While we are not in the business of selling annuities, clients or prospective clients of AMM may have questions about these seemingly complex insurance products. Whether an annuity was inherited, purchased from a previous advisor, or otherwise acquired, common questions we receive from clients include: what type of annuities do they have, what are the rules and tax implications, and if they inherited an annuity – what’s next?
AMM’s Stance on Most Annuities
AMM does not sell annuities and does not typically advise clients to purchase annuities over a diversified portfolio of securities that are more liquid, more transparent, and less expensive. In general, we maintain the view that annuities should be utilized for purposes typically associated with life insurance (i.e. protecting income and assets from uncertainty surrounding mortality and longevity) and not as investment vehicles. In the latter instance annuities remain a costly and overly complex way to invest your financial assets.
However, we do recognize that certain types of annuities may be helpful in some circumstances. For example, a fixed index annuity may be a viable option for a very conservative investor seeking a guaranteed source of income with implicit downside protection.
If you would like AMM to analyze an annuity that you currently own, or if you have any additional questions related to annuities, please contract our team and we would be happy to discuss with you.
Types of Annuities:
Annuities come in many different forms. At the highest level, annuities are insurance contracts in which premiums are paid to the insurance company via a lump sum or over time and then regular payments are made back to the contract owner either immediately or at some time in the future (deferred).
Annuities are also categorized as either fixed or variable. Fixed annuities are pooled investments by the annuity company and provide a guaranteed fixed payment. Indexed annuities are a type of fixed annuity in which funds are invested in a manner that mimics a market index such as the S&P 500, there is no risk of principal loss, but in exchange, contract owners only receive a portion of upside gain in the underlying investments. Variable annuities are invested in individual accounts and allow for fluctuations in the value of the account dependent on underlying investments. Because the account value can fluctuate, the amount of money an annuitant will receive can also fluctuate.
As most American companies have done away with pensions, some annuities present an opportunity to receive a guaranteed stream of income for life, similar to Social Security.
Qualified pension contracts are used as retirement savings in which owners pay into the annuity over time with rules similar to a Traditional Retirement Account (deduct the contributions now, pay taxes on the distributions later, must annuitize by age 72, cannot take withdrawals without penalty prior to age 59 1/2).
Other non-qualified annuities can be used as investment vehicles and do not have the restrictions that qualified annuities have, but still have plenty of opaque rules.
After the contract period, annuitants may have the option to leave their money invested with the insurance company or to annuitize (begin receiving distributions).
Similar to a traditional IRA, any disbursements from a qualified annuity will be taxable as ordinary income. For non-qualified annuities, an exclusion ratio is calculated to determine what portion of the disbursement is a return of capital (non-taxable) and what portion represents earnings which are taxed as ordinary income.
There is typically an option to take a lump sum, or various payout options outlined below:
- Lump sum: If a qualified annuity, the annuitant would owe income tax on the total amount received in the lump sum payment. For unqualified annuities, the portion of the annuity representing a return of capital would be returned tax-free and any earnings would be considered ordinary income. This is a disadvantage when compared to other capital investments which have the potential to receive preferable capital gains tax rates.
- Life: Monthly disbursements are calculated based on the annuitant’s projected lifespan. Payments end when the annuitant passes away, regardless of how much money was paid out. This has the potential to be a winning or a losing bet.
- Period Certain: Monthly payments are received over a guaranteed period of time.
- Life with Period Certain: For this option, monthly disbursements are calculated based on the annuitant’s life span, but guaranteed for a period of years. In the event that the annuitant passes away during the guaranteed period, beneficiaries would continue to receive payments for the remainder of the guaranteed period.
- Survivorship: If there is a survivorship option, this means after the annuitant is deceased, payments would continue for the life of the surviving beneficiary. Often the surviving beneficiary must be of the same generation as the annuitant. Survivorship typically significantly reduces the monthly payout as the insurance company is factoring in two lifespans instead of just one.
Distributions can often be a combination of several of these payout options; for example, Life with 50% Survivorship, meaning that the annuitant would receive payments for life and the surviving beneficiary would receive 50% of the benefit for their remaining life when the annuitant passes.
Determining the most beneficial payout option for you depends on what you think your life expectancy will be, your monthly cash flow needs, and desire to leave funds to beneficiaries.
Annuities, unlike other types of inherited investments, do not receive a step-up in basis and will have the same tax rules to the beneficiary as they did for the annuitant – typically resulting in some amount of ordinary income tax.
If you inherit a qualified annuity, a large portion, if not 100%, of the annuity will be taxable as ordinary income to the heir. For non-qualified annuities, the principal paid into the annuity will be returned tax-free and any earnings in the account will be taxable as ordinary income.
Prior to receiving a distribution, ask the annuity administrator what portion of your inherited annuity is taxable and in what order you will receive taxable vs non-taxable funds.
If you inherit an annuity, you will typically have three options as to how to receive the funds:
- Lump Sum
- Annuitize over your life span
- 5-Year Rule: All funds must be distributed within 5 years but can be distributed in any portion at any time during that period as long as 100% is distributed within 5 years or less.
Why Annuities Can Seem Attractive
Many retirees are concerned that they have the potential to outlive their savings or are worried about the impact that a large downturn in the market could have on their retirement nest egg. Fixed annuities allow for a pension-like guaranteed payment for life.
Pros of annuities:
- Guaranteed income for life, or a predetermined amount of time, or monthly amount of money.
- Tax deferral. No capital gains or income tax is owed until distribution.
- Limited exposure to market downturns, fixed annuities protect investors from losing money in their annuity account.
- Peace of mind associated with a conservative investment.
Cons of annuities:
- Annuities often have a contract period in which you cannot move your money without heavy penalty – they are illiquid for a period of years dictated by the contract.
- With indexed annuities, investors may not obtain the full benefit of the market when it does go up because indexed annuities (type of fixed annuity) often have “participation rates” which cap the amount of upside you can earn in your account. If the market does better than that cap, the annuity company keeps the additional profits.
- Once annuitized, the monthly payment is usually fixed and will not increase with inflation. Inflation riders may be purchased for an additional cost.
- Unclear fees that often make annuities an expensive investment choice.
- Brokers are typically paid a commission up-front for the sale of an annuity product which enables the system to be riddled with self-interest. Brokers are not always fiduciaries who are legally required to put the client’s best interests first.
- Earnings are taxed as ordinary income to the annuitant and beneficiaries. There is no step-up in basis for heirs.
The Fees Add Up
The most common qualm with many annuity contracts, especially variable annuities, is that extensive fees may be hidden in the fine print. The amount of fees typically increases with the complexity of the annuity contract. For example, fixed annuities, which are relatively more straight-forward than variable or index annuities, will likely have lower fees.
According to Annuity.org, in total, average annual fees on a variable annuity are 2.3 percent of the contract value and can be more than 3 percent. The list of fees can include the following: Commissions, Annuity Rider Fees, Administrative Fees, Surrender Charges, Mortality Expenses, Investment Expense Ratios, Transfer Charges, Distribution Charges, Third Party Transfer Fees, Contract Fees, Underwriting Fees, Redemption Fees, and General Fees.
Our recommendation is to make sure you ask about each of these and understand the total amount of fees you will pay up front, on an annual basis, and afterward to transfer the annuity BEFORE deciding if this type of contract is right for you.