8 - 1 Annuities  What are they?  Contracts providing for the systematic liquidation principal and interest in the form of a series of payments over a period of time  Taxation is governed by IRC section 72  Accumulation phase  Investor makes cash payments to the insurance company  The money remains invested with the insurance company and is periodically credited with some growth factor  Payout phase  The insurance company agrees to pay the owners a specified amount (the annuity payments) periodically beginning on a specified date Chapter 8 Tools & Techniques of Life Insurance Planning

8 - 2 Annuities  What is it? (cont'd)  Immediate annuity  Payout begins within one year of the date the contract is established  Deferred annuity  Payout begins more than one year of the date the contract is established  Life annuity  Payouts will continue as long as the annuitant lives  Fixed period annuity  Company promises a payout for a fixed or guaranteed period of time, independent of the survival of the annuitant  Combination of life and fixed period payout  Example – For the greater of ten years for the life of the annuitant Chapter 8 Tools & Techniques of Life Insurance Planning

8 - 3 Annuities  What is it? (cont'd)  Fixed annuity  Invested in the general fixed account of the insurance company  Variable annuity  Invested in the separately managed sub-accounts selected by the annuity owner  Additional features  Guaranteed death benefits  Living benefits - company guaranteed benefits for owners or beneficiaries  That would be higher than actual investment performance would provide for  Variable annuitization  Payments fluctuate depending on the investment performance of the underlying sub- accounts Chapter 8 Tools & Techniques of Life Insurance Planning

8 - 4 Annuities  What is it? (cont'd)  Taxation  Accumulation phase  Growth is tax deferred  Withdrawals during this phase are taxed on a LIFO basis  Withdrawals are consider to be withdrawals of growth first and principal second  Payout phase  A portion of each payout is considered a return of principal  A portion of each payout is considered interest or growth  Calculation of those portions (the exclusion ratio) depends on the principal invested, the period of the payout and an internal growth factor for the payout period Chapter 8 Tools & Techniques of Life Insurance Planning

8 - 5 Annuities  When is the use of this tool indicated?  When a person wants a retirement income that cannot be outlived  When an individual wants a retirement income higher than their other conservative investments and is willing to have principal liquidated  To avoid probate and pass a large sum of money by contract to an heir and reduce the possibility of a will contest  When tax deferred growth is desired for an investment  When an investor wants to be free of the responsibility of investing and managing assets  As a supplement to an IRA Chapter 8 Tools & Techniques of Life Insurance Planning

8 - 6 Annuities  When is the use of this tool indicated? (cont'd)  For fixed annuities  Safety of principal is paramount  Investor wants guarantee level of interest  When a conservative complement to other investments is desired  For variable annuities  When an investor wants more control over the investments and is willing to bear the risk  When a person is looking for potentially increasing retirement income  When an individual desires to be invested in variable sub-accounts  But also desires some aspect of risk management  Guaranteed death benefits / living benefits Chapter 8 Tools & Techniques of Life Insurance Planning

8 - 7 Annuities  Advantages  Guarantees of safety, interest rates and lifelong income  Protects and preserves person’s cash reserves  Allows investment in the market while moderating risk  Client can “time” the receipt of income and shift it into lower tax bracket years  Annuity paying the same rate of interest as a taxable investment will result in a higher effective yield  Variable annuities – client may take on greater risk in the underlying investment options (equities, small market capitalizations, high yield bonds etc.) while still maintaining a reasonable risk exposure due to the underlying guarantees Chapter 8 Tools & Techniques of Life Insurance Planning

8 - 8 Annuities  Advantages (cont'd)  Adjusted Gross Income (AGI) may be reduced in years where the annuity id held without withdrawals  Lower taxable income may be recognized during the payout phase  Due to partial recovery of basis associated with each payment  Disadvantages  Receipt of lump sum could result in significant tax burden  Income averaging may not be available  Cash flow received may not keep pace with inflation  A 10% penalty tax imposed on withdrawals prior to age 59 ½ Chapter 8 Tools & Techniques of Life Insurance Planning

8 - 9 Annuities  Disadvantages (cont'd)  Corporate owned annuities  Growth is subject to taxation  Liquidation in the early years  Management, maintenance fees could prove expensive  Management fees and mortality charges could run from 1% to 2&1/2% of the value of the contract  Back end surrender charges  Investment earning taxed at owners ordinary income tax rate  Regardless of the source or nature of the return  Returns associated with long term capital appreciation do not enjoy the capital gains tax rate Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Tax implications  Exclusion Ratio Formula Investment in the contract Expected Return  Applies to each annuity payment equally throughout the payout phase  Example – 70 yr old pays $12,000 for the annuity. His expected return throughout the payout phase is $19,200.  The exclusion ratio is 62.50%  If the monthly payment is $100, then  $62.50 is considered a return of principal  $37.50 is considered taxable income  Once the entire investment in the contract has been recovered, then 100% of each annuity payment received is taxable income Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Tax implications (cont'd)  Expected Return  Total amount the annuity owner should receive  Payments specified x life expectancy (or term certain if elected)  Life expectancy based on IRS Table V (single lives) or Table VI ( joint lives)  If annuitant dies before receiving the full amount guaranteed under a refund or period certain annuity  Balanced received will not be taxed (unless it exceeds the investment in the contract)  For joint and survivor annuities  Surviving owner excludes from income the same percentage of each payment that was excludible by the first annuitant  An income tax deduction may be available to the survivor owner to the extent inclusion of the annuity in the estate of the first annuitant generated an estate tax (IRD) Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Tax implications (cont'd)  Owner makes a partial withdrawal and takes a reduced annuity  Partial withdrawal subject to income tax  Owner takes a partial withdrawal & chooses same payments for different term  To the extent cash value exceeds investment in the contract, gain will be realized in the form of a taxable withdrawal of interest  Variable Annuities  No tax will be paid until the earlier of  Surrender of the contract  Withdrawals from the contract  Time that payments commence from the annuity  To obtain annuity treatment the underlying investments must be adequately diversified under IRS regulations Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Tax implications (cont'd)  Variable annuities (cont'd)  Different Exclusion Ratio Investment in the contract # of years of expected return  Example:  Male 65 purchases variable annuity for $20,000  Life expectancy of 20 years (Based on Table V)  He can exclude $1,000 from each payment ($20,000 / 20)  Assume at age 70 he receives only $200 ($800 less than his excludible amount)  Assume at age 70 his life expectancy is 16 years  He can add $50 ($800/16) to his $1,000 excludible amount Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Tax implications (cont'd)  Annuitant dies before payments received equal cost  Loss deduction allowed  For amount of un-recovered investment  itemized deduction  Amounts payable under a deferred annuity at the death of annuitant  Partially taxable as ordinary income to the beneficiary  Equal to excess of death benefit over gross premiums  Dividends, loans, cash withdrawals and other amounts taken out before the annuity starting date  Taxed as ordinary income to extend the cash value exceeds the investment in the contract  LIFO basis Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Tax implications (cont'd)  Premature Distributions  Subject to ordinary income tax plus 10% penalty tax  Tax applies to amount of distribution included in income  Penalty for premature distributions does not apply to:  Payments that are part of a substantial equal periodic payments made for life  Payments on or after age 59½  Payments made on account of contracts owner disability  Payments from qualified retirement plans and IRA’s  Payments to beneficiary after death of annuitant  Distributions under an immediate annuity contract  Annuity purchased on the termination of certain qualified employer retirement plans  Payments allocable to investment in the contract before August 14 th, 1982 Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Tax implications (cont'd)  If annuitant dies before annuity starting date  Cash value must be distributed within 5 years of death or  Used within one year to provide for a life annuity or installments payments not longer than the beneficiaries life expectancy  If spouse is the beneficiary  Spouse can elect to become the new owner of the contract instead  Annuity contract transferred by gift  Tax deferral allowed on the inside build-up is terminated  Tax-free build-up is allowed only to “natural persons”  For non-natural persons – income is treated as ordinary income in the year received Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Tax implications (cont'd)  Tax-free build-up is allowed only to “natural persons”  For non-natural persons – income is treated as ordinary income in the year received  Exceptions  Annuities received by the executor of a decedent  Annuities held by a qualified retirement plan or IRA  Annuities considered qualifying funding assets  Structured settlements  P&C companies funding periodic payments for damages  Annuities purchased by an employer on termination of a qualified plan  Immediate annuities Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Alternatives  Municipal bond funds  Income exempt from federal and some state income taxes  Money can be withdrawn without tax penalty  Example - Taxable equivalent yield of 8.6% for a bond yielding 6% (30% tax bracket)  Disadvantage  Lack of guaranteed return  Potential for capital losses  If interest rates rise and bonds sold before maturity  Single Premium Life Insurance Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Alternatives (cont'd)  Single Premium Life Insurance  Tax free death benefit  Tax deferred growth of cash surrender values  Withdrawals & loans subject to LIFO taxation and 10% penalty if distribution occurred before age 59 1/2  Mutual funds  Do not enjoy tax deferred accumulation  Tax on capital appreciation is deferred until gains are realized  Realized gains are taxed either as short term or long term gains  Step up in basis at death Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Fees and acquisition costs  Investment management fees  Typically from.25% to about 1%  Administrative expense and mortality risk charge  Typically from a low of about.5% to as high as 2%  Annual maintenance charge  Typically $25 to $100  Charges per fund exchange  $0 to $10.  Some companies permit a limited number of charge-free exchanges per year Chapter 8 Tools & Techniques of Life Insurance Planning

Annuities  Fees and acquisition costs (cont'd)  Maximum surrender charge  Vary from company to company  Generally phase out over a number of years  Selecting the best policy  Spreadsheet costs and features  Fixed annuities – compare the total outlay with the total annual annuity payments  Variable annuities - Evaluate the total returns for the variable annuity sub-accounts over multiple time periods  Morningstar and Lipper Analytical Services Inc.  Compare the relative financial strength of the company  Rating agencies - A.M. Best / Moody’s/ Standard & Poor’s Chapter 8 Tools & Techniques of Life Insurance Planning