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 the most 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, and there “ain’t no easy way” to avoid it. No penalty is imposed on one's principal, i.e. the money put in by the owner is the owner’s money.
Didn’t say that there was NO way to avoid this penalty prior to the age of 59 ½. There just happens to be 3 ways to avoid it:
It makes no difference how old the annuitant (or owner) of the contract is, if they die then there is no penalty. Also, 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 59 1/2.
Unless the contract is “owner-driven”, the owner can be any age, from new born 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even with the penalty, it could still make good sense for a young person(s) but would depend upon how soon the money is withdrawn and the assumed rate of growth.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 is in the 33% bracket, he would have to pay $3,337 in state and federal income taxes. Therefore, 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 has his original $10,000 and he has an additional $5,765 in his account.
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.
This “disadvantage” can best be explained by an illustration.
CONSUMER APPLICATION
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 2d year of 7% of principal = $700.
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 86% 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.
This was introduced earlier but it bears further discussion here also. 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 are 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.
This was discussed earlier, but let’s look at it in another way. 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.
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 a 10% 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 withdraws 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 may be 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.
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.
F 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 contract holder required).
When comparing an annuity with other types of investments, there are advantages and disadvantages, basically depending upon how Uncle Sam treats the investment at tax time, how easily and rapidly can the investor get at his funds, whether there is an actual credit risk or risk on the market, i.e. how stable is the investment when the market fluctuates, etc., and lastly but not least-ly, what guarantee is available to the investor that the funds will be there when needed?
The following investment “types” pretty well tell the story. Of course not all investment types are listed as there are all kinds of options on the market, dot.com investments (e.g. Google), investments in the brother-in-laws business, etc. Mutual Funds have been discussed earlier in this text.
Please note that the tax treatment of the investment product does not take into consideration such investment being used for a tax-deferred program, particularly IRAs, Keogh plans, SEP plans, TSAs, etc.
STUDY QUESTIONS
1. One of the disadvantages of annuities often quoted by financial planners is
A. there are potential IRS penalties and taxes.
B. Mutual Funds can grow at a better rate because of their taxation advantages.
C. there is no tax advantage in any respect in an annuity.
D. only NASD licensed personnel can sell them & they all change jobs too often.
2. If an annuity contract is owner-driven, then at death of the owner
A. all IRS penalties will be waived.
B. no IRS penalties will be waived.
C. IRS penalties will be waived if the owner is older than 59 ½.
D. all value reverts to the state.
3. The taxable portion of an annuity benefit is
A. taxed at Capital gains rates.
B. not taxed at distribution.
C. the total of contributions and internal growth.
D. taxed as ordinary income.
4. Partial withdrawals
A. can result in high taxation.
B. can be tax sheltered for the life of the annuitant plus 8 years.
C. are never taxed, even at annuitization.
D. are repayable at 1% interest.
5. The Annuity Aggregation rule
A. does not allow an annuitant to own more than 2 annuities.
B. does not allow a TSA participant to own other types of annuities.
C. requires insurers to pool the premium income of all annuities.
D. applies to multiple annuity contracts issued by the same company to the same
contract owner within 12 months of each other.
6. A “stepped-up” basis for taxation
A. applies to all annuity benefits at time of death of the contract owner.
B. does not apply to annuities and takes place only when the owner of the asset dies.
C. is required for every Variable Annuity, including EIAs.
D. is the upper tax bracket into which an annuitant falls at annuitization.
7. A withdrawal penalty for early withdrawal from an annuity kicks in
A. only when the withdrawal is in excess of the free withdrawal privilege.
B. upon the death of the contract owner.
C. upon the death of the annuitant and the beneficiary.
D. upon the retirement or disability of the contract owner.
8. Most contracts allow early withdrawal without penalties upon
A. withdrawals to purchase a first home.
B. withdrawal to pay for college education debts.
C. death, disability or annuitization.
D. a period of three years in a row of excess interest accumulation.
9. The guaranteed death benefit is a unique feature of an “investment vehicle” and
A. there is no extra charge or fee for this feature.
B. it is always sold as a rider for a sometime exorbitant fee.
C. the insurer collects a mortality fee to offset the cost of this benefit.
D. all funeral expenses are also paid, at no extra cost to the annuity owner.
10. If an annuity has an annual contract maintenance charge, then the annuity is not
A. a fixed-rate annuity.
B. an EIA.
C. a Variable Annuity.
D. a small amount annuity.
ANSWERS TO STUDY QUESTIONS
1A 2A 3D 4A 5D 6B 7A 8C 9C 10A