Annuities are used for individuals and corporations to provide group benefits. Regardless of what the purpose of the annuity is to be, there are certain considerations that should be kept in mind.
As a general rule, annuities should be considered part of a long-term investment strategy rather than as a short-term liquid savings account. One of the primary benefits of annuities— the tax-deferral on interest — applies only as long as the funds deposited in the annuity are not withdrawn. When the tax consequences are discussed later in this text, it becomes apparent that the Internal Revenue Service tax penalties can be quite severe. In addition, the insurance company imposes its own penalties in the form of surrender charges or interest rate adjustments when annuity funds are withdrawn under certain circumstances.
The exception to the long-term investment strategy is the use of a single premium immediate annuity, as discussed in a previous section, to begin providing income payments as soon as possible. In this case, of course, the purpose is to pay an immediate stream of income, not to build up funds for the future.
For the most part, however, annuities are purchased with flexible premiums in order to defer the income return until some future date and to reap the tax benefits in the meantime. Annuitants who adhere to the long-term strategy are thus “rewarded” and annuitants that do not are penalized. At the same time, the flexibility and withdrawal privileges of newer annuities are more sensitive to changing financial circumstances, so that annuity owners who encounter large, unexpected immediate financial needs are able to access their annuity funds to some extent.
Variable Annuities and Equity Index Annuities, especially, are best perceived as long-term investments. Like the stock market, the securities that underlie a Variable Annuity have in the past, generally performed well over the long term in spite of some significant downturns from time to time.
Historically, a mix of securities, such as those that are investments for Variable Annuities and mutual funds has been profitable over an extended period of time. The key to using annuities successfully and for the purpose to which they are designed, is avoiding the temptation to withdraw from the investment during temporary downturns in the market.
NOTE: The recently passed tax bill, Economic Growth and Tax Relief Reconciliation Act of 2001, changed dramatically the taxation of life and health insurance, particular in the areas of employee benefit plans, and in particular, the 401(k), pension and profit-sharing plan. These limitations and provisions will be the presented in italicized style as applicable to the subject under discussion.
The Act provides that its provisions and amendments do not apply to taxable, plan, or limitation years beginning after December 31, 2010, and that the Internal Revenue Code and ERISA shall be applied to such years as if the Act had not been enacted.
Annuities may be written as either qualified or nonqualified contracts. “Qualified” means the annuity is established and maintained according to Internal Revenue Service rules that permit a tax deduction for the premiums paid. This means no current income tax is required on the portion of income used to pay premiums for a qualified annuity. Nonqualified annuity premiums, on the other hand, are paid for with after-tax dollars, which means contributions is not tax deductible.
In the survey of the 21 EIAs discussed above, the Minimum/maximum age varied with some companies as to whether the plan was qualified or non-qualified and in some cases, the minimum and maximum premium. The maximum premium in those policies are usually equal to the maximum allowable contribution to an IRA.
The only qualified annuities available for most individuals are those used to fund Individual Retirement Accounts (IRAs). For corporations and other business entities, group annuities designed to fund employee or other group retirement plans may also be qualified. In both individual and group situations, the annuities must be designed for and operate under stringent IRS qualification guidelines.
While most insurance companies offer both qualified and nonqualified annuities, some do not. Of the various types of annuities offered by a single insurer, some types may be written only as qualified plans while others may be written only as nonqualified annuities. Some may restrict their qualified annuity offerings to certain uses, such as for IRAs or for 403(b) organizations, discussed later.
Individual Retirement Annuities (IRAs) which are established on an individual basis, allow wage earners to make independent contributions to their own retirement plans. Either a fixed or Variable Annuity may be used. An IRA is always a flexible premium deferred annuity. IRAs provide a limited tax deduction for the individual’s contribution as well as interest accumulation on a tax-deferred basis. Instruments other than annuities may be used to establish individual retirement accounts, but this discussion is limited to annuities used for this purpose.
Originally, the purpose of an IRA was to offer retirement savings incentives to people not included in a corporate or employer-sponsored plan. This is still the primary use for an IRA, but some people who are covered by employer plans may establish tax-deductible IRAs as well.
A popular use for an individual annuity is as a rollover IRA to receive money from a company-sponsored pension or profit sharing plan. Individuals who leave an employer take with them any such monies in which they are fully vested—which means they own 100% of their share of the plan. To protect themselves from adverse tax consequences, they must have the funds immediately reinvested in another tax-favored plan. A rollover IRA provides this protection.
At one time, individuals could have possession of such funds for 60 days before rolling the funds into another plan. However, by federal law, to avoid all penalties the corporate plan proceeds must be paid from the former employer’s plan directly into another instrument. If the individual chooses to have a check made payable to him or herself while deciding where to re-invest the money, the employer is required by law to withhold 20% and send it to the IRS.
Further information regarding the regulations regarding rollover into IRA’s, etc., are discussed elsewhere in this text. A point to remember specifically is that if the entire amount, which includes the 20% that is “earmarked” for the government, is not rolled over within 60 days; there are dire tax consequences. A rollover IRA that is used properly keeps the funds intact and retains the tax-deferral benefits on the pension funds.
A “Roth IRA” will be discussed in detail elsewhere in this text. An annuity may be used to fund a Roth IRA, the difference being as to when taxes must be paid on the investment income.
Unless an individual annuity is used to fund an IRA, it is nonqualified. While premium deposits to a nonqualified annuity are not tax deductible, interest earnings are tax deferred and enjoy all of the other advantages as discussed in this text.
In addition, nonqualified individual annuities are not subject to the strict contribution limitations of an IRA. As a result, individuals may deposit much more cash into a nonqualified annuity each year than they are permitted to deposit into an IRA. For many people, the flexibility, the potential for depositing greater sums for retirement savings and the relatively fewer Internal Revenue Code requirements and limitations on nonqualified annuities add up to a better choice than an IRA.
With the burgeoning senior population who control a large percentage of financial assets and savings dollars, the insurers have developed annuities with their needs in mind, leading to what has been called, “the senior industry.”
Typically nonqualified, annuities geared to senior needs have many of the same features of other flexible premium or single premium deferred annuities already discussed. The seniors have free withdrawal privileges and a nursing home withdrawal or bailout feature, which is typically included automatically for this group of people. In addition, the senior age annuity owner is generally permitted to annuitize at anytime, without paying surrender or withdrawal charges and begin receiving income payments regularly, as discussed in the sections regarding variable and equity-indexed annuities.
Interest rates are as competitive on senior-directed annuities as on other annuities, although rates may be graded downward at the upper age range. Current declared rates are guaranteed for a limited time, after which a new renewal rate goes into effect.
The death benefits have been outlined previously, and it is apparent that some of the death benefit options are geared towards the older annuitants.
Taxation drives the Retirement plans more than any other single factor. Taxation of the various retirement plans will be discussed in another section of this text, but will be briefly and broadly discussed here. The use of annuities specifically as a funding mechanism requires more mention during this discussion of annuities.
Those who are self-employed, whether as sole proprietors or as business partners, may establish retirement plans for themselves (under a law named for the congressman – Keogh - who introduced it). They receive beneficial tax deferrals provided they qualify under the Internal Revenue Code. However, there are some features that should be highlighted in discussing annuities specifically.
In addition to covering the self-employed person, Keogh plans must also cover some employees as stipulated in the law, while other employees, such as certain part-timers, may be excluded. The plan must have a funding formula that doesn’t discriminate unfairly among employees who are required to be covered, specifically not penalizing lower-paid employees while providing an unfairly greater benefit for highly paid employees. Laws limit the amount that may be contributed to a Keogh plan.
Self-employed individuals who contribute to a Keogh plan may take a business tax deduction for contributions made for themselves and for employees. The contributions and interest earned are not taxed as current income. These amounts aretaxed when they are paid out as retirement income or otherwise withdrawn. Employees may make their own personal contributions to the Keogh plan. While these voluntary contributions are not tax deductible to the employees, they do accumulate and earn interest on a tax-deferred basis, with tax payable on the interest only when funds are withdrawn.
Annuities may be used to fund Keogh plan benefits as either a defined benefit plan or a defined contribution plan. (Also, see discussion under Qualified Pension Plan section)
As the name implies, a defined benefit plan is one that specifies or defines the amount of the benefit that will be paid at retirement. When the plan is established, a formula is included for determining the benefit amount. Contributions to the plan are then made in order to provide that predetermined benefit.
Qualified Defined Benefit Plan Limits: The Act increases the dollar limit on annual benefits from $140,000 to $160,000, subject to future indexing in $5,000 increments, in accordance with current law. The limits for early and late retirement are also made more generous: the dollar limit is reduced only if benefits start before age 62, while the limit is increased if benefits start after age 65. Effective for years ending after December 31, 2001.
Notice of Significant Reduction in Benefit Accruals: The Act amends the Internal Revenue Code to require the administrator of a defined benefit pension plan or a money purchase pension plan to give advance written notice of a plan amendment that provides for a significant reduction in the rate of future benefit accrual. Unlike the requirement under current law, the new notice requirement also applies to any elimination or reduction of an early retirement benefit or retirement-type subsidy. The notice must include sufficient information to allow participants to understand the effect of the amendment and must be provided within a reasonable time before the effective date of the amendment. A plan administrator that fails to comply with the notice requirement is subject to an excise tax. The Act also amends ERISA § 204(h) to provide that a plan amendment may not significantly reduce the rate of future benefit accrual in the event of an egregious failure by the plan administrator to comply with a notice requirement that is similar to the notice requirement in the Code. Effective for plan amendments taking effect on or after the date of enactment; however, the period for providing any required notice will not end before the last day of the 3-month period following the date of enactment. A good faith standard of compliance applies before the issuance of Treasury regulations.
A defined contribution plan specifies a formula for the amount of the contribution that will be made, rather than the amount of the benefit to be paid at retirement. The law stipulates a maximum amount that may be contributed. While the future benefit amount is unknown, it can be estimated at various points based upon the participant’s length of service, amounts actually contributed, and the estimated and actual earnings on contributions.
• Qualified Defined Contribution Plan Dollar Limit: The dollar limit on annual contributions is increased from $35,000 to $40,000, with more rapid future indexing (in $1,000 increments rather than the current $5,000 increments). Effective for years beginning after December 31, 2001.
• Qualified Defined Contribution Plan Percentage Limit: The Act increases from 25% to 100% the percentage-of-compensation limit on annual contributions. Effective for years beginning after December 31, 2001.
Annuities may also be used to fund corporate pension and profit sharing plans. While Keoghs are designed for self-employed persons, these plans are aimed at retirement for people employed by corporations. Like Keogh plans, these corporate plans must meet strictly written requirements to be considered “qualified” for special tax treatment.
A corporate pension plan may be either a defined contribution or a defined benefit plan. By law, pension plans must be established specifically to pay retirement benefits to employees. Contributions are paid by the employer on behalf of employees, subject to very detailed nondiscrimination requirements regarding lower-paid and highly-compensated employees.
Pension plans must conform to a formula for determining the amount of contributions or the amount of benefits.
Corporate profit sharing plans, which are designed to share actual company profits with employees, are more flexible in terms of how contributions are made. Some plans have a formula to determine what portion of profits will be distributed to employee accounts, while others do not. Even when no formula exists, non-discrimination controls must be in place to ensure individual employee contributions will be made fairly.
• Qualified Plan Compensation Limit: The limit on eligible compensation is increased from $170,000 to $200,000, with future indexing in $5,000 increments (rather than the current $10,000 increments). Effective for years beginning after December 31, 2001.
A group deferred annuity is one option available to corporations for funding defined benefit or defined contribution plans. Each year, the employer uses the contribution to purchase a single premium deferred annuity for each employee included in the plan. After many years, the employee receives the benefits from all annuities purchased on his other behalf.
Group deferred annuity plans have been popular because, first, they guarantee income since they are provided by an insurance company with the same guarantees any other annuity enjoys; and second, the insurer takes responsibility for all of the administrative details. As new forms of funding have been developed, however, group deferred annuities have become less popular with larger businesses, although many smaller businesses still find them attractive.
A more popular way to use annuities for retirement funding is through a group deposit administration contract. Under this arrangement, funds deposited with the insurer are not allocated for individual annuities, but instead, provide a pool that the insurer invests as a whole. The employer may choose investments providing a fixed rate, equity investments with variable rates, or a combination. Typically, a group deposit administration plan allows the employer to move funds between investment accounts from time to time to capitalize on changes in the market.
Under this type of plan, no annuity exists for an individual employee until the employee retires. The insurance company transfers funds from the pool of money to purchase a single premium immediate annuity for the employee, beginning retirement income payments at that time.
Corporations that have a qualified profit sharing plan in place may use annuities to offer employees another type of qualified plan popularly called 401(k) plans in reference to a section of the Internal Revenue Code. This will be discussed in detail elsewhere in this text. Again, the usage of annuities for 401(k) plans have been briefly discussed in the chapter on annuities, but some salient points regarding annuities are discussed here for emphasis.
Under 401 (k), employee participation must be optional. Whether the income to be deferred is actually a salary reduction or included additional compensation such as bonuses, the individual must be able to choose whether to take the cash when earned and be taxed as usual, or defer receiving the salary or bonus, and therefore defer taxation, until sometime in the future.
One of the primary advantages of a 401(k) plan from the employer’s point of view is that the contribution is essentially made with the employee’s money, rather than from an employer contribution over and above regular salary or bonuses paid. At first glance, a 401(k) might appear less advantageous for the employee since that person’s current salary will be smaller or a bonus will not be received currently. However, the employee not only has the benefit of tax deferral on accumulations, but also avoids paying federal income taxes on salary and bonuses deferred. Some state and local governments also defer income taxes for 401(k) funds.
A 401(k) plan is subject to many of the same rules as other qualified plans, plus additional rules unique to the 401(k). A fairly low maximum amount may be deferred into a 401(k) plan annually. The specific amount is indexed for inflation, so it changes periodically. This upper limit is the total deferral permitted for all CODAs (Cash or Deferred Arrangements) in which an employee may be eligible to participate. Under certain circumstances, employees could be involved in more than one deferral arrangement, and the total maximum is specified by law. As a result, participants must be careful to coordinate how much is deferred into each plan or face penalties for paying in more than the maximum.
• §401(k) Dollar Limit: The limit on § 401(k) contributions is increased from $10,500 to $11,000 in 2002. Beginning in 2003, the limit is increased in $1,000 annual increments until the limit reaches $15,000 in 2006, with future indexing in $500 increments. Similar changes are made to the limits on contributions to § 403(b) annuities, § 457(b) plans, and other elective plans.
Hardship Withdrawals: The Treasury is directed to revise its regulations to reduce from 12 to 6 months the period during which an employee's contributions must be suspended following a hardship withdrawal. The regulations are to be effective after December 31, 2001. In addition, no hardship distribution is an eligible rollover distribution (even if the distribution is not subject to § 401 (k) restrictions), effective after December 31, 2001.
• Catch-Up Contributions to Qualified Plans: An additional increase in the dollar limit on §401(k) contributions and other pre-tax elective contributions allows individuals age 50 or older to make catch-up contributions. For §401(k) plans, the increase in the dollar limit starts at $1,000 in 2002 and increases by $1,000 for each subsequent year until it reaches $5,000 for 2006, with future indexing in $500 increments. Catch-up contributions are not subject to any other contribution limits and are not subject to nondiscrimination testing. However, the plan must allow all eligible participants to make the same catch-up contribution election; all plans of related employers are treated as a single plan for this purpose.
Multiple Use Test: The Act repeals the multiple use test, which applies to highly compensated employees who participate in plans that allow both § 401(k) contributions and after-tax or matching contributions. Effective for years beginning after December 31, 2001.
Tax Sheltered Annuities (TSAs) are available only to people employed by specifically named tax-exempt entities such as religious, charitable and educational organizations. Other names by which these special annuities are known include Tax Deferred Annuities (TDAs) and 403(b) or 501(c) (3) annuities, the latter two referring to applicable sections of the Internal Revenue Code (IRC). Only the tax-exempt and nonprofit organizations listed in these sections of the IRC are eligible to purchase TSAs for their employees.
TSA rules require the employer to purchase the annuity on behalf of the individual employee. While the employer is responsible for paying the annuity premiums, it is the employee’s money that is used. Up to 20% of compensation times the employee’s years of service may be accumulated in the annuity. A total dollar maximum also applies and contribution amounts must be considered in light of other cash or deferred arrangements as mentioned in the previous section for 401(k) plans. In order to participate, employees must either take a salary reduction, with the reduced amount going to the TSA or the employer must pay additional compensation, earmarked specifically for the TSA. In both cases, this is income the employee never has because the employer pays it directly into the annuity.
Like other qualified plans, the benefit to employees is the tax deferral for the amounts contributed and for interest earnings, with the taxes then being paid at retirement when withdrawals begin.
The taxation of annuities has remained functionally the same in recent years, with taxation changes being more applicable to “methods” instead of “instruments.” For example, the rather recent regulations regarding Individual Retirement Accounts (IRA) and the addition of the Roth IRA affects the taxation of the method of accumulating funds, and not whether the underlying mechanism to fund the IRA is taxed differently than previously. However, a note of caution: while annuity products have retained tax advantages through numerous revisions in tax laws and Internal Revenue Service and tax court rulings, both laws and interpretations are subject to change. When the precise details of taxation are important to decisions regarding annuities, professional counsel is imperative. The information in this textbook does not represent legal or professional advice of any kind.
As indicated earlier in this text, certain tax benefits accrue during the accumulation phase. Except where specifically noted otherwise, the tax rules presented here apply to both fixed and Variable Annuities and equity index annuities.
The premiums an individual pays for a nonqualified annuity are not tax deductible for federal income taxation purposes. For a qualified annuity for an Individual Retirement Account (IRA), the premiums are deductible as discussed earlier. When the IRA owner is also covered by an employer-sponsored retirement plan. The amount of the tax deduction permitted gradually decreases until it reaches zero when the stipulated adjusted gross income maximums are reached.
Annuities may be used to fund any of the group retirement plans described earlier. When these are qualified retirement plans, the premiums, or contribution as they are often called, are tax deductible to the employer who makes them on behalf of employees. A Keogh plan can appear to provide an individual tax deduction when the plan benefits only a sole-proprietor that has no employees. In this case, the effect is the same as an individual’s deduction.
Payments made to qualified annuities are either tax deductible or the amounts used for this purpose are not declared as current income when paying income taxes. For example, an employer’s contributions to a group annuity are not reported as income when the contribution is made. And, while the employer’s contribution to an employer-sponsored IRA must be reported as income, it is “washed out” by the tax deduction the employee takes.
Some states assess state premium taxes on annuity premiums. When this is the case, the purchaser does not pay a separate tax. Instead, the insurance company deducts the correct amount from each premium payment and pays the tax directly to the state. Where state premium taxes apply, they generally equal about 2% or 2½% of the premium. Some insurers pay the premium taxes themselves and do not deduct the taxes from the annuity premiums.
During the accumulation period, annuity values build on a tax-deferred basis, with the interest remaining untaxed until money is withdrawn from the annuity. This is true for both qualified and nonqualified annuities.
As stated earlier, interest paid on deferred annuities is not taxed until annuity funds are withdrawn. Because this tax benefit is intended to encourage long-term savings for retirement, the Internal Revenue Code requires immediate tax consequences for early withdrawals— defined as withdrawals before the individual’s age 59½. These tax consequences include current income taxation and an additional penalty tax.
Generally, speaking a distribution occurs when the employment is terminated, the employee retires, or the plan is terminated. However, there is a premature distribution tax of 10%, which is applicable to many distributions from qualified retirement plans. This premature distribution tax is in addition to any income tax due on the distributions.
As with most laws or regulations, there are exceptions. They have been divided into three categories by many accountants and other tax practitioners.
Generally, the first exception(s) treats the reason as to why the distribution was made. Obvious exceptions are death or disability before age 59 ½. The least obvious exceptions are
The second exception(s) allows distributions because of separation of service for any reason, as long as they are in the form of a “Qualifying Annuity.” Basically, a qualifying annuity is an annuity starting at any age and paid in (substantially) equal payments and not less frequently than annually, for the life of the participant and his/her beneficiary. The qualified plan may purchase commercial annuities to satisfy the requirements of this exception. (Does this bring visions of “golden parachutes” funded by annuities?)
The third is the “roll over” discussed briefly earlier. The key words for this exception is “timely” and “fully.” This exception can be lost if it takes more than 60 days for a participant to make up their mind, and if less than the entire plan distribution is rolled into the new IRA or other qualified retirement plan.
There is no specific tax penalty for those who retire after age 59 ½, but there is a reduced benefit in Social Security payments for retiring prior to age 65.
Funds that are paid to a participant at normal retirement age escape taxation only on the funds that they have contributed to the plan. The funds that the employee contributes have been taxed earlier, so are not subject to tax again at retirement.
Distributions can be made either in installments or annuitized.
Distributions that are made in installments are taxed as ordinary income in the year they are received.
For annuitization, there are separate rules. First, as can be expected, if the person receiving the distribution (the distributee) has not paid any money into the plan (i.e. has no cost basis),then all payments are taxed as ordinary income.
Secondly, if there is a cost basis (i.e. the distributee has paid for part of the retirement plan) and if any distributions are made before the annuity starts, then part of the distribution will be taxed as ordinary income, and part as a “return of cost basis.” In order to determine the cost basis portion of the distribution, the following formula can be applied:
Total amount of previously taxed employee contributions.
Total present value of annuitant’s account balance or accrued benefit.
Lastly, the Exclusion Ratio may be used only until the distributee has recovered the entire cost basis. If the distributee/annuitant dies and has not recovered the entire cost basis, then the amount that has not been recovered can be used as a deduction on the annuitant’s last income tax return.
If a person chooses to take the distribution in a lump sum, they can do so and qualify for the favorable tax treatment, but the employee must be at least age 59 ½, or dies, separated from service (common-law employees), or become disabled (self-employeds). The distribution must be 100% of the employee’s account balance/accrued benefit, and further, the entire distribution must be made in one taxable year!
Mention should be made of the TRA ’86 related to those who reached age 50 by 1/1/86, and who elected to receive lump sum distributions on contributions made prior to 1/1/1974. Without going into all of the technicalities of this rule, this allowed for some of them to be taxed on the capital gains basis. These rules do not apply to distributions from tax sheltered annuities. If more detail is needed, one should contact a tax accountant.
For those who attained age 50 after 1/1/86, the rules are more pertinent. They cannot have portions of a lump sum distribution on pre 1974 contributions, taxed as capital gains as opposed to ordinary income. They lose the right to any income averaging on lump sum distributions before they reach age 59 ½. In addition, under TRA ‘86 there was a 10 year averaging of a lump sum distribution, that was reduced to 5 years, but effective 1/1/2000 even the 5-year averaging will not be available.
The TRA ’86 is discussed here as it is still applicable in certain situations. For example, if an individual is retiring now and has contributed to his retirement plan, he has several choices in respect to taxation of distributions. Some of these choices could (and probably are) be applicable:
On the ordinary income part of the distribution, he can elect either 5 or 10-year income averaging.
If he should use the 10 year averaging method allowed under TRA ’86, he would be taxed as if he were single and at the rate effective in 1986 (not present rates). Further, if he uses this method, this distribution and any other income will be separated for tax purposes.
If any part of the distribution is attributed to contributions made prior to 1974, he may be taxed at capital gains rates effective prior to 1974.
He can make the choice of rolling the entire distribution into an IRA (see below) and postpone paying any taxes until he withdraws his funds. However, he would lose his right to do any 5 or 10 year averaging.
As should be obvious, this is a highly technical area of taxation that has little to do with Financial Planning, but if it should arise, it would call for the professional expertise of a qualified tax accountant.
This subject has been approached previously, but deserves more detail and some repetition.
Any income tax on an annuity or insurance contract that has been distributed from a qualified plan can be postponed by converting the annuity or insurance contract to a “nontransferable” annuity within 60 days. Current taxation on the qualified distribution can be avoided if it is rolled over into a regular IRA.
Important: The funds must be rolled over directly into the IRA to avoid tax consequences. If the funds are not rolled over directly into the IRA or if they receive the money and then roll it over within 60 days, the taxable portion of this distribution is subject to withholding tax of 20%, i.e. the IRS requires that 20% of the money be withheld in anticipation of income taxes being due on that money. Oh yes, the “distributee” can recover that 20% at the end of the year when the individual income tax is filed. But (and it’s a big “but”) the distributee must pay into the new rollover account (IRA) the total amount. This means that the distributee would have to dig deep into their own pockets to pay the 20% that the IRS is holding, and which the distributee cannot recover until they have filed their next income tax.
If the distributee just deposits 80% of the amount into the IRA, the 20% that is being held in account for the distributee or the IRS will be taxed as ordinary income – even though the distributee only has 80% of the fund. In addition, there is a possibility that the distributee would be subject to a 10% penalty tax. (Double whammy!)
Once the funds have been deposited into the IRA, taxes will not have to be paid on the rollover until the IRA starts to distribute its assets. Any lump sum distribution will be taxed as ordinary income, and any annuity distributions will be taxed as previously discussed.
A partial distribution to an employee of the funds held in their account may be rolled over into a regular IRA unless (1) the employee reaches age 70 ½, (2) payments will be made for 10 years periodically or for the life expectancy of the employee, or (3) the amounts are not included in the gross income in the absence of the roll over.
The income tax that must be paid on an early withdrawal or surrender is based upon whether or not the cash accumulation value of the annuity is greater than the premiums paid at the time of withdrawal. When the cash value is greater, the so-called interest-out-first rule applies and the withdrawal is taxed entirely as interest to the extent of the cash value excess.
CONSUMER APPLICATION
Billy has paid $15,000 into his annuity, which has a present cash value of $20,000, when he decides to withdraw $3,000. The value of the annuity is $5,000 more than he has personally paid in. Therefore, the $3,000 will be subject to taxation as interest.
Billy decides that if he has to pay taxes on his withdrawal, he will have to take out more money in order to purchase what he wants, so he withdraws $6,000. Then the first $5,000 is treated as interest, and the other $1,000 is treated as both interest and principal, with taxes to be paid only on the interest portion of the $1,000.
While only a few insurers offer loan options with annuities, they are treated as the receipt of current income. As a result, the amount of the loan is taxed as income. Besides having to pay income taxes, the annuity buyer also pays interest to the insurer, so loans from annuities are not particularly attractive.
The distribution of benefits of a qualified plan has been discussed above. While the taxation of individual plans closely follow those discussed for the qualified plans, they must be studied separately.
When the annuity liquidation phase begins as scheduled, special tax rules apply to annuity distributions provided the income payments meet the Internal Revenue Code requirements to be considered amounts received as an annuity. The requirements are:
By meeting these requirements each income payment is divided into taxable and nontaxable portions. The part that is considered return of premium is not taxed, but the interest portion is taxed. How the taxable portion is calculated is a function of what the IRS calls an Exclusion Ratio.
The Exclusion Ratio is a percentage determined by dividing all premiums paid for the annuity by the expected benefits:
Total Premiums Paid = Exclusion Ratio
Total Benefits Expected
While some fairly complex rules govern this calculation, the following example describes basically how it works. The IRS provides tables to help determine the expected benefits, using a number called a multiple which is the number of years the annuitant is expected to live (assuming there is only one annuitant). This multiple is applied to the monthly annuity benefit that will be paid and also factors in the age at which the annuitant’s benefits are to begin.
CONSUMER APPLICATION
Tim Foyt has paid $90,000 for an annuity that will pay him $1,000 per month for life beginning at his age 65. The multiple from the IRS table is 20 at age 65 (and would be a different number at other ages). The multiple times the monthly benefit times 12 months equals the expected benefits:
20x$1,000x12 = $240,000
After the expected benefits are calculated, the Exclusion Ratio is then determined:
$90,000 = 37.5% (the Exclusion Ratio)
$240,000
For each $1,000 monthly payment Foyt receives, 37.5% or $375 is excluded from taxation. The balance, $625 per month, is taxed as current income. Or it may be stated: 62.5% of every monthly payment is taxed.
The specific numbers that apply to each situation will differ depending upon premiums paid, monthly benefit promised and the age at which liquidation begins. For Joint annuitants, IRS tables take into consideration the life expectancies of both people at their ages when annuity payments start. Once the Exclusion Ratio is calculated, that same ratio applies to every payment as long as payments are made.
Obviously, the treatment of Variable Annuities will differ from fixed annuities because the amount of each Variable Annuity payout can fluctuate making it impossible to determine the total benefits expected. However, if an individual had paid in $90,000 and expected to receive payments for 20 years; dividing $90,000 by 20 years results in $4,500 per year - representing return of premiums only. Then, for example, if the earnings on the account resulted in the annuitant receiving $6,000 for one year, $1,500 (“interest” paid over and above the $4,500 base) would be taxable. If this annuitant received only $3,000 for one year, none of it would be taxable since it all represents return of premium, no interest. With a Variable Annuity, the exclusion could be recalculated when payments change, following IRS procedures.
When an annuity has a death benefit payable to a beneficiary, the Exclusion Ratio still applies under certain circumstances. If the annuitant dies after payments have begun in the liquidation phase, the beneficiary must receive the death benefit in installments, either on the same schedule as the deceased or faster, in order for the Exclusion Ratio to be used.
Different rules apply if the annuity owner dies before the liquidation phase begins. If the beneficiary is the spouse of the annuity owner, the spouse is permitted to receive payments on the same schedule that the deceased would have received them, using the same Exclusion Ratio.
The Exclusion Ratio also applies to distributions to beneficiaries other than the spouse if the death benefit is handled in one of the following ways:
If, on the other hand, the survivor simply receives the annuity death benefit as a lump sum, taxes are due on the entire amount that represents interest earned. This results in taxes being due currently on a larger amount than is the case when the Exclusion Ratio applies.
Those persons whose estates are of a substantial size, must deal with federal estate taxes. The value of the annuity at the time of death must be included in the annuitant’s estate in proportion to the amount the deceased person personally contributed to the premiums that bought the annuity. The value of the annuity is the accumulated cash value to date if the individual dies before the liquidation phase begins. After liquidation payouts have begun, the insurance company determines the value of the annuity at the time the annuitant died.
The determination of how much of the annuity’s value must be included in the estate for federal estate taxation is quite simple. If the annuitant had paid 100% of the premiums, 100% of the annuity value would go into the estate. On the other hand, if the annuitant had paid 50% and someone else had paid 50% of the premiums, only 50% of the annuity value would be included in the estate.
This text has addressed the simpler aspects of annuity taxation. Tax laws can be quite complex as a particular type of annuity is used in any given case since different people have a variety of personal, business and financial situations that can affect taxation. Professional counsel is always recommended for determining the tax consequences of financial transactions.
CHAPTER 8 – STUDY QUESTIONS
1. The main difference between a “qualified” and a “non-qualified” annuity is
A. the qualified annuity allows a tax deduction on premiums paid and a non-qualified annuity is paid for with after tax dollars.
B. a qualified annuity can be sold in every state while a non-qualified annuity can only be sold in certain states.
C. The qualified annuity allows any amount to be deposited, tax deductible, while the non-qualified is limited to $3,000 per year.
2. “Keogh” plans are designed specifically for
A. individual employees that do not have a retirement fund.
B. large foreign based companies.
C. small unincorporated businesses.
3. A qualified “defined benefit” plan defines the amount of benefits that can be paid upon retirement. What is this maximum amount in the year 2000?
A. $100,000 during the rest of the retiree’s lifetime.
B. $150,000 every 5 years.
C. $160,000 per year with indexing of $5,000 per year.
4. The increase in value in an annuity
A. is taxable each year, the same as any other investment.
B. is taxable in accordance with the “exclusion ratio” when the annuity becomes annuitized..
C. is not taxable.
5. Early distribution of money in a qualified pension plan is not penalized if
A. the monies are used to purchase a second home.
B. the money is used to satisfy a court order in a divorce case.
C. the money is used to purchase a car.
6. A 40 year old person has decided to change jobs and has a retirement plan furnished by the present employer. They should
A. take out the money in the present retirement plan and use to buy a new home.
B. “Role over” the funds into an individual IRA.
C. leave the money in the retirement plan.
7. When an early withdrawal is done on a pension plan, the taxation of the withdrawal is based upon
A. last in, first out (LIFO).
B. first in, first out (FIFO).
C. last in, last out (LILO).
8. If an annuitant has a death benefit in an annuity and the annuitant dies after the annuity has been annuitized, the beneficiary will receive
A. nothing.
B. the same payout as the annuitant if the beneficiary is the spouse.
C. the balance of money in the annuity are paid out in a lump sum in an amount equal to 50% of the money still remaining in the annuity.
9. A qualified plan that specifies a formula for the amount of money to be paid into a plan is called
A. a defined benefit plan.
B. a contributory benefit plan.
C. a defined contribution plan.
10. Whose money is used to fund a TSA?
A. The employer’s.
B. Employer and employee in equal shares.
C. The employee.
ANSWERS TO CHAPTER EIGHT REVIEW QUESTIONS
1A 2C 3C 4B 5B 6B 7B 8B 9C 10C