The previous chapters focused on the many advantages of both the fixed rate and Variable Annuities It might seem self-defeating to show the disadvantages of such a time-honored product, but one must be aware that nothing is perfect – not even annuities. As a matter of fact, there are three disadvantages listed by financial planners - and according to some, there are even more than three. However, the three that seem to have validity are:
(1) there are potential IRS penalties and taxes,
(2) potential insurance company penalties, and
(3) the ongoing expenses of Variable Annuities.
No matter what type of annuity you purchase, it is subject to a 10 percent IRS penalty for withdrawals of growth of income made prior to age 59 ½. No penalty is imposed on one's principal, i.e. the money put in by the owner is the owner’s money.
It makes no difference how old the annuitant (or owner) of the contract is, if they die then there is no penalty. Also, the Section 72 of the IRS Code states that the penalty is waived if the annuitant (or owner) is disabled. Generally, it must be the death or disability of the annuitant, not the contract owner or beneficiary, except where the contract is owner-driven, in which case all IRS penalties will be waived upon death or disability of the owner.
If the contract is annuitized, it will avoid penalty, but such annuitization must be elected by the contract owner within one year after investing in the annuity. The age of the owner does not have to be 59 ½, indeed it is irrelevant.
The final way in which the 10 percent IRS penalty can be avoided is the contract owner being age 59 1/2 or older.
Because of these penalties, annuities are usually recommended for younger people unless it is part of a retirement plan such as an IRA or pension plan or profit-sharing plan. Of course, there is always the exception of the person who has sufficient funds so that they would not have to touch the funds in case of an emergency. Annuities are ideal candidates for the investor who is near or past age 591/2.
Unless the contract is “owner-driven”, the owner can be any age, from newborn to centenarian. But even with the penalty, it could still make good sense for a young person(s) but would depend upon how soon the money is withdrawn and the assumed rate of growth.
CONSUMER APPLICATION
David inherits $10,000 from an uncle, at age 29. He invests it into a Variable Annuity and the VA performs admirably, giving him an average annual compound rate of return of 15 percent. At 15%, at the end of five years, his investment will more than double and be worth $20,113. David is married at the end of the five years, and needs some money for a new car and $10,113 is about right to let him buy the car, using his old car for the down payment. He discovers that he can have the money but he will have to pay a 10 percent penalty on the $10,113 growth portion of his annuity ($1,011). That would come out of the proceeds that David receives, so he would get only $9,102.
Now he finds out that he will have to declare this amount on his income tax, and the taxable amount would include the penalty, so he will have to show income of the full $10,113.
If David were in the 33% bracket, he would have to pay $3,337 in state and federal income taxes. So when he finally winds his way through the penalty and taxes, his actual proceeds would be $15,765 (gross profit less penalties, minus taxes on the growth of the fund, plus the original investment).
Actually, when he got to thinking about it, he still had his original $10,000, he had an additional $5,765 in his account and he is driving a new SUV.
Inside an annuity, the contract-holder’s money will grow and compound tax-deferred, not tax-free. To say it another way, any and all income tax liability can be postponed indefinitely. The death of one spouse will not trigger income taxes provided that the beneficiary was the surviving spouse. What happens when the surviving spouse remarries? The survivor can name themselves as the beneficiary and can name a new partner as the annuitant. When the last spouse dies, the beneficiary(s) can postpone taxes for up to an additional five years.
Income taxes are always due in the year in which income or growth of the fund is received. The return of principal is never taxed, regardless of who receives the money. The amount of taxes on the growth will be based on the tax bracket of the person receiving the funds. Unfortunately the taxable portion is always considered as ordinary income, and does not qualify for capital gains treatment.
As is obvious, taxes will have to be paid at some time or other. This may be considered as a “negative” but perhaps it is not all bad. For instance, the owner of the annuity decides when withdrawals are to be made. Therefore, one would attempt to take out the money when they are at the lowest income tax bracket, i.e. their income is the lowest. Frequently this is when the person retires.
CONSUMER APPLICATION
Bill is a partner in a business with Ned. They sell their business at a nice profit and after investing in a new business, they each have $1 million to invest as they had no retirement plan at their previous business. They are both in a 33% tax bracket. They talk it over and decide that they should be getting around 12% per year on their investment.
Ned invests his entire $1 million in a growth and income mutual fund as his brother-in-law is a securities dealer. However, since Bill’s brother-in-law is an insurance agent, to keep peace in the family he invests it in a Variable Annuity.
Twenty-four years later they retire at age 65 and they compare notes and find that the mutual fund and the Variable Annuity both have provided a 15 percent pretax rate of return. However, Bill now has $16 million in his retirement fund with the annuity, and even after paying taxes of about $5 million, he still has $11 million.
Ned is not a happy camper when he sees what Bill has done. Since Ned paid income taxes every year for 24 years, he will net approximately $6,829,000. Ned never speaks to his brother-in-law again.
If, for instance, Bill had withdrawn some of the funds during the “lean years” when their business suffered for a variety of reasons and Bill’s income was lower – putting him into a lower tax bracket, the overall results would have been even more outstanding.
But that isn’t all the good news for Bill! Since he and Ned were both over age 65 at retirement and drawing Social Security benefits, and retirement for them both was the original $1 million investment, the Social Security tax (wherein up to 85 percent of their benefits become taxable) applies if they have an adjusted gross income of at least $32,000 (both married). This formula to determine the income level includes all sources of income, including interest from tax free bonds and Social Security payments except it does not include the deferred growth or income within an annuity.
Now Ned’s wife won’t speak to her brother…
This “disadvantage” can best be explained by an illustration.
Don is 45 years old, and a year ago he invested $100,000 in a Variable Annuity that now is worth $120,000. This annuity has a surrender penalty that starts at 8% the first year, and 7% the second year, etc.
Don wants to take the growth, $20,000, out of the annuity. In this example a substantial portion of the $20,000 will be needed for taxes and penalties. The penalty the second year is 7%, and Don is in the 33% bracket (ignore state taxes for this illustration).
Withdrawal $20,000. Income taxes @ 33% = $6600.
Penalty 2nd year of 7% of principal = $7,000.
Amount that Don will receive ($20,000 minus $6600 minus $700 equals) - $12,700. (36.5%)
CONSUMER APPLICATION
Bertha owns a Variable Annuity, recently turned 65, and is receiving Social Security. She does not want to annuitize the VA at this time, but is concerned about taxation of the growth.
Under the Social Security Tax laws, up to 85% of the Social Security Benefits are taxable if the adjusted gross income is at least $25,000. Bertha owns her house and her car totally, and the only debt she has is a small credit card bill that she pays every month. She has children who take care of many of her other financial needs, so her income is kept at $24,000. However, she knows that any source of income such as interest from tax-free bonds and Social Security can trigger the 85%. But she is glad to know that the formula that determines the income level does not include the deferred growth or income within an annuity.
CONSUMER APPLICATION
Johnson is 47 years old. A year ago, he invested $100,000 into a Variable Annuity, and that annuity is now worth $120,000. The Variable Annuity contract includes an 8 percent declining surrender-rate penalty schedule (which is now 7 percent since the contract is in its second year). Johnson wants to get a new SUV and needs $20,000 as he does not want to pay interest on an auto loan, even though the rate is quite low. His son is an accounting student, and suggests that his father “do some math” to see if he should take the earnings out of his annuity. So Johnson starts writing on a legal pad, and is amazed at what he discovers:
Withdrawal from the annuity $20,000
Income taxes, at 40 percent (state and federal combined) $8,000
7 percent back-end load or penalty (year two of the contract) $700
10 percent IRS penalty under age 59 1/2 $2,000
Net remainder $9,300
Whoops! Smart son. Johnson finds an auto loan more acceptable.
The annuity aggregation rule may sound complicated, but actually it is quite logical. It applies to multiple (more than one) annuity contracts established after October 21, 1988, issued by the same company, to the same policyholder and within 12 months of each other.
If two or more contracts were issued by the same insurer to the same contract owner, distributions from either contract would be combined for income tax purposes. The result could be that tax liability could be greater than if the second contract had been purchased from another insurance company.
CONSUMER APPLICATION
Benton invests $50,000 in an annuity with Acme Insurance in June 1999. Six months later, he invests another $50,000 in an annuity with Acme Insurance.
The annuities grow at an annual return of 8%, with the combined value of $171,382 at the end of the 7th contract year. Benton withdraws $85,671 at the end of the 7th contract year. The total remaining with Acme is $85,671.
Lamar invests $50,000 with Acme Insurance in July 1999. In October, he invests another $50,000 with Standard Annuity Company. These annuities both grow at an annual return of 8%, with a value of $85,671 from Acme and $75,671 from Standard. Lamar also withdraws $85,671 at the end of 7 years from Acme Insurance. In effect, there is no more value in the Acme annuity, but $85,671 in the Standard annuity.
Assuming the same tax rates (1997 for a single person):
For Benton, the taxable amount is $71,382 with taxes due of $17,131.
For Lamar, the taxable amount is $35,671 with taxes due of $6,789.
Therefore, Lamar is in a better financial position at the end of 7 years, as both have a remaining balance of $85, 671.
But is this the final word. Hardly.
If Benton is to eliminate the remaining balance, there would be no tax liability as the $85,671 is less than the original $100,000 – and is entitled to a loss for tax purposes of $14,309.
If Lamar eliminates the remaining balance (the same amount as Benton), the tax liability of Benton would be based on a gain of $35,671 – which is the gain of $85,671 minus $50,000.
Lesson to be learned is that the annuity aggregation rule should be of concern only under particular withdrawal situations.
While most knowledgeable investors understand tax deferral, frequently they are not aware of the benefit of the stepped up basis. Basically, most assets will receive a “step-up” in tax basis to the “fair market value” at the time of death. Annuities and other retirement accounts do not receive this “step-up” in basis. Actually, the tax deferral on the unrealized (and untaxed) appreciation becomes tax “forgiveness.” But don’t get too excited – this stepped-up basis takes place only when the owner of the asset dies through the act of inheritance.
CONSUMER APPLICATION
Eugene buys a lot in an undeveloped shopping center that later is developed. He paid $100,000 for the lot and now it is worth $900,000. Eugenr dies, and this property passes to his son, Harold. Harold will receive this property and for tax purposes, the “stepped-up” value will be $900,000 – even though his father only paid $100,000 for it.
Harold sells the lot for $950,000 soon after he inherited it. He will owe taxes only on the $50,000 – not on the $850,000 that the lot has actually appreciated since it was purchased by Eugene.
If Harold had sold the lot for only $875,000, then there would be a loss of $25,000 that can be used to offset other gains or a small amount of ordinary income each year.
The bad news is that annuities, retirement accounts and gifts do not qualify for such a step-up in basis, regardless of how long the account was held by the deceased or the heir or beneficiary. It is beyond the scope of this text to go into detail, but suffice it to say that there is a big difference in taxation because of the step-up basis, and that of holding the asset for a comparable period of time and then selling it. As an example, a $10,000 investment earning a10% annual compound interest rate for a period of 20 years would indicate that the step-up basis investment on an after-tax basis, would be approximately 30% more than the same investment using the tax deferral of an annuity.
Many states have state premium taxes, which become due if and when the contract is annuitized and is based on the value at the time it is annuitized. While states vary, it can be as high as 3.5% of the contract value and the entire tax is deducted before the first distribution is submitted. Not all states have this tax, so it behooves the professional to know if it applies and the rate, and notify the clients of this charge, if any.
If the contract owner takes out more than a certain specified amount, expressed as a percentage, and within a specified number of years since inception of the policy, most insurance companies will impose an early-withdrawal penalty. The range of years is from zero (no penalty) to 10, years with fixed annuities usually being four years and Variable Annuities, eight years. A very few companies impose a penalty that is not applicable when the contract is annuitized, or death. The penalty schedule is usually published in the sales literature, and with some plans, is referred to as a “contingent deferred sales charge” (CDSC), “back-end load”, or surrender charge.
This surrender charge has been discussed elsewhere in this text, but to reiterate, the annuitant can make annual withdrawals of, usually, 10% to 15% per year, after the contract has been in force for one year. Company policies vary, as some companies will use a dollar amount that is based on the principal and all accumulated growth up to the time of withdrawal. Also, as a general practice, the permitted withdrawal amount does not accumulate, i.e. if nothing is withdrawn during the first two years the contract is in force, then the amount that can be withdrawn is still the first year amount. Some plans allow withdrawal of accumulated growth (not principal) at any time without penalties
This penalty kicks in if the withdrawal is in excess of the free withdrawal privilege. The insurance company penalty occurs if the withdrawal is for an amount in excess of the free withdrawal privilege.
CONSUMER APPLICATION
Harley invests $100,000 into an annuity. Harley is aware that he can withdraw a specified amount each year without penalty, but after the 7th year, there is no penalty.
Harley decides that he wants to buy a used SUV (those expensive SUV’s!) and needs $15,000 after having the annuity for 4 years. He has $9,000 of “free” withdrawal but the $6,000 in addition that he would need to buy the car would be subject to a penalty. The annuity penalty is stated to be 4% (rather typical), so $240 would be subtracted from the request, and Harley would get a check for $14,760. He then has to come up with an additional $240 to buy the car.
While some annuities have a penalty period of up to 10 years, most have periods that last for 5 to 8 years, and the penalty will decline each year. An example would be a “6-5-4-3-2-1-0” thereafter." Obviously, this means that the first year excess withdrawal would be subject to 6%, etc., and after 6 years, there is no penalty. Keep in mind that some companies have no penalty at all. In addition, remember that the penalty applies to only the excess amount.
Most contracts allow penalty avoidance if any of the following situation arises:
(1) death,
(2) disability,
(3) annuitization,
(4) withdrawals limited to those allowed under the free withdrawal privilege, and
(5) waiting until the penalty period lapses.
The insurance industry reports that over 75% of all the people who invest in an annuity never take out any money
The guaranteed death benefit is a unique feature of an “investment vehicle”, and the insurer collects a mortality fee to offset the cost of this benefit. This fee is intended to cover the cost of the death benefit, including commission and administrative cost.
The charges or fees for the death benefit will usually range from less than .5% to nearly 2%, with the most common being 1.25%. Since it is a “life insurance” vehicle, the fee (or premium for the death benefit) can never be increased and is shown clearly on all Variable Annuity contracts. For the purchaser of a Variable Annuity, since it is an investment by law, the prospectus given to all purchasers and which shows the different sub-accounts, their performance and charges, will show the fee among other charges required to be shown in the prospectus.
There still is no such thing as a free lunch. There would not be a mortality and maintenance charge if there is no guaranteed death benefit.
The prospectus will also show an annual “contract maintenance charge”, generally ranging from nothing to $50 per year. This amount is used to cover the cost to the insurer of maintaining the contract, i.e. administrative cost of keeping the policy active every year. It is normally waived if the annuity is above a certain minimum amount. This charge does not apply to fixed-rate annuities (there is no “annual”, or more frequent, report to the contractholder required).
STUDY QUESTIONS
1. One of the disadvantages of annuity is
2. If the annuity contract is annuitized
A. there will be no early withdrawal penalty.
B. the withdrawal penalty will still remain.
C. the withdrawal will be penalized, unless the amount is spread over 10 years.
D. the invested amount will be returned immediately to the annuitant, the rest to U.S.
3. Inside an annuity, the contract-holder’s money will grow and compound
A. tax-free.
B. tax-deferred.
C. taxable each contract year.
D. and estimated taxes must be paid quarterly.
4. Joe annuitizes a $50,000 annuity in 1998, but is going to receive his money in 1999, and is going to be taxed (income tax) on $30,000. When are his taxes due?
A. Each year at the annual anniversary of the contract.
B. 1998
C 1999
D. Quarterly, starting with the quarter in 1998 when he notified the insurer.
5. If the beneficiary of an annuity is the spouse of a deceased annuitant, and the surviving spouse remarries, naming the new spouse as the annuitant and herself as the beneficiary. When are the taxes paid?
A. When the original spouse died.
B. When the original beneficiary dies.
C. When the last spouse dies, the beneficiary can postpone paying taxes for 25 years.
D. When the last spouse dies, the beneficiary can postpone paying taxes for up to 5 years.
6. Bob has an annuity worth $55,000 that he has had for 3 years. If he wants to take money out of the annuity (early withdrawal) in excess of the allowed amount
A. he can do so by law, with no penalties.
B. he will have to pay income taxes on the income plus the penalty.
C. he will have to pay income taxes on the withdrawn amount, less the penalty.
D. he will have to pay both income taxes and capital gains taxes.
7. If two or more contracts were issued by the same insurer to the same contract owner, distributions from either contract would be combined for income tax purposes. This is called the
A. annuity stepped-up basis.
B. tax-deferred rule.
C. annuity aggregation rule.
D. accumulation ratio.
8. The guaranteed death benefit is unique to annuities. Which is true?
A. There will probably be a fee or mortality charge.
B. The premiums for this death benefit are included in the premiums and it is illegal to
charge another premium.
C. There is a fee for this benefit which will increase every year.
D. There is no additional fee as the premiums are taken out of agents commissions.
9. Most assets receive a “step-up” in the tax basis to the “fair market value” at death.
A. Annuities also receive the step-up basis at death of the annuitant.
B. All retirement accounts except 401(k) plans receive the step-up basis.
C. Annuities and other retirement plans do not receive this “step-up” in basis.
D. Annuities are the only asset that does not receive the step-up basis.
10. When John’s fixed premium annuity annuitizes,
A. there will never be a state tax on an annuity that annuitizes.
B. he will not have to worry about state taxes as that is illegal.
C. all states have premium taxes that become due when the plan annuitizes.
D. many states have premium taxes that become due when the annuity annuitizes.
1C 2A 3B 4C 5D 6B 7C 8A 9C 10D