How Are Annuities Taxed

One of the biggest impediments to accumulating wealth is the income tax which is why investors are drawn to investments that can help minimize or avoid them. This is the reason why annuities have had such great appeal for investors over the years, as it is one of just a couple of investment vehicles that enjoys favorable tax treatment by the U.S. tax code. Understanding how annuities are taxed would be important for any investor who seeks to maximize returns by minimizing taxes.

Annuity Tax Basics

There are essentially two stages to an annuity contract: the accumulation stage and the income distribution stage. Both stages have specific tax rules that apply.

Accumulation Stage Taxation

All annuities have an accumulation account in which earnings are generated from interest rates (fixed annuities), or from investment returns (variable annuities), or based the actual movements of stock indexes (indexed annuities). No matter how the earning are generated, the taxes owed on them are deferred until they are withdrawn, at which time they are taxed as ordinary income. Because withdrawals from annuities are deemed to be earnings first, and then principle, they are taxed until the earnings portion is depleted. There are no taxes on the withdrawals of principle.*

In return for the favorable tax treatment of earnings, the tax code specifies certain requirements that must be met. The primary requirement on withdrawals is that they cannot be made prior to the age of 59 ½ without incurring a 10% penalty on the withdrawal amount. If an annuity owner “annuitizes” an annuity prior to age 59 ½, that is, when the annuity is converted into a serious of equal, periodic payments for life, the 10% penalty is waived.

Income Distribution Taxation

At the time an annuity is annuitized, the account balance is turned over to the life insurance company to convert it to a stream of income. The income payments are determined by calculating the number of periodic payment, the amount of interest that will be earned in that period and then dividing the account balance plus the future interest earnings by the number of period payments. The result is an income payout that consists of both principle and interest in which the principle is excluded from income taxes. The remaining interest portion is taxed as ordinary income.

Annuity owners who are younger than 59 ½ can avoid the withdrawal penalty by simply annuitizing their annuity to receive equal, periodic payments over their life expectancy.

One of the advantages of annuity income is that it is not factored into the income calculation of Social Security taxes.

Taxing Annuity Death Benefits

If the annuity owner dies during the accumulation stage, a designation beneficiary will received the annuity account value as a death benefit. Unlike, life insurance death benefit proceeds, which, in most cases, are not taxable to the beneficiary, proceeds from annuity death benefits are includable as ordinary income to the extent that they are earnings. Additionally, the proceeds are included in the estate of the deceased annuity owner.

If death occurs during the distribution stage, after annuitization, and a refund option was selected, the portion of the refund that is comprised of earnings will be taxed as ordinary income. In the case where the deceased annuitant has a spouse, he or she would continue to receive the annuity payments and pay ordinary income taxes on the earnings portion.

Summary

Annuities provide tax conscious investors with the opportunity to accumulate their assets faster through the tax deferral of earnings. The deferral of taxes can be extended if the annuity is converted to income, and, when planned properly, the income can also be taxed minimally.

The biggest tax disadvantages of annuities it their treatment upon withdrawals when they are taxed as ordinary income. This, as compared to redeeming mutual fund shares which may be taxed at the more favorable capital gains tax rate. Additionally, the death benefit proceeds present a double whammy to the beneficiaries in that they are both taxed as ordinary income and they are included in the estate tax calculation.

Used in the proper context of a long term retirement plan, the tax advantages of annuities will outweigh any potential disadvantages.
*Annuities purchased prior to August 13, 1982 are considered to be “first in-first out” which means that the initial withdrawals come from the principle and are, therefore, not taxed.

Indexed Annuities Explained

Although hardly a fairytale, indexed annuities might best be explained in the context of the Goldilocks parable in which they are not too cold (as in low yielding fixed annuities), or not too hot (as in riskier variable annuities), but just right, for investors looking for something in between. Indexed annuities were introduced at a time when fixed annuity rates were coming down from their 1980’s highs, and variable annuities were under a lot of scrutiny for their lack of transparency and high expenses. Indexed annuities were a breath of fresh air for investors who still appreciated the unique features of annuities.

Often characterized as a fusion of fixed annuities and variable annuities, indexed annuities do offer some elements of both, however, they probably hold more appeal for investors who seek a greater degree of safety than those who seek growth type returns. Although their yields are tied to stock market returns, their upside potential is limited, but typically greater than the returns available through fixed annuities. For investors who seek returns north of fixed yield annuities or CDs, and who are still concerned with the preservation of their principal, indexed annuities can be ideal investments.

The Mechanics of Indexed Annuities

Indexed annuities, with their ability to generate rates of return that exceed fixed yield investments while protecting against the loss of principal, may seem to be “too good to be true”. The truth is that they don’t come without some controversy, primarily that they can be fairly difficult to understand. It would stand to reason that, in order to create a financial product that offered only upside with little or no downside, it would have to involve some complexities. After all, indexed annuity providers (life insurers) need to be able to make some money while providing, essentially, no risk returns.

Capturing Market Yields

Like fixed annuities, indexed annuities credit a fixed rate of return for a one year period. Unlike fixed annuities, the indexed fixed rate is linked to the movement of a major stock index. So, the credited yield is derived from the gain in the index, either as a year-over-year percentage, or has an average of monthly benchmarks over a twelve month period. In the year-over-year measure, the annuity yield is based on the actual percentage gain in the index.

Sharing in the Gains

In years in which the stock index experiences a gain, the life insurer credits a portion of the gain based on a pre-determined “participation rate”. The participation rate is the percentage of the actual gain in the index that is credited to the accumulation account. A participation rate of 80% applied to a 15% gain in the index translates to a 12% yield credited to the account. Participation rates can range from 20% to 90% and, unless otherwise stated, may be subject to downward adjustments after the first contract year.

Capping the Gain

After limiting your participation in the gain, the life insurer may also place a cap on the yield it will credit to the account. If the contract calls for an 8% yield cap, then, instead of earning a 12% credit, the account would be credited with 8%. Yield caps also vary and can be as high as 15% or as low as 4%. Yield caps may also be adjusted, so it would be important to study the contract to know when and how much they can change.

Protecting the Downside

Up to this point, it may seem as though the life insurer is simply chiseling away at your return, but there is a very good reason. When the stock index experiences a decline, the life insurer will still credit your account with a minimum rate of return. Essentially, you are giving up a portion of the upside in return for protection against the downside. Minimum rate guarantees can range from 0% (better than a loss of principal) to 3%.

Locking in Your Gains

As if it weren’t enough that your account is credited with a gain even after a stock market decline, the life insurer will further protect your gain by adjusted your basis each year which will ensure that your account balance will never decline in value (unless a withdrawal is made). The actual method for resetting the account balance varies. Some contracts reset year-over-year, and others use a point-to-point method which may cover several years.

Keeping the Rest of Annuity Benefits

Aside from the opportunity to generate higher rates of return in a fixed yield type investment, investors enjoy the same benefits that are standard in fixed annuities of all types.

Tax Deferral:

All earnings are allowed to accumulate without paying current taxes.

Account Access:

Withdrawals of up to 10% of the account balance can be made once annually.

Surrender Fees/Penalties:

Withdrawals in excess of 10% made within the surrender period are subject to a fee which starts out high (as much as 15%) and drops by a point over the course of the surrender period which can last as many as 15 years.

Death Benefit:

As with all annuities, your beneficiaries are guaranteed to be paid a minimum death benefit, which for indexed annuities, is the adjusted principal basis each year.

Guaranteed Income Distribution:

Indexed annuities may be converted into an income annuity which guarantees payments for a specific period of time or for life. The payments may also be linked to a stock index which means they can increase during years when the index gains.

Summary

If Goldilocks was an investor, she would probably have chosen an indexed annuity because they are ideal for anyone who doesn’t want the biggest or hottest, nor the smallest and coolest, but something that offers the right amount of upside with the least amount of risk. For annuity investors, indexed annuities can play a vital role in balancing out a portfolio of annuities that might include both fixed and variable annuities.

Indexed Annuities Vs Mutual Funds

In the world of investing annuities draw comparisons to just about all other types of investments, especially mutual funds. While variable annuities draw the closest comparisons to mutual funds, the new kid on the block, indexed annuities are often weighed as an alternative as well, due largely to the fact that their returns are generated from stock market returns. After that, the comparisons stop because they have little else in common.

The commonality shared by indexed annuities and mutual funds is that they are both seen as investment alternatives that have the potential to earn returns higher than those found in fixed yield investments. Beyond that, their structure, objectives, risk orientation, and their overall investor benefits couldn’t be more different. Let’s examine mutual funds first.

Mutual Fund Basics

Mutual funds are professionally managed portfolios that invest directly into stocks, bonds, or a combination of both. They usually live in families comprised of a variety of different funds with varying investment objectives. One mutual fund family might have several stock funds that invest in different categories of stocks, such as Blue Chip stocks, international stocks, precious metals stocks, etc. The same for bond funds which can include government bonds, or corporate bonds, foreign bonds, or a combination. Each fund is managed to specific investment objectives, and depending on the investment methodology and the composition of the portfolio, each is assigned a different level of risk.

For small investors, mutual funds provide the best opportunity to invest in the markets in a way that can minimize their risk while generating higher returns. Mutual funds investors benefit from instant diversification and professional management they couldn’t accomplish on their own. And, with the ability to invest in many different funds, it’s possible to develop an investment portfolio using an allocation strategy that best suits their individual investment objectives within their tolerance for risk.

During positive market performances, mutual funds have been able to deliver solid double digit returns, sometimes for years at a time. During negative market performances, they have also been known to deliver double digit losses. So, investors in mutual funds need to be able to tolerate the sometimes wide swings in the markets on their way to achieving their accumulation goals.

Indexed Annuity Basics

Indexed annuities were introduced as an alternative to fixed yield annuities, which, in low interest rate environments delivered low rates of return. They are also seen as an alternative to variable annuities, which, like their mutual fund cousins, generate their returns with direct investments in the markets. Indexed annuities have also seen their share of losses when the markets have declined. Indexed annuities are unique in that, while they do generate their returns from the stock market, they also protect the accounts from the losses.

A significant difference between indexed annuities and mutual funds is that, indexed annuities don’t invest directly into stocks. There is no managed portfolio. Rather, there is an accumulation account that is credited a fixed yield is based on the percentage change of a stock market index. The yield will vary from year to year as the stock index moves, but it will never fall below a minimum rate. So, even if the stock index ends the year with a percentage loss, the accumulation account will not decline in value.

The upside return is limited, however, in that the account is only credit with a portion of the index change through what is called a participation rate. If an indexed annuity has a 70% participation rate, then the account will be credited with 70% of the gain in the index. Additionally, most indexed annuities have a rate cap that further limits the amount credited to the account. A rate cap can be as high as 12% or as low as 5%. So, as an example, if the stock index ends the year with a gain of 20%, the rate credited to the account with a 70% participation rate would be 14%. If the annuity contract includes an 8% rate cap, then that is the maximum rate that would be credited.

Which is the Better Investment?

Because we’re comparing apples and oranges, it is difficult to assign a level of suitability without fully understanding a person’s individual financial profile. There are probably a lot of mutual fund investors who would love the notion of participating in the upside of the market without any downside risk. But then, would they be satisfied with earning only a portion of the stock market return?

Mutual fund investors enjoy favorable capital gains tax rates if they hold their fund shares for at least a year, but, typically, they pay taxes every year on income earned from their funds. Indexed annuity owners don’t pay any current taxes, but will pay ordinary income taxes when they withdraw their funds.

Any gains made in mutual fund accounts can be totally wiped out, and investors can lose ground in a steep market decline. The gains made in indexed annuities are, essentially, locked in every year so there is no chance for values to lose ground.

Summary

There really is no “better” between the two except for their ability to match an individual’s particular needs and tolerance for risk. For many investors, the ideal solution would be to include a mix of index annuities with a portfolio of mutual funds. Most everyone needs to be able to earn higher returns over the long term to meet their retirement goals. While a diversified portfolio of funds can achieve the growth needed, an indexed annuity can provide the stability and predictability that most people appreciate when the markets don’t perform well.

How Are Annuities Regulated

There are several types of annuities that an investor will be able to purchase. Each annuity may be regulated differently depending on its characteristics. To begin with, an annuity is a contract between an investor and an insurance company, therefore an annuity is regulated as insurance instruments, though others are viewed and regulated as investment securities.

Generally, annuities provide two distinct benefits: they offer predictable investment growth and they also put off any taxes on that growth until the first withdrawal is made at a later date, at which point the investor would pay taxes only on that growth and not the principal, if the purchases were made with after tax dollars. Despite their complexity of regulations, they remain a favorite among seasoned investors.

As a whole, annuities are regulated by state governments. Since various annuities might have similar characteristics as investments vehicles and life insurance some of them fall under SEC rules. When purchasing an annuity, it is prudent to ask how you are specific annuity if regulated and protected. Nevertheless, there are still some general rules to the regulation, depending on which type of investment vehicle you have.

As a whole, fixed annuities are not subjected to the SEC rules. One the other hand variable annuities, which are able to invest in several mutual funds at once, are subject to SEC regulations. Another popular annuity is the index annuity, which may or may not be regulated by federal regulators. The reason is that index annuities offer some characteristics of insurance items, such as a guaranteed return – of which is spelled out in the contract. However, indexed annuities also provide a return that is pegged to the overall market which is a characteristic of a SEC regulated security.

Though a bit more complicated, an indexed annuity can be regulated by the SEC, but not necessarily so. If the index annuity is not regulated by the feds, then it may fall under jurisdiction of the individual state regulators. Likewise, depending on what is being sold, the annuity agent may need to hold a specific license to actually sell the product. An investor should always check on the annuity agents license and his ability to sell in your state.

The investor may know that there are three kinds of annuities as stated above, however, not all annuities may be regulated in a similar manner. Earning a fixed rate of interest, fixed annuities can generate a predictable level of income for the investor while growing in a tax deferred account. A variable income can provides the investor a variety of investment options including the ability to place funds via a percentage into various funds that could differ in risk. Index annuities are often linked to the overall market growth or contraction.

While investments like annuities that fall under the “securities” umbrella are not guaranteed because they their value may fluctuate, one of the important things the SEC ensures is transparency. Therefore, what the SEC requires is that all investors have the ability to gain access to the health and data of its activities. So, for example, having a prospectus and regular reports would be necessary. Many insurance companies, who are not regulated or mandated to publish a prospectus anyway, to allow for increased confidence in the company from the investor.

Understanding Indexed Annuities

When investors enter into a contract for purchasing an indexed annuity in exchange for a future payment amount, they agree to future distribution that is yet to be determined by the market’s performance. This slight variation from other annuities, often deem them more complex investments within the annuity family. Indexed annuities are contracts between the investor and the insurance company, and can be viewed like other similar investments vehicles in that they have a payment or “accumulation” phase, as well as a payout or “distribution” period.

After the accumulation period occurs, the insurance company will make installment payments or a “lump sum” payment to the investor after determining the final payment agreed upon under the terms of the contract. Gains during the accumulations period are protected from taxation on a yearly basis up until the investor makes his first withdrawal, making this an exceptional favorite among many investors.

Since the rate of return for the investor relies on the performance of the index market, it is possible for the investor to ultimately get less in return than what he actually paid into the annuity – again, depending on the terms of the contract and the market. Further, if index annuities are cashed out before maturity or a specified date, then significant fees and penalties will apply.

Depending on the contract features of the indexed annuity, these investments may or may not be registered with the SEC. Typically for SEC registered securities, for example, the insurance company must provide a minimum rate of return for the investor. This is not always guaranteed due to the inherent nature of market fluctuations and the type of investment. However, index annuities provide a viable option for investors who would like to diversify their portfolio and peg their earning directly to the performance of the market with a particular investment vehicle.

As with other savings vehicles, the investor should know several key features to the index annuity before entering the contract with an insurance company, such as the margin or the administrative fee, which can take a take a portion of the return during the distribution phase. Take for example an indexed annuity contract with the margin fee of say 2%. A margin fee may be considered an “administrative fee” to handle the account. This fee will could chip away at your overall return. For a brief illustration, if the index or market’s performance gained 12% over certain period of time, the result would be 12% – 2% of margin fee to equal a 10% return for the investor.

With index annuities there may also be ceilings, or the maximum rate of interest which can be earned by the investor. Say for example that the interest rate ceiling or “cap” for a particular contract is set at 9%, and the market grows 14% over a determined period of time, the investor would only be compensated only 9% and not the 14%.

Since annuities are not backed by the FDIC, investors who purchase annuities should be aware of the inherent risks due to the volatility of the market. Index annuities are particularly sensitive to the market’s performance. An assessment of risk should also be determined for particular strength and stability of the insurance company in question.

Nevertheless, index annuities are a great option for the long-term investor who would hedge a percentage of their future retirement income stream based on the market’s historical trend for increased growth.