetime pensions to their workers. As the medical technology advanced through the 1900s so did the financial burden of providing this lifetime pension. By the end of the last century, it seems that only a small percentage of the largest corporations and governmental entities were still providing a lifetime pension.

In an article titled A Brief History of Retirement In America (Part 1) by MELP on October 18, 2009 (http://www.thenexthill.com/a-brief-history-of-retirement-in-america-part-1.htm) the author states, “nearly everyone in America over the age of 40 obsesses about retirement. It is the epilogue of the American Dream. A secure retirement is the end mark of a life well lead, even something of a status symbol… But retirement wasn’t always the stuff of sweet daydreams. 150 years ago, almost no one thought of retiring. In fact, the idea of retirement as something we should all aspire to has only been around for about 60 years.”

As the US moved from an agriculturally based work force to people working in factories, the funding of retirement changed. As factory owners sought to maintain a highly productive work force, they implemented incentives for older workers to retire and provided limited funding. By about 1920, as much as 40 plus percent of the white males over 60 were retired. Then Congress enters the mix by passing The Social Security Act of 1935. It was originally framed by Congress as a way to deal with large levels of unemployment coming out of the depression with a permanent benefit that allowed a small replacement to the wages the worker previously earned.  Although, the first versions of the bill provided for the benefit to start at age 70, Congress voted on age 65. Think back to 1840, only 4% of the US population was over age 60 and by 1935 this had only grown to just over 6%.  In 2010 due to increased life expectancy and the baby boom generation’s aging, this segment accounts for approximately 12.5% of the total US population.

In 1945 an estimated 17% of those retiring from a private sector job had a pension. The next thirty years saw a tremendous growth in the number of companies providing a pension.  In 1975 it was estimated that as much as 55% of the private sector provided pensions for their retiring employees. So once again Congress enters and passed Employee Retirement Income Security Act (ERISA) and created the Pension Benefit Guaranty Corporation to ensure that employees received their pensions if their plans went bankrupt.

The long-term result of ERISA was that corporate America began to recognize that they could not fund the pensions promised to workers. Those looking back and analyzing this lay the blame in part to the extended life expectancy but also that ERISA mandated a survivor’s benefit that further extended the cost of providing a pension.

In Tax Reform Act of 1978, the tax code saw the introduction of the 401k plan. Section 401 provided for a qualified savings plan. This was the birth of the 401k as we know it today. Over the next few decades the responsibility of funding an individual’s retirement was shifted to the retiree as companies quickly moved from defined benefit plans to defined contribution plans with an increasing emphasis of the employee self funding via the 401k plans. In 1975 over 70% of the workers in the private sector who had a retirement benefit were covered by a defined benefit plan whereas by 2006, over 75% of the workers in the private sector covered by a retirement plan were covered by a defined contribution plan.

But some will ask, what about Social Security? The fact is that Social Security was never intended to be the sole source of a person’s retirement. It was meant to be a supplement to that company pension. On the Social Security’s Web site (http://ssa.gov/pubs/10024.html) it says: “Social Security was never meant to be the only source of income for people when they retire. Social Security replaces about 40 percent of an average wage earner’s income after retiring.”

However over the past few decades many have reached retirement with very little in savings and no pension. According to (http://www.retirement-income.net/blog/retirement-savings/average-retirement-savings-all-measurements-lead-to-the-same-conclusion/) published: August 14th, 2008, “The ‘baby boomer generation’ are those people between 45 and 62 years of age (as of 2008). This generation has saved on the average retirement savings of $38,000, excluding pensions, homes, and social security. However, “baby boomers” with qualified retirement plans have an average retirement savings of $88,000. The $88,000 of average retirement savings will generate an annual retirement income of about $5,000 yearly.” The online article continues to say: “It’s estimated that the average projected post-retirement income replacement needed among employees of large U.S. employers is 126% of final pay, a level only about 19 percent of employees are expected to satisfy, according to a Hewitt Associates report released July 1. If we assume that the average person earns $40,000 annually, they would need about $50,000 in retirement income, requiring an average retirement savings of $833,000 (not taking into account any social security income). In fact, according to the report, Total Retirement Income at Large Companies: the Real Deal 2008, about 67 percent of the more than 1.8 million employees of 72 large U.S. employers tracked in the study are expected to have accumulated less than 80 percent of their projected needs at age 65.”

In another online article posted (http://20somethingfinance.com/average-retirement-savings/) by G.E. Miller on October 19, 2009, The Shockingly Low Amount of Retirement Savings per American: “According to the Employee Benefits Research Institute’s (EBRI) 2009 Retirement Confidence Survey, 53% of workers in the U.S. have less than $25,000 in total savings and investments. The typical American household (headed by a 43 year old) has just over $18,000 in savings!”

According to the 2011 Retirement Confidence Survey, Employee Benefit Research Institute and Mathew Greenwald & Associates, “retirees say Social Security makes up a major share of their income (68%). However, EBRI research found in 2009 that 60% of those 65 or older received at least 75% of their income from Social Security.”

The EBRI study further states: “The age at which workers expect to retire is gradually rising. In 1991, half of workers planned to retire before age 65, compared with 23 percent in 2011.  …. Seventy-four percent of workers now say they plan to work for pay after they retire. Almost all retirees (90%) who worked in retirement name at least one financial reason for doing so, such as wanting money to buy extras (72%), a decrease in the value of their savings or investments (62 percent), needing money to make ends meet (59%), and keeping health insurance or other benefits (40%). Many workers are also planning to rely on income from employment to support them in retirement. Three-quarters of workers say that employment will provide them (and their spouse) with a major (24%) or minor (53%) source of income in retirement (77% total, up from 68% in 2001 but statistically equivalent to 79% in 2009 and 77% in 2010).”

This stark reality seems to be the bi-product of the two factors mentioned above, the change from companies providing lifetime pensions (defined benefit plans) and the extended life expectancy afforded by advances in medical technology. As CPAs and tax professionals, we need to understand the stark change that has occurred in the retirement landscape and we must be active in this conversation with our clients of all ages. Financial planning is a service your clients need from you.

Jerry Love, CPA, is the sole owner of Jerry Love CPA, LLC in Abilene, TX. Contact him at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Written by: Jerry Love, CPA

Published: 17 February 2012

This is the time of year when many students will be graduating from college and anxiously looking forward to beginning their chosen career. It is also the time that many face the reality of how to begin repaying their college loans. Recent articles indicate that the nation's total outstanding student debt has now surpassed a trillion dollars and exceeds the country's outstanding credit card debt.  

Unfortunately, the increase in the total of school loans and the number of outstanding loans seems to also bring an increased number of people defaulting on the repayment of those loans.  Some reports place the default rate to be approaching 9%. Congress has recently had hearings to consider whether they will step in with some type of program to assist with the repayment and/or provide expanded debt forgiveness programs. 

The U.S. Department of Education has announced a new program called the Special Direct Consolidation Loan Program, which offers eligible borrowers a short-term special consolidation opportunity that will be available to eligible borrowers through June 30, 2012. This program is not the same as the traditional Direct Consolidation Loan Program, and only certain borrowers are eligible. To be eligible, the borrower must have at least one student loan held by the Department—a Direct Loan or a Federal Family Education Loan (FFEL), owned by the Department and serviced by one of the Department’s servicers—and have at least one commercially-held FFEL loan (an FFEL loan that is owned by an FFEL lender and serviced either by that lender or by a servicer contracted by that lender.) More information on this program is available at: http://studentaid.ed.gov/PORTALSWebApp/students/english/specialconsolidation.jsp

The fact seems to be that most students need some form of loan to pay for their college education.  It is reported that as many as two-thirds of the undergraduate students graduating with a Bachelor's degree incurred some debt. Further, over 85% of the students who applied for student aid during their undergraduate years indicate they had to take out loans to pay for a portion of their education. Basically, education loans come in three major categories: 1) direct student loans such as the Stafford and Perkins loans, 2) loans made to the student's parents called PLUS loans, and 3) private student loans.

Although the typical term for repayment of student loans is up to 10 years, a variety of flexible repayment arrangements of up to 30 years may be available. After graduation, many students will receive offers to consolidate all their loans, giving them the convenience of a single payment. However, the student should be careful to understand the terms of this consolidation and whether this convenience will end up costing them more in the long run.  

This option would afford the borrower to combine several loans into one loan and allow him/her to write one check per month (or to have only one bank draft per month). The basis considerations are: 1) will the borrower qualify for loan consolidation, 2) will the interest rate be higher and 3) will the borrower be giving up any favorable features of his/her existing loans.

Generally, all federal student loans have a fixed low interest rate with a grace period. Under most federal programs, a student does not start making payments for six to nine months after graduation. This gives them time to find a job and receive a paycheck before the first payment is due.

Further, many federal programs offer a deferral period. For example, the loans may qualify for a deferment if the student is back in graduate school at least half time, or faced with economic hardship. A deferment period may be granted if one or more of the following conditions are present: unemployed and actively seeking employment, suffering from serious health problems, or having significant personal problems. Generally, however, the interest is not subsidized during forbearance periods and continues to accumulate, leaving the student responsible for paying an even larger balance.

Students are often presented with an assortment of repayment options. The fundamental concept is to present a win/win proposition that would afford the student flexible repayment plans they can sustain, and the lender will have a profitable loan that is fully repaid.

The most fundamental repayment plan calls for the loan to be repaid over a ten-year period with a fixed payment and a fixed interest rate. However, the thing that often seems to be a nuisance is that a person is very likely to have several different types of loans from several different sources. When considering the repayment options, the first thing to do is to make sure you have a complete and clear understanding of all the terms of each loan, including the balance owed, the interest rate, the repayment terms, and any deferment options. It is critical to understand that in many cases, if the student consolidates her loans, she may be changing one or more of those fundamental elements.

Although the fundamental repayment may be offered as described above, the options available to a borrower for repayment may seem unlimited. A good starting place is to start with each lender and discuss the options that are available. Ask if the student qualifies for any reduced interest rates or variations of your repayment terms.

With a graduated repayment plan, you would start with a low payment in the early years, when you presumably would be making less money as you start your career, and then the loan payment would increase in later years. The caution here is the borrower should clearly come to an understanding of the interest rate (is it fixed or variable), and consider if the payments in the early years cover the interest charge but make only a small principal reduction.  

The fundamental analysis from a planning perspective is to achieve a balance between the borrower’s cash flow requirements and the goal of reducing the total payments required to pay off the debt. For example, with a graduated repayment plan, the person may actually pay more over time, because the interest charged may be based on the unpaid balance each month. Therefore, the higher loan balance in the early years translates into higher total interest charges and the borrower will wind up paying more interest over the life of the loan.

Another popular option is an extended term for repayment of the loan. The extended period could be anywhere from 15 to 30 years. This is particularly appealing to a student who may have incurred loans well in excess of $60,000. Even if the interest rate is relatively low and fixed like a home mortgage, because of the length of the payback period, the overall cost in interest may be very high.

Borrowers may have federal student loans that were made under the government's William D. Ford Direct Loan program. Under this program, monthly payments would be based on the student's income, family size, and amount of loans. After 25 years of repayment (not counting time spent in deferment or forbearance), any remaining balance on the loans may qualify for discharge.

Further, borrowers should make sure they are aware of any loan forgiveness component that is available to them. This can be a critical thing to consider as they graduate and interview. For example, a teacher might qualify for loan forgiveness if he/she teaches in a Title One school.

This option would afford the borrower to combine several loans into one loan and allow him/her to write one check per month (or to have only one bank draft per month). The basis considerations are: 1) will the borrower qualify for loan consolidation, 2) will the interest rate be higher and 3) will the borrower be giving up any favorable features of his/her existing loans.

The first step in analysis of the repayment options is to determine the amount of discretionary income the borrower has available each month. After you determine the amount of available discretionary monthly income, the borrower needs to assess his/her individual circumstances to pick the best repayment option available to them.

Jerry Love, CPA, is the sole owner of Jerry Love CPA, LLC in Abilene, TX. Contact him at This email address is being protected from spambots. You need JavaScript enabled to view it..