Obviously, Annuities are important for a person who needs a vehicle to meet their financial needs. The financial needs of corporations that provide group benefits also benefit from annuities. Financial planners use annuities for a variety of reasons, and in today’s market, annuities must compete with other investment vehicles. Therefore, for annuities to take their proper place in the area of investments there are some basic considerations that must 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 (with one notable exception – the immediate annuity). This statement will be repeated in one form or another throughout this text, as it underlies the entire subject of annuities used as an investment. 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benefits of annuities— the tax-deferral on interest—applies only as long as the funds deposited in the annuity are not withdrawn.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 discussing the precise tax consequences, it is apparent that Internal Revenue Service tax penalties can be quite severe. As discussed elsewhere also, it be noted that 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company imposes its own penalties in the form of surrender charges or interest rate adjustments when annuity funds are withdrawn under certain circumstances.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 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.
Generally annuities are purchased with flexible premiums so as 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 who do not are “penalized.” At the same time, the flexibility and withdrawal privileges of newer annuities are more sensitive to changing financial circumstances, therefore annuity owners who encounter large, unexpected. immediate financial needs are able to access their annuity funds to some extent.
In particular, Variable Annuities are best perceived as long-term investments. When the stockmarket is a “bull” market, that also means that the investments underlying a Variable Annuity will also perform well over the long term.
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 is avoiding the temptation to withdraw from the investment during temporary downturns in the market.
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 also means that no current income tax is required on the portion of income used to pay the premiums for a qualified annuity. On the other hand, nonqualified annuities are paid for with after-tax dollars, which means contributions are not tax deductible.
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.
Most insurance companies offer both qualified and nonqualified annuities, but some do not. An insurer may offer types that 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.
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 and:
F - 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 our 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. Because Congress tinkers with IRAs every few years, the regulations and limitations change from time to time and at this time of writing, other changes are being discussed in Congress. The purpose of this discussion is to better understand annuities; therefore the following applications of annuities into retirement plans emphasize the position and applicability of the annuities only.
IRAs are available to every wage earner who is under 70½ years old; after age 70½, individuals may not establish an IRA. Each wage earner is limited to an annual contribution of $4,000 or 100% of earnings, whichever is less. For example, an individual earning a total of $1,500 annually may contribute no more than 100% or $1,500 per year to an IRA. Someone who earns $4,001 or more per year may contribute only the $4,000 maximum rather than 100% of earnings for the year 2007.
There is an exception to the “wage earner rule.” The wage earner may make an additional contribution on behalf of a non-employed spouse. For a spousal IRA, which provides retirement funds for both the wage earner and spouse, the wage earner may contribute up to $4,000 a year or 100% of earnings. Spousal IRAs can be set up in a single IRA with two accounts—one for each person—or in two completely separate IRA accounts. The $6,000 may be divided between the accounts in almost any proportions desired as long as no more than $3,000 per year is contributed to just one of the accounts. Note that if one spouse is over age 70 ½, the other spouse, if employed, cannot make more than the one contribution of $2,000.Even people participating in employer-established retirement plans may contribute to IRAs and enjoy tax deferral on the interest build-up. How much, if any, of the IRA contribution is tax deductible to the individual depends upon his or her adjusted gross income.
NOTE: In 2005 the annual contribution limit will be $4000.00
In 2008 the annual contribution limit will be $5000.00
As indicated, any wage earner who contributes to an IRA receives the benefit of earning interest without paying taxes on the earnings until the funds are withdrawn. Wage earners who are not included in an employer-sponsored qualified retirement plan may deduct the entire amount of the contribution from taxable income for the year the contribution is made.
Wage earners who do participate in a qualified retirement plan at their place of employment are also eligible to take a tax deduction for the amount contributed provided they meet Internal Revenue Service guidelines, as briefly outlined in the next paragraph.
The entire amount of the contribution is deductible for a single taxpayer whose adjusted gross income (AGI) is less than $34,000 annually and for married taxpayers filing jointly whose AGI is less than $54,000 per year. (These amounts will be indexed in later years). The portion of the contribution that is deductible is gradually reduced as income rises until it phases out completely. No deduction is available for a single wage earner when AGI reaches $44,001, nor for joint filers when their AGI reaches $64,001. But remember the tax deferral on interest continues even though the contribution is not tax deductible.
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, a federal law now states that 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 government.
The individual still will not be required to pay any taxes if the money is rolled over within 60 days, but there’s a huge hitch in this plan. The individual must roll over the entire amount, which includes the 20% that has been sent to the government. Therefore, the individual must find that 20% somewhere else, add it to the funds actually received, and. roll all of that into the rollover instrument. Not only does the individual get only part of the funds, but if the person cannot pay the additional 20% to make up the entire amount, the 20% already sent to the government is taxed as current income—even though the individual never had access to it.
However, the 20% previously sent to the IRS will be reclaimed on the individual’s tax return, but meanwhile the government has had temporary use of the individual’s money and has also forced the person either to find another 20% to complete the rollover or to pay taxes on money the individual never had because the government took it. A bill has been introduced to repeal this highly unfair law that penalizes anyone who is ill-informed, but as of this writing, the rule applies.
In the meantime, a rollover IRA that is used properly keeps the funds intact and retains the tax-deferral benefits on the pension funds.
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 related advantages.
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.
In the development of innovative annuity products, insurers have not missed the opportunity arising from the so-called “graying of America,” the phenomenon of many millions of people over age 65 who are currently alive and in need of income. People in the senior age groups control a high proportion of both personal financial assets and savings dollars. Some insurers have begun to offer annuities with features especially for older adults, aiming at those age 55 and higher — although the products may be purchased by younger people as well.
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 is usually an automatic feature. 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.
Interest rates are as competitive on senior-directed annuities as on other annuities, although rates may be graded downward at the upper age range. One company, for example, reduces the current interest rate by one-fourth percent for ages 80 to 90, and another one-fourth percent reduction for those ages 91 to 100.
A death benefit typically applies following a stipulated period of time. The benefit may become larger as the policy ages. For example, after the first year, the benefit might be just a return of premiums; followed by return of premiums plus the minimum guaranteed rate; then, in later years, premiums plus all interest earned.
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.”
This section will discuss uses for group annuities and other types that are owned by businesses rather than by individuals. These will be qualified annuities – i.e. those used to fund qualified retirement plans that benefit employees. By definition, a Group Annuity is a contract providing a monthly income benefit to members of a group of employees. A group annuity has the same characteristics as an individual annuity, except that it is underwritten on a group basis.
People 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 who introduced it. Known as Keogh or HR-10 plans, they receive beneficial tax deferrals provided they qualify under the Internal Revenue Code. While the extensive details of the legal requirements are beyond the scope of this course, the following paragraphs highlight critical features.
In addition to covering the self-employed person, Keogh plans must cover some employees as stipulated by 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. The amount that may be contributed to a Keogh plan is limited by law.
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 are taxed 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.
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.
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.
Annuities may also be used to fund corporate pension and profit sharing plans. While Keoghs are designed for self-employeds, 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 with regard to 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.
A group deferred annuity is one option available to corporations for funding defined benefit or defined contribution plans. Every 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). The actual terminology for a 40l(k) is a Cash or Deferred Arrangement (CODA) wherein the employee defers receiving some portion of current income in order for the 401(k) contribution to be made. Still another name for this arrangement is a salary reduction plan, again referring to a reduction in current salary with the remainder of the salary contributed to the 401(k).
Under a 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 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.
STUDY QUESTIONS
CHAPTER 2
1. Annuities are generally purchased with _________________
A. fixed premiums.
B. 401(k) roll over funds.
C. flexible premiums.
2. IRAs are available to everyone who is
A. under 59 ½ years old.
B. under 70 ½ years old.
C. unemployed with no income.
3. The retirement plans known as “Keogh” plans are only for the use of
A. those employees also covered under an employer-sponsored retirement plan.
B. self employed persons, either sole- proprietors or partners. plan he/she receives.
C. those employees of large publicity traded corporations.
4. Interest paid on deferred annuities
A. is not taxed.
B. is not taxed until the funds are withdrawn.
C. is taxed each year it is earned.
5. An annuity that offers free withdrawal and nursing home withdrawal privileges is
designed for
A. IRA rollovers.
B. aggressive investors.
C. the senior market.
6. From the viewpoint of the employer, one of the advantages of a 401(k) plan is
A. the contributions are made from the employers money only.
B. the contributions are made from the employees money.
C. the contributions are from bonus or merit pay of the employees.
7. Group Deferred Annuity plans are popular because
A. it does not cost the employer anything -it is 100% contributory.
B. they get a much better return than any other type of annuity if the market drops.
C. they guarantee income and the insurer handles the administrative details.
8. As a general rule, annuities should be considered
A. part of a short term investment strategy.
B. outside the purvey of being used for investments.
C. part of a long term investment strategy.
9. A Single Premium Immediate Annuity is used to
A. begin paying an immediate income stream.
B. balance out other annuities in long term investment programs.
C. form the basis for an Equity Adjusted Indexed annuity.
10. If income tax is not required on the premium used to fund an annuity then the annuity
would be
A. a qualified annuity.
B. a flexible premium annuity.
C. a non-qualified annuity
Answers: 1C, 2B, 3B, 4B, 5C, 6B, 7C, 8C, 9A, 10A