Annuity, annua? A lifetime income?
About 5 minutes read.
DISCLAIMER: This article and example are only provided for educational purposes and general information, and not for advertising nor soliciting Annuity products. Author also does not provide any tax nor legal advise. Always perform your own due-diligence and consult with a qualified tax and financial professionals, and evaluate for your own condition and situation for various financial products before taking any action or purchase.
How does it work In a Nutshell
- You fund (premium) an Annuity contract (issued by an issuer/insurance company) aka the Accumulation period for a certain period of time (usually years) OR a one-time lump sum, with an expected rate to grow the cash value (premium minus cost), and agree (written in the contract) on a future date (aka Annuity Start Date) when you (the annuitant) will start receiving payout from the issuer. (Note: If the Annuity contract owner deceased during the Accumulation Phase, there is a death benefit clause to pay out the funded premium minus cost/fees plus other income riders if applicable.)
- When the payout starts (liquidating your funded premium + earnings and minus cost) aka the Annuitization Phase, you cannot fund your Annuity contract anymore, and it will start paying out (based on settlement option) until certain condition is met which terminates/fulfills the contract obligation from the issuer.
Annuity is a contract with the issuer, and activity such as terminating, withdrawing, assigning, assuming, garnishing, gifting, inheriting, or settlement in a trial, etc. could trigger taxable events. Although, most are covered in the disclosure (if you read them!!!!!!!!!!!!!!!!!!), still, it is always recommended to consult with a qualified tax professional and a life agent to review your situation and assumption.
Note, the benefit of tax-deferred (means you pay tax on earnings later, not every taxable year) applies to annuity contracts, and has nothing to do with qualified versus non-qualified annuity which is explained in the next paragraph.
An Annuity Contract
I only highlight what I think is important as a reminder and what I think most people overlook or forget. For the full contract and review, please consult with a qualified life agent licensed in Annuity.
A general way to distinguish a qualified or non-qualified annuity can be categorized based on whether the qualified annuity is funded with pre-tax dollars and meets the qualified plan rules which limits the contract owner’s for certain rights (e.g. assign, alienation, loan, garnishment, age restrictions, Required Minimal Distribution, etc). Think of it as your individual 401(k)/403(b) or IRA plans, those restrictions apply.
An Annuity contract involves 4 parties - insurer, contract owner, annuitant, beneficiary.
- Insurer - issue the unilateral annuity contract, usually the insurance company.
- Contract Owner (usually the Insured)
- natural person, entity such as corporation, a qualified plan, an employer, or trust
- owns the contract, pays the premium, has the right to withdraw cash value, surrender, transfer/assign, use it as collateral for loan, name/change the beneficiary during accumulation period, designate annuitant, receive insurer-declared dividends, choose settlement options, and IRC 1035 exchange.
- Annuitant - the person receiving the annuitization payout, and must be a natural person, and has the life contingency (contract depends on this person’s life) and impact to the income benefits when this person dies.
- If Contract owner is the Annuitant, this is called a Simple structure.
- If Contract owner is NOT the Annuitant, this is called a Complex structure.
- Owner-driven - death of annuitant before annuitization, contract owner becomes the annuitant. No death benefit is paid to beneficiary until the contract owner (annuitant) dies.
- Annuitant-driven - death of annuitant triggers death benefits paid to beneficiary. But death of contract owner will only paid the accumulated cash value to the beneficiary, not the death benefit.
- Joint and Survivor (more than 1 annuitant)
- Beneficiary
- The designated natural person or entity to receive the death benefit or the remaining payout based on the type of annuity contract and condition.
- Listed as beneficiary for an Annuity contract bestows certain rights and options and eligibility for Medi-Cal (Section 14006.41 (a) SB No. 483).
The Easily Forgotten Part in the Contract
Do you remember what you have signed 5-10 years ago when opening a bank account or signing a loan document or any contract? I cannot. Hence, I want to point these out which are the most forgetful and confusing part when time pass. Although, everything in a contract is important, however, because I am forgetful, and to remind myself, I would like to highlight the following provisions and clauses, plus some gotchas that are the critical ones impacting your benefits and pockets.
- Settlement Options - How do you receive the payout and benefits
- Life Annuities (Straight Life) - payout continues until the annuitant pass away
- Minimum Payment Guarantee
- Period certain - payment goes to beneficiary up to certain period if annuitant dies before the certain period window.
- Refund - cash or installment refund
- Withdraw - liquidating your funded premium or cash value prematurely or after annuity start date
- LIFO (Last In First Out) rule on the gain
- 10% penalty if applicable. Qualified age (e.g. age 591/2+)? Qualified plan (401/403k/IRA rollover to purchase Annuity)?
- Market value adjustment, plus additional withdraw charges from issuer
- Surrender Charges - if you want to cancel your Annuity contract, a fee is applied. This is also known as Contingent Deferred Sales Charge (or CDSC).
- Annuity Start Date - make sure you remember this date for retirement and tax planning
- Assign/Gift/Inherit - triggering taxable events
- Taxable income are treated as Ordinary Income, not Capital Gain (Even you invest in mutual fund, etc. in a Variable Annuity Contract)
Different Types of Annuity Contracts
- Cash Value Accumulation in your Annuity contract
- Fixed - insurer’s general account, insurer’s bear the risk
- Guarantee minimum credit interest or at current rate (declared-rate)
- Indexed - cash value allocated to an index strategy in the index term period
- Cash value is usually protected with upside gain (cap rate could be applicable)
- Variable - insurer’s separate/structured/fixed account, policy-owner’s bear the risk
- cash value can allocate to one of the sub-accounts in separate/structured/fixed account in accumulation or annuitization period and it varies by contract
- e.g. sub-accounts in separate account includes common stock/bond/money-market fund and more depending on insurer
- Policy-owner bears the risk to elect for one/multiple accounts to allocate premium and may have different duration (lock-in period), cap rate, loss buffer respectively
- May require premium allocation duration (lock in for elected account)
- Vary cap rate and loss buffer per account e.g. using Equity Index as an example,
- Equity index level started at 100, ended at 125, and cap rate is 12%. Current rate is 25% = [125 - 100] / 100 * 100, but it will be capped at 12% only
- Equity index level started at 100, ended at 75 and loss buffer is 10%. Current rate is -25% = [75 - 100] / 100 * 100, loss buffer will cover 10% loss. Policy-owner lost is -25% + 10% = 15%. Policy-owner allocated premium in this account will reduce 15%.
- When benefits are paid out (Payout/Annuitization period)
- Deferred (SPDA/FPDA)
- Immediate (SPIA) - client gives insurer a lump sum of money in exchange for insurer's promise to make regular smaller payments over a period of time.
- Premium (In Accumulation period. The pre-paid premium cannot exceed future unpaid premium / 10 future paid premium if less then the sum of future unpaid premium)
- Single Premium
- SPImmediateA (SPIA) - only one premium payment
- SPDeferredA (SPDA) - fixed, level, or flexible premium
- Flexible Premium (always Deferred)
- FPDeferredA (FPDA)
The Rate Myth
Annuity Planning Strategies and Scenarios
If you are NOT new to Annuity, and are interested in different ways how Annuity are used in different financial planning strategy, you can read up the article “Annuity Planning Strategies”. Note: Be aware of the gotchas when planning Annuities. Annuity is for long-term planning, and any early withdraw/termination could subject to charges and fees, and trigger taxable events. Consult with a qualified tax professional and life agent for your situation.
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