Types Of Annuities And Basic Tax Rules

<div class="Section1">A fixed immediate annuity is an immediate annuity (a contract in which regular annuity payments must commence no later than one year after purchase) in which the payments will remain level or increase only in accordance with a “cost of living” rider, if elected. The payments will persist for the entire annuity payout period, which may be a term of years, the lifetime(s) of one or two annuitants, or the latter, with a “refund provision” that will take effect if the annuitant(s) die prior to the refund guarantee period.</div><br /> <div class="Section1"><br /> <br /> Some older fixed immediate annuities are not “commutable” (i.e., they cannot be modified after annuity payments begin). Others provide for commutation, including the right of the owner to take a cash settlement in lieu of future annuity payments.<br /> <br /> </div>

<div class="Section1">A fixed declared rate deferred annuity is a deferred annuity (i.e. one in which annuity payments may be deferred), represented in terms of fixed units (U.S. dollars), in which interest is declared <em>prospectively, </em>at the beginning of each crediting period (which may be one year or every N years). It has all the characteristics of other fixed deferred annuities (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="498">498</a>), including a guarantee of principal (provided that the contract is held to the end of the surrender charge period) and a guaranteed minimum rate of interest.</div><br />

<div class="Section1">There are two types of variable annuities: (1) variable immediate annuities and (2) variable deferred annuities.<div class="Section1"><br /> <br /> For both types, the value of the contract (the cash value of the deferred contract or the size of the income payment of the immediate contract) varies with the performance of the &ldquo;separate accounts&rdquo; chosen (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="510">510</a>).<br /> <br /> Unlike fixed deferred annuities, variable deferred annuities do not guarantee either a minimum rate of interest or safety of principal. Indeed, the concept of &ldquo;interest&rdquo; can be misleading when applied to a variable deferred annuity, as the value of the contract does not vary by the addition of interest, but in the fluctuating value of the &ldquo;accumulation units&rdquo; purchased in the &ldquo;separate accounts&rdquo;. (For monies allocated to the &ldquo;fixed account&rdquo; of a variable deferred annuity, principal is generally guaranteed and a set rate of interest is credited each year).<br /> <br /> Variable&nbsp;immediate annuities differ from fixed immediate annuities in that the size of the payments is not guaranteed but varies according to investment performance of the &ldquo;separate accounts&rdquo; (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="510">510</a>).<br /> <br /> </div></div><br />

<div class="Section1">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&amp;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.</div><br /> <div class="Section1"><br /> <br /> 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 loss that exceeds the contract’s downside protection.<br /> <br /> 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.<br /> <br /> 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).<br /> <br /> 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.<br /> <br /> </div>

<div class="Section1">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 &ldquo;separate accounts&rdquo; (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="510">510</a>) chosen. As with all deferred annuities, there are two periods in the contract.<div class="Section1"><br /> <br /> The &ldquo;accumulation period&rdquo; lasts from contract issue until the annuity starting date (ASD) (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="536">536</a>), during which the &ldquo;accumulation units&rdquo; 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 &ldquo;gain&rdquo; is the result of increases in the value of the accumulation units chosen.<br /> <br /> The &ldquo;annuity&rdquo; or &ldquo;payout&rdquo; period lasts from the ASD until the end of the annuity payout period chosen. During this period, the amount of each year&rsquo;s annuity payments will vary to reflect investment performance unless a &ldquo;fixed&rdquo; annuity payout method has been chosen (in which case, the payouts will act like, and be taxed like, payments under a <em>fixed </em>contract.<br /> <br /> </div></div><br />

<div class="Section1">A “fixed annuity” is an annuity contract in which the value is reckoned in fixed units (in the U.S., U.S. dollars). By contrast, the value of a “variable” annuity is determined by the dollar value of its accumulation or annuity units, the value of which can and will vary over time.</div><br /> <div class="Section1"><br /> <br /> There are three classes of fixed annuities: (1) fixed immediate annuities, (2) fixed deferred annuities, and (3) fixed deferred income (“longevity”) annuities.<br /> <br /> A <em>fixed immediate annuity </em>is one that pays a defined amount of income each period (which may be level or increasing in accordance with a “cost of living” provision), commencing no later than one year after purchase, and persisting for a defined period (which may be the lifetime(s) of the annuitant(s)).<br /> <br /> A <em>fixed deferred annuity</em> is one providing for the payment of an annuity income at some later time (perhaps many years after purchase); during the accumulation period (from purchase to the annuity starting date (ASD)), the contract will earn interest.<br /> <br /> There are two kinds of fixed deferred annuities: (1) the fixed declared rate deferred annuity, and (2) the fixed index annuity.<br /> <br /> The <em>fixed declared rate deferred annuity </em>will credit a rate of interest each year during the accumulation period. The interest rate is declared at the beginning of each period (usually, one year) and may change, though not below the guaranteed minimum interest rate.<br /> <br /> The <em>fixed index annuity </em>is identical to the declared rate annuity except that interest is credited retroactively at the end of each period (of one or more years) and will vary according to the increase in the value of one or more specified external market indices (often, the S&amp;P500®). Like the declared rate contract, a minimum interest rate is guaranteed, provided that the contract is held for the entire surrender charge period.<br /> <br /> The third basic class of fixed annuities is the fixed deferred income, or “longevity” annuity. This is a contract guaranteeing a certain amount of income for a specified period (or lifetime(s)) to commence at some specified later age, usually an advanced age. During the accumulation period, there is no interest crediting and the contract may terminate without value if the annuitant dies prior to the ASD, although some contracts provide for a pre-ASD death benefit.<br /> <br /> </div>

<div class="Section1">A fixed deferred annuity is a deferred annuity (i.e., one in which regular annuity payments may be deferred), the value of which is represented in fixed units (U.S. Dollars) rather than variable units (as is the case in a <em>variable </em>annuity). There are two basic types of fixed deferred annuities:<div class="Section1"><br /> <br /> &ldquo;Declared rate&rdquo; fixed deferred annuities, in which the interest rate to be credited is declared <em>prospectively</em> by the issuing insurer at the beginning of each crediting period (which may be annually or every few years) and is credited at the end of each crediting period. (See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>.)<br /> <br /> &ldquo;Indexed&rdquo; fixed deferred annuities (commonly called &ldquo;index annuities&rdquo;), in which interest to be credited is declared <em>retrospectively </em>at the end of each crediting period. The interest rate to be credited is linked to the change in value of an external index (which may be the S&amp;P500&reg; or some other commonly used index). Most contracts permit the owner to select more than one index to be used in such crediting. (See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="500">500</a>.)<br /> <br /> Both contracts offer a guarantee of principal and a minimum interest crediting guarantee, <em>provided that the contract is held to the end of the surrender charge period. </em>The current interest declared in a guaranteed rate deferred annuity may never be lower than the contractually guaranteed minimum rate.<br /> <br /> In all deferred annuities, there are two periods: (1) The <em>accumulation period</em>, during which interest is credited to the cash value of the contract, and during which partial withdrawals or surrenders may be made, and (2) the <em>payout</em>, or <em>annuity period</em>, during which regular annuity payments are made to the owner, pursuant to the <em>annuity payout election </em>made.<br /> <br /> Typically, annuitization may be elected at any time beyond the first year or few years, and must be elected by the <em>maturity date</em> (at which point the contract must be annuitized).<br /> <br /> </div></div><br />

<div class="Section1">The “separate accounts” in a variable immediate or deferred annuity are investment accounts, similar in some respects to mutual funds, with specified investment objectives. The contract owner purchases these accounts in “accumulation units” (for deferred variable annuity contracts) or “annuity units” (for immediate variable annuities). The cash value of the deferred annuity and the amount of each annuity payment in the immediate annuity will vary according to the performance of these units, which are re-priced daily.</div><br /> <div class="Section1"><br /> <br /> There is, in both immediate and variable annuities, an annual expense charge of each separate account which impacts the cash value of the deferred contracts and the amount of annuity payments in immediate contracts. The amount of this charge can usually change over time, and, in some contracts, may be waived in some years.<br /> <br /> Variable <em>deferred </em>annuity contracts also offer “fixed” accounts, which act like fixed deferred annuities in having a guarantee of principal and a fixed rate of interest that is usually declared each year. There is no annual expense charge for this “fixed” account.<br /> <br /> </div>

<div class="Section1">An annuity contract held by a trust or other entity as agent for a natural person is considered held by a natural person.<a href="#_ftn1" name="_ftnref1">¹</a> If a non-natural person is the nominal owner of an annuity contract but the beneficial owner is a natural person, the annuity contract will be treated as though held by a natural person.<a href="#_ftn2" name="_ftnref2">²</a> Also, an annuity owned by a grantor trust will be considered to be owned by the grantor of the trust.</div><br /> <div class="Section1"><br /> <br /> In a letter ruling, the IRS decided that a trust was considered to hold an annuity contract as an agent for a natural person where the trust owned an annuity contract which was to be distributed, prior to its annuity starting date, to the trust’s beneficiary, a natural person.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> In another ruling, the IRS considered an irrevocable trust whose trustee purchased three single premium deferred annuities, naming the trust as owner and beneficiary of the contracts and a different trust beneficiary as the annuitant of each contract. The terms of the trust provided that the trustee would terminate the trust and distribute an annuity to each trust beneficiary after a certain period of time. The IRS held that the non-natural person rule was not applicable.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> The IRS concluded that the non-natural person rule does not apply to a trust that had invested trust assets in a single premium deferred variable annuity where the same individual was the sole annuitant under the contract and the sole life beneficiary of the trust.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> Where a trustee’s duties were limited to purchasing an annuity as directed by an individual and holding legal title to the annuity for that individual’s sole benefit and the trustee was not able to exercise any rights under the annuity contract unless directed to do so by the individual, the IRS concluded that the trustee was acting as an agent for a natural person.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> Further, where the trustee of an irrevocable trust purchased an annuity and had the power to select an annuity settlement option or terminate the annuity contract, the annuity was still considered to be owned by a natural person.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> A charitable remainder unitrust, however, was not considered to hold an annuity contract as an agent for a natural person and, thus, was required to include income on any annuity contracts in ordinary income each year.<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> Although it is not entirely clear that all permissible beneficiaries of a trust named as owner of a deferred annuity must be natural persons, it is significant that, as of June 2010, all private letter rulings addressing whether a trust named as owner of a deferred annuity was acting as “the agent of a natural person” have specified that all beneficiaries were, in fact, natural persons.<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> If all beneficiaries of a trust owning a deferred annuity must be natural persons, must the term “beneficiary” be taken literally? In the case of a “special needs” trust (such as an OBRA “D(4)(A)” trust), it is not clear whether the position of creditor occupied by the state Medicaid agency (to the extent of any Medicaid payments made to the trust beneficiary) will constitute the interest of a “beneficiary,” where the state Medicare statute does not specify that the state’s interest is that of a “beneficiary.”<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 72(u)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     H.R. Conf. Rep. No. 99-841 (TRA ’86) <em>reprinted in</em> 1986-3 CB Vol. 4 401.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     Let. Rul. 9204014.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     Let. Rul. 199905015.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.     Let. Rul. 9752035.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.     Let. Rul. 9639057.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.     Let. Rul. 199933033.<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.     Let. Rul. 9009047.<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.     Let Ruls. 20049011, 20049013, 20049014, 20049015, 20049016, 200018046.<br /> <br /> </div>

<div class="Section1">Strictly speaking, the term &ldquo;annuity&rdquo; refers to a series of payments over time in which the principal (or purchase price) and interest are amortized over the payout period, so that no value remains at the end of the annuity period; it is a <em>stream of income.</em> However, most people who use the term &ldquo;annuity&rdquo; are referring to an <em>annuity contract</em>, under which that stream of income is guaranteed.<div class="Section1"><br /> <br /> There are several types of annuity contracts: (1) commercial annuities, which are contracts between a purchaser and an insurance company, (2) charitable gift annuities (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="607">607</a>), and (3) private annuities (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="603">603</a>). With the exception of Q <a href="javascript:void(0)" class="accordion-cross-reference" id="603">603</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="609">609</a>, all of the discussion in this book will deal with <em>commercial annuities.</em><br /> <br /> There are many types of commercial annuities and they are very different because they are designed to do very different jobs. For this reason, any statement that begins &ldquo;Annuities are&hellip;.&rdquo; is probably misleading or outright false, precisely because the term covers so many different types of contract.<br /> <br /> The chart below shows the various types, in terms of <em>when annuity payments begin.</em><a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <a href="http://localhost/taxfactsqa/wp-content/uploads/2017/12/Fig-1-1-2.jpg"><img class="size-medium wp-image-38832 aligncenter" src="http://localhost/taxfactsqa/wp-content/uploads/2017/12/Fig-1-1-2-500x334.jpg" alt="" width="500" height="334"></a><br /> <br /> The following chart shows these types in terms of how the contract value is invested.<br /> <br /> <a href="http://localhost/taxfactsqa/wp-content/uploads/2017/12/Fig-2-1-2.jpg"><img class="size-full wp-image-38835 aligncenter" src="http://localhost/taxfactsqa/wp-content/uploads/2017/12/Fig-2-1-2.jpg" alt="" width="432" height="254"></a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Chart from &ldquo;John Olsen&rsquo;s Guide to Annuities for the Consumer&rdquo; (John L. Olsen, 2015), by permission.<br /> <br /> </div></div><br />