Annuity Basics and Accumulation

Annuities originated from the life income settlement option offered by a life insurance policy. Annuities are insurance products, but they are not designed to provide protection in the event of premature death. An annuity protects someone against living too long and outliving their financial resources. The payments from an annuity are guaranteed for a fixed period, commonly for life, in which case the annuitant cannot outlive the stream of monthly payments.

Annuities are often used to accumulate funds for retirement. As with life insurance, premiums paid are not tax-deductible, but grow tax-deferred until withdrawn. Due to the tax-deferred growth and unlimited contribution amounts, annuities are popular with people in high tax brackets.

Annuities may be purchased with a lump sum investment (single premium annuity) or with periodic payments. A single premium annuity may also be an immediate annuity, if the owner elects to begin receiving payments immediately. It’s more common to purchase an annuity over time with periodic payments and begin receiving payments at some future date, which is a flexible premium deferred annuity.

The accumulation stage is the period when the owner is investing money into the contract. During the accumulation stage, the cash value in the annuity is invested in shares of open-end investment companies or UITs called accumulation units.

During the accumulation stage, the terms of the contract are quite flexible. Unlike life insurance, there is no required premium with an annuity. The owner can invest any amount at any interval. The owner may withdraw funds and may also terminate the contract during the accumulation stage.

A withdrawal during the accumulation stage is a taxable event. The owner of the annuity contract has an ordinary income tax liability on any withdrawal from an annuity in excess of his/her cost basis. Any taxable withdrawal is also subject to a 10% penalty if the owner is under age 59½.

If the owner of an annuity dies during the accumulation stage, the beneficiary will receive the greater of:

1. The cash value of the contract on date of death
2. The decedent’s cost basis

If the cash value exceeds the cost basis, the beneficiary will have an ordinary income tax liability on any amount exceeding the decedent’s cost basis, but the 10% penalty will not be imposed.

When the owner of an annuity elects to begin receiving guaranteed monthly payments from the annuity, the contract is annuitized. The accumulation units are converted into annuity units and the contract enters the annuity stage. Annuitization should not be taken lightly, as the process is irreversible and cannot be altered or canceled. Upon annuitization, the owner relinquishes all rights to the cash value in the contract in exchange for the insurance company’s payout guarantee.

The four variables required to calculate the amount of an annuitant’s initial payment are:

1. Life expectancy of the annuitant (age and gender)
2. Assumed interest rate (AIR)
3. Cash value of the annuity contract
4. Payout option

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Lesson Summary

Annuities originated as a life income settlement option from life insurance policies. They are designed to protect against outliving financial resources, offering guaranteed payments for a fixed period, commonly for life, while not providing protection against premature death.

• Annuities serve to accumulate funds for retirement, and premiums are not tax-deductible but grow tax-deferred until withdrawn, making them popular with individuals in high tax brackets.
• Annuities can be purchased with a lump sum or periodic payments, with options like single premium immediate annuities or flexible premium deferred annuities.
• During the accumulation phase, the owner has flexibility in investing money, with no required premium and the ability to withdraw funds, though withdrawals are taxable events.
• If the owner dies during the accumulation phase, the beneficiary receives either the cash value or the decedent’s cost basis, with tax implications.

When the annuity owner chooses to receive guaranteed payments, the contract is annuitized, wherein the owner gives up access to the cash value in exchange for a payout guarantee from the insurance company.

• Calculating initial annuity payments involves factors like life expectancy, assumed interest rate, cash value, and payout option.

• Annuity payments are taxed differently based on annuitization status, with no 10% penalty post-annuitization.

Annuities are complex financial products with tax implications and various options for investors seeking to manage retirement income and risk.

Chapter Vocabulary