Navigating the Maze of Variable Annuities

In general, these rules regarding immediate variable annuities provide that the amount which can be excluded from gross income in a taxable year is the portion of the investment in the contract which is allocable to that year. This is determined by dividing the investment in the contract by a multiple taken from the annuity tables which represents the anticipated number of years over which the annuity will be payable. All amounts received in excess of this yearly exclusion are fully taxable.

In the case of an annuity contract with a starting date after 1986, the amount determined may be excluded from gross income only until the investment in the contract is recovered.

What is a variable deferred annuity?

A variable deferred annuity is a kind of deferred annuity in which the contract value can, and usually will, vary daily, to reflect the performance of the "separate accounts" chosen. As with all deferred annuities, there are two periods in the contract.

The "accumulation period" lasts from contract issue until the Annuity Starting Date (ASD), during which the "accumulation units" of the separate accounts chosen will vary in value (and the contract value, which is the sum of those units), as well. Interest is not credited to a variable deferred annuity. Any contract "gain" is the result of increases in the value of the accumulation units chosen.

The "annuity" or "payout" period lasts from the Annuity Starting Date until the end of the annuity payout period chosen. During this period, the amount of each year's annuity payments will vary to reflect investment performance unless a "fixed" annuity payout method has been chosen (in which case, the payouts will act like, and be taxed like, payments under a fixed contract.

What is an indexed variable annuity?

Although known by several different names and subject to a broad range of potential product features, an indexed variable annuity is essentially an annuity product where investment returns are tied to the performance of one or more stock indices (e.g., the S&P 500 or the Dow Jones). Unlike straight equity investing, however, the product itself offers a cushion against investment losses in exchange for a cap on the potential for investment gains.

Unlike fixed indexed annuities, in an indexed variable annuity, principal is not necessarily guaranteed. The carrier may offer 10, 15, or 20 percent (or more) buffers against investment losses, meaning that if the underlying investments generate a loss, the insurance carrier absorbs a set percentage of that loss before the taxpayer experiences any loss. As such, if the chosen index declines, for example, by 10 percent and the taxpayer has chosen a 15 percent buffer, the taxpayer's account value will decline only by the 5 percent loss that exceeds the contract's downside protection.

However, as a trade-off for the downside protection afforded by these contracts, participation in the linked index's gains will be subject to a cap for a fixed term of years. Despite this, the term of years can be as short as a single year for some contracts, allowing the taxpayer a degree of flexibility that he or she might not otherwise find available in a fixed indexed annuity product. Further, some contracts provide for an upside cap that fluctuates annually—or, in some cases, as frequently as weekly or monthly.

Some insurance carriers even offer products that cover 100 percent of the downside risk of the investment, but these carriers also set the upside caps on these contracts at a lower percentage (in some cases, as low as 1.5 percent) that resets frequently (for example, every two weeks).

Despite their lack of guaranteed principal, indexed variable annuities offer many of the benefits that traditionally accompany an annuity product, including the valuable elements of tax deferral and death benefits for account beneficiaries.