An annuity is a flexible financial tool that can be tailored to meet your needs and, possibly, have a role in your estate plan. The ability to deliver a stream of income makes annuities popular retirement planning tools. However, due to the variety of types and the multiple structures that can be used, the right match for a person’s needs can be created for other reasons as well.
What is an Annuity?
A basic definition of this financial tool is a good place to start when considering its use in financial planning. In the Internal Revenue Service’s Publication 575 (“Pension and Annuity Income”), an annuity is defined as a contract for a series of payments to be made at regular intervals over a period of more than one full year. You can choose to have the payments be either fixed so that you receive a definite amount each time or they can be variable, fluctuating based on investment performance or other factors. These payments could be immediate (the income payments are not delayed after the annuity is created) or deferred (payments are subject to an “accumulation” phase before the “payout” phase provides the income stream).
Also, you can buy the contract on your own, but these often are offered through a person’s employer. The latter are considered “qualified annuities” because they are components of tax-advantaged retirement plans. The first type of contract creates a “nonqualified” annuity as it is privately obtained from insurance companies or financial institutions, in general. There are differences in tax treatment between these two types, and the reasons for obtaining one that is nonqualified is not necessarily related to concerns regarding retirement income. The focus here will be on the nonqualified annuity purchased by an individual.
Who Are the Key “Players” in its Creation?
Some basic definitions of the main “players” when an annuity is created is a good starting point because they are important in determining the way that this tool will be set up. The annuity owner, the annuitant, and the beneficiary are the three categories essential to consider when planning.
The annuity owner purchases the contract that creates this investment. She creates the terms for the annuity with the insurance company or financial institution that issues it. Key decisions include choice of the definition of the “annuitant,” the designation of beneficiaries, and the determination of who would have the right to sell the contract.
While the annuity owner is the purchaser of the annuity, this person may not be the annuitant, who is the individual over whose life expectancy income is paid. Owners commonly name themselves as the annuitants, but there are considerations that can lead to different choices. For example, the annuity owner might want someone younger as the annuitant since the longer life expectancy leads to smaller payments that are paid over a longer period, which extends the tax liability and reduces the taxable income on a yearly basis.
Many annuities are set up with only one annuitant (a “single life” annuity), but others may have a second annuitant, who is to receive payments at regular intervals after the first annuitant’s death. These “joint and survivor” annuities often involve spouses, but this is not always true. Since the second annuitant can be considered a beneficiary, the joint and survivor annuity will considered in more detail later.
Although the periodic payments are calculated based on the annuitant’s life expectancy, the annuity owner must remember that actuarial tables do not dictate an individual’s lifespan. If the annuitant dies sooner than would be predicted, this would leave some of the assets remaining to be distributed. The annuity contract needs to include provisions for who receives what would remain in this circumstance. Beneficiaries are important for this reason.
The beneficiary is the third key “player” when the annuity is being created. Two points to bear in mind are that there can be multiple beneficiaries and that organizations can be beneficiaries. In addition, although an owner can name himself as the annuitant, he cannot be a beneficiary of his own annuity.
Unless the contract requires the naming of an irrevocable beneficiary, the owner usually can change beneficiaries. Furthermore, the owner may be wise to have multiple beneficiaries because, if there are remaining investments after an annuitant’s death, the owner probably would want to be sure that someone is alive to receive these assets.
Some Considerations regarding Beneficiaries
With no beneficiary, an annuity can go through probate or estate administration, but the assets that it still holds may be surrendered to the insurance company or financial institution that issued the contract. Therefore, even without multiple primary beneficiaries, the annuity owner should consider possible contingent beneficiaries, who receive the primary beneficiaries’ payments when the annuitant outlives these beneficiaries.
When multiple beneficiaries are included, the annuity contract can provide for the death benefits to be divided into equal shares or by specified percentages among the beneficiaries. The owner could decide to go in a different direction when choosing a beneficiary, as well. Beneficiaries do not have to be individuals, but the contract owner should consider the legal implications here.
Entities are subject to different requirements as the beneficiaries of annuities. A possible choice for the annuity owner is to assign any remaining payments to a trust. However, after the trust receives this amount, it has five years to pay out these funds. This means that spreading out the taxation based on life expectancy is not possible, while this option does exist when payments are transferred to an individual as the beneficiary.
Choices that Depend on Why You Want an Annuity
While the “players” now have been defined, this does not answer what an annuity is good for. With its flexibility as a contract between the owner and an insurance company or financial institution, there could be a number of reasons that annuities may be appealing. However, we will look at common categories (and choices) that are considered when it is being set up.
One choice is between an immediate annuity and a deferred annuity. A person could decide on a deferred annuity in which taxation is deferred. This is a benefit when retirement planning and may be a good choice if you have made the maximum contribution to a 401(K) plan or an IRA. It would not be subject to any IRS contribution limits and can create a guaranteed stream of income payments during retirement. There would be taxation at ordinary income rates at that time, and there could be annual charges from the financial institution or insurer that issued the contract. They also are likely to be subject to a 10-percent penalty from the IRS for withdrawals prior to the age of 59½.
The choice of deferred payments can be paired with either variable or fixed income payments. A deferred variable annuity is one in which the issuer of the policy places your assets in riskier investments. People with longer time horizons are better candidates for this type of annuity because they have the ability to weather market fluctuations that tend to occur during shorter investment periods. Payments from this annuity type depend on the success of the investments made with the assets that were traded to establish it.
A more conservative investor who is looking to set up guaranteed payments for a number of years after she retires probably would lean toward a deferred fixed annuity. Typical of all fixed annuities, this is not subject to market risk but instead makes regular periodic payments of specified amounts to the annuitant. It could produce earnings that compound on a tax-deferred basis, although withdrawals prior to 59½ years of age might incur the IRS’s 10-percent penalty.
Choosing an immediate annuity results is smaller periodic payments. It may appeal to someone who is or soon will be retired because the wait for the payment stream to begin is not an issue here. The tradeoff involves the acceptance of a smaller amount of guaranteed income for life or, at least, a set period of time (if a “fixed-period” annuity is chosen). Generally speaking, the owner should have a large lump sum of money to trade for a cash flow that extends into the future when creating an immediate annuity. However, there is an example below in which this asset “rule” does not hold.
This often is paired with a fixed income stream. However, the owner may be able to set up cost-of-living adjustments for the income stream over the annuity’s timeframe by paying an extra cost for this benefit.
Annuities May Help Even People of Modest Means
While an annuity can provide a stable source of financial support during retirement for many individuals, it is flexible enough to be adapted to individual circumstances. This can involve tailoring the annuity based on such variables as age, income, and net worth. Also, the amount available to invest will dictate the options that are realistic – even a modest investment might be used to create a workable annuity. Remember that reasons beyond increasing retirement income can be met through this financial instrument, and they should be examined to determine if such an investment might be desirable depending on a given situation.
For instance, one possibility that may be overlooked concerns Medical Assistance. The individual on Medical Assistance would have a relatively low income. This person might look at a single-premium immediate annuity since one often can be obtained even when there are rather limited assets available. To be used to supplement income in this situation, the annuity has to be irrevocable, actuarially sound, and – importantly – payable to the Medical Assistance agency that would be designated in Pennsylvania as the beneficiary after the recipient’s death.
Single-premium immediate annuities also could be useful for retirees who are over the age of 59½ but not yet 70½. If an individual wants to delay the payment of Social Security benefits as well as any tax-deferred distributions for as long as possible, then he or she might consider this type of annuity to provide a stream of income to realize this goal.
Increasing Usefulness by Purchasing Riders and Other Options
As has been noted previously, an annuity is a flexible tool. This flexibility can be increased when the owner purchases various riders or other options. For instance, a person might want to have a rider that provides for accelerated payouts in the event of a diagnosis of a terminal illness.
Riders and options often are added on behalf of beneficiaries. The decision to create a deferred or immediate annuity can influence this choice. With deferred annuities, beneficiaries receive the total amount contributed to the account if the annuitant dies during the accumulation phase and receive the amount remaining in this account after payments that were made to the deceased annuitant have been subtracted during the payout phase.
However, with many immediate annuities, such as a lifetime immediate income annuity, the issuing company keeps any money that remains at the annuitant’s death. The owner might purchase a refund option or a rider for a term certain regarding the annuitant’s life so that beneficiaries can get whatever remains if the annuitant dies when the option or rider would be effective.
A standard death benefit rider may be desirable when it is needed to designate beneficiaries for the annuity if the remaining funds after an annuitant’s death would be forfeited to the issuing company. This is the most basic rider of this type. Other death benefit riders can be used to affect the amount received by beneficiaries, as well. Examples include “return of premium” riders (this equals greater of the market value of the contract and the sum of all contributions minus fees and withdrawals) and “stepped-up” death benefit riders (beneficiaries receive the highest amount using the values of the contract on the anniversaries of the purchase date, with fees and withdrawals subtracted). The basic rule to remember is that a rider which increases the amount going to beneficiaries also will increase the annuity owner’s cost to add it.
A Look at Death Benefit Payout Options
Death benefit payout options involve how the benefit will be paid to beneficiaries instead of how much can be paid. Three options commonly exist for beneficiaries who are not spouses of the annuity owner. The lump-sum distribution transfers the designated funds in a single payment. A “non-qualified stretch” payout provides beneficiaries with minimum payments stretched out over their life expectancies. Finally, the five-year rule payout option allows beneficiaries to make withdrawals during a five-year period or receive the entire amount in the fifth year.
A surviving spouse who is a named beneficiary has an additional option here. The spouse could continue the annuity contract as the new owner and – if the deceased spouse was the annuitant – step into that role, taking over the stream of payments, which delays immediate tax consequences that other beneficiaries face. This is known as “spousal continuation.”
The Joint and Survivor Annuity
This leads again to consideration of “joint and survivor” annuities. It is important to remember that the beneficiary does not have to be a spouse. However, non-spouse beneficiaries again have less flexibility than a surviving spouse would have.
With a joint and survivor annuity not involving a spouse, the beneficiary has the right to receive a payment stream instead of a lump sum of what assets remain upon the death of the annuity owner. This beneficiary lacks the ability to change any terms of the annuity contract, though. As a result, any access to the annuity’s funds continue to be controlled by deceased owner’s contract.
When the surviving spouse is named as beneficiary of a joint and survivor annuity, she can transfer the contract into her name and assume all rights from the initial agreement. Based on the terms of the original contract, the spouse may have the ability to accept all remaining payments and any death benefits, as well as the right to choose beneficiaries (if the predeceasing spouse could have done so).
An Overview of the Topic of Taxation
Taxation of nonqualified annuities is complicated so what follows merely provides information to raise awareness of things to review. While employer-sponsored programs and commonly recognized retirement programs make payments that are not taxed, nonqualified annuities provide payments that are taxable income in Pennsylvania, as well as for federal income tax purposes. To the extent that the distributions that are taxable for federal income tax purposes, they also are taxable as interest income in Pennsylvania.
Nonqualified annuities must use what is termed the “general rule” for federal taxation. Under this rule, payments can consist of a tax-free part of an annuity payment that is based on the ratio of the cost of the annuity contract to the total expected return, which is the total amount that the annuitant expects to receive. The expected return is calculated from IRS life expectancy (actuarial) tables. You can look at IRS Publication 939 for more details regarding this rule.
Beneficiaries also face income taxation. They owe income tax on the difference between the principal paid into the annuity and its value at the annuitant’s death (minus the principal that was paid to fund the annuity initially). If a beneficiary receives this amount as a lump sum, then income tax is due immediately on this amount. If the payments are arranged to be spread out over time, then the taxation will be spread out as well.
When a single premium was paid for an annuity with named beneficiaries, then the annuity represents a return on an investment, which is subject to inheritance tax in Pennsylvania. It would be listed on Schedule G (Inter-Vivos Transfers and Miscellaneous Non-Probate Property) of an inheritance tax return. Notably, the $3,000 exclusion for transfers within one year of death that is mentioned in the instructions to this schedule would not apply in this situation.
When an annuity fund creates the future interests that are reported on Schedule K of the inheritance tax return, the value of the fund creating these interests is reported as part of the estate assets on whichever schedule from Schedule A through G of the tax return is appropriate. As always, you probably want to consult a tax expert about up-to-date information on the various ways that annuities can face taxation, of course.
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With the extensive varieties of annuities that are available and the ability to customize these contracts by working with annuity experts who have a solid understanding of how to tailor this financial tool to meet a client’s needs, an annuity can be fashioned for someone who possesses only modest assets to apply for this purpose. If the size of any death benefits also is a concern, the contract owner also needs a well-crafted annuity that provides for a better future for a beneficiary for whom financial protection after the owner’s death is a goal. Remember that there are numerous possibilities that can be discussed in order to make the right choice for your specific circumstances.