If you take the time to look it up, the dictionary defines an annuity as "the annual payment of an allowance of income." Spin that into the broader world of the financial sphere, however, and you'll arrive at something
Take that one step further into estate planning and you'll start hearing advisors talk about annuities as a means for wealth transfer and intergenerational giving. So how did something so simple begin to sound so complicated? And what does it all mean, with tax season upon us, for your clients? Learn some of the basics (and a few of finer points) of annuities, taxation and the knowledge that can help you coach your clients through both.
Annuity primer
Perhaps the most basic way of explaining the entire family of products under the annuity heading is this: An annuity is a guaranteed stream of income. Annuities originally were designed as immediate products, meaning an investor paid a one-time premium and that benefits were scheduled to begin flowing soon thereafter, usually within one year from the initial payment of premium.
Over the years, the types and number of different annuity options have proliferated, and so has their status as they relate to taxation. At present, the benefit of annuities is that – assuming they are non-qualified (i.e., they are not IRAs) – the funds in them grow tax deferred. And they grow that way indefinitely.
So why are annuities sometimes mentioned as a poor financial planning product? According to Richard Everett, president of Everett Financial Group Inc. in Northhaven, Conn., it has to do with a misperception of fees.
Every once in awhile, something is published that says that annuities are bad for seniors or bad for young people. "When a headline says that all annuities have high fees," Everett notes, "that's just not accurate. Variable annuities do, but fixed annuities have no fees – you can't group all the class together. That's like saying all stocks are volatile – that's just not fair."
In fact, it is increasingly the case among senior clients that while annuities may have been initially funded to guarantee a given monthly payout during retirement, they actually become very effective as a tool to pass down wealth.
According to Barry Humphrey, LUTCF, advance market director with PinnacleUSA in Quincy, Mass., what may have been purchased for one reason turns out to work quite nicely for another.
"I think, quite frankly, most people don't annuitize their product anyway," Humphrey says, "because of a nest egg [that they may have] or they want to pass it along to their heirs."
The tax man cometh
So you know that tax day is coming, but what does the taxman take away as it relates to annuities? As mentioned above, all non-qualified annuities grow tax-deferred. When those funds are accessed, they are taxed based on the scenario of the withdrawal.
If a client pulls all of his funds out in a lump sum, he will be required to pay tax on the gain at the current, ordinary rate. Should he choose to annuitize it, where the client gives up control of his money to the insurance company, and the insurance company, in turn, gives him X amount of dollars for X amount of years, tax advantages exist.
Here, payouts from annuities are subject to the exclusion ratio, an IRS regulation that, in effect, lowers the amount of tax that will come due. To quote JD Edwards' resources on annuities: A portion of your payment will be considered a return of premium and will not be subject to ordinary income tax. The amount that is taxable will be determined at the time you elect to annuitize the policy. A calculation will be made by the insurance company to determine the "exclusion ratio," which will determine the percentage of each payment that will be excluded from income tax.
How does it play out? Generally speaking, approximately 25 percent of the income streaming out is taxable and the rest is a return of principal. So if a client had, for example, a $100,000 contract and annuitized it at $1,000 per month, he'd only be taxed on $250 of that sum, and that at his ordinary rate.
