In the last section, we explored the phases of annuities and how contributions are made to them and distributions made from them. This section covers the advantages and disadvantages of annuities and the parties involved, as well as how they are taxed.
There are four key parties involved in any annuity contract. They are listed as follows:
- Contract Owner – This is the person who purchases the contract and pays the premiums. Usually, the contract owner is also the annuitant, but not necessarily. There can also be more than one owner on a contract; all forms of joint tenancy are permitted for annuity ownership. Trusts and corporations can own annuities as well.
- Annuitant – This is the person named in the annuity contract who is scheduled to receive the annuity payments.
- Beneficiary – This person will receive the funds in the event that the annuitant/owner dies before the funds are redeemed.
- Insurance Carrier – This party is the life insurance company that holds the funds, administers the contract and is responsible for making payments to the beneficiary.
- Annuities are similar to life insurance in that it is impossible (and illegal) for the same person to be listed as owner, annuitant and beneficiary on a given annuity contract.
Advantages of Annuities
Annuities are among the most unique types of investments available, and there are many reasons why investors look to them as a key retirement-savings vehicle. Some of the key benefits provided by annuities are:
Tax Deferral – Annuities stand alone as the only investment that is inherently accorded tax-deferred status. All money invested into annuities of any kind grows tax-deferred until it is withdrawn. Annuities have no limit on the amount of money that can be placed into them, and there are also no income phaseout schedules that apply to contract owners or annuitants. This gives them a substantial advantage over Individual Retirement Accounts (IRAs) and qualified plans for wealthy investors who can shelter millions of dollars from taxation inside these contracts.
Guaranteed Payout – Annuitants who choose any type of life payout option can rest assured that they will receive some sort of payment until they die, even if they completely exhaust the value of the contract beforehand.
Protection from Probate and Creditors – Annuity contracts are generally exempt from creditors in most cases and are unconditionally exempt from probate proceedings nationwide. Exemption from creditors can vary somewhat from one state to another; for more information on this matter, call your state insurance commissioner.
Exemption from FAFSA Asset Status – Parents and students who apply for financial aid do not have to list any annuity contracts that they own as assets on the Free Application for Student Aid (FAFSA)form, provided that they are not receiving any payments from the annuity at the time the FAFSA is being completed. This can obviously make a huge difference in the amount and terms of loans and grants that the student is eligible to receive. However, it should be noted that nonqualified annuities do count as an asset on the CSS financial aid profile, an application that is used by about 200 private colleges in addition to the FAFSA.
Disadvantages of Annuities
Despite their benefits, annuity contracts can also present several disadvantages to investors, although they will vary considerably from one investor to another and depend upon various factors. The main drawbacks of annuities are listed below:
Costs and Fees – Annuities are one of the most expensive types of investments available in the financial marketplace. A breakdown of the fees for each type of annuity will be provided in later sections.
Illiquidity – Most annuity contracts charge stiff surrender penalties for early withdrawal, plus a 10% premature distribution penalty to investors who take withdrawals before age 59½ (see below).
Complexity – Although annuities can provide tremendous benefits for investors when used correctly, they are by nature complex instruments, especially indexed and variable contracts. Even experienced investors sometimes have difficulty understanding these vehicles, and a great deal of education is usually required to understand how they work.
Taxation – All withdrawals received from an annuity contract that are not considered to be a return of principal are taxed as ordinary income, regardless of the holding period of the contract (see below). There is no chance to qualify for capital gains treatment.
Annuity Withdrawal Penalties
As mentioned previously, most annuity contracts have a back-end declining surrender charge schedule that usually expires anywhere from one to ten years from the date of purchase. The surrender charge in the first year can be as high as 10% or even 15%, then declines by a percent or two each year before expiring. However, many annuity carriers allow investors to access some or all of the funds in their contracts under certain conditions, listed as follows:
Hardship or Disability – Contract owners who experience a medical or other emergency can apply for a partial or total withdrawal under these circumstances. In many cases the annuity carrier will permit the owner to withdraw some or all of the contract value at no charge.
Partial Withdrawal – Many annuity contracts allow owners to access a portion of their contract value (usually around 10%) each year for any reason. This window generally remains open until the surrender charge schedule expires.
Free Look Period – Virtually all annuity contracts have a free look period, during which the owner can return the contract for a full refund. For example, according to the SEC, variable annuities have a free look period of ten or more days.
Taxation of Annuities
Annuities stand alone in the investment world as unique vehicles in which all interest and other earnings grow tax-deferred until they are withdrawn. However, no tax deduction of any kind can be taken for contributions to annuities, unless the contract is purchased inside an IRA or qualified planand funded with contributions to the plan or account. If this is the case, all distributions taken from qualified annuities are fully taxable as ordinary income because of the contribution deduction.
All normal annuity distributions from non-qualified contracts consist of a combination of earnings and principal. Therefore each distribution is only partially taxable, as the portion of principal that is returned in each payment is tax-free. The taxable portion of annuities is calculated by using the Exclusion Ratio, which is a fraction that divides the amount of principal invested by the total value of the contract. If an investor purchases a $50,000 annuity and it grows to $150,000 after 30 years, then a third of each payment is considered a tax-free return of principal. The remaining balance is taxed as ordinary income. After the investor has recovered all of his or her principal from the contract, 100% of each remaining payment is taxed as ordinary income.
Annuities have the same 10% early withdrawal penalty for investors under age 59½ as IRAs and qualified plans. This penalty will be assessed on top of any early withdrawal penalties charged by the contract. Annuitants must also begin taking required minimum distributions at age 70½ from any contracts that are inside an IRA or qualified plan. Failure to do so will result in a 50% penalty being assessed upon the amount of distributions that should have been taken. However, there is no RMD requirement for nonqualified annuity contracts, although some carriers require annuitants to begin taking distributions by age 85 or on up to 100.
In the next section, we will examine the various parties that market annuity contracts and the regulators who oversee them.
Author: Mark P. Cussen, CFP®, CMFC, AFC