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A primer on annuities.

For most CPAs, the basics of annuities are learned in their first accounting class. Essentially, an annuity is a series of fixed payments, usually made monthly over a certain period of time. Simple examples of annuities would be rental payments to a landlord or lease payments for autos or other equipment. In the financial planning arena, annuities can be more complicated. In this context, they are considered a financial "product" and can serve a variety of functions, such as providing a constant income stream to a retiree, as a device to accumulate money on a tax-deferred basis, or to provide pension benefits to retirees. There are different types of annuities available, which are especially useful in fulfilling many of the financial needs of older adults. A general understanding of the concept and workings of an annuity contract is critical for the personal financial planner and tax practitioner.

Annuity Classification

There are a number of factors that an adviser needs to be aware of when helping clients with annuities. Annuities can be categorized in a variety of ways.

Immediate vs. deferred: An immediate annuity provides payment of benefits immediately on funding. Deferred annuities, however, are invested in for a period (accumulation phase), after which periodic payments are made to the annuitant (distribution phase). Deferred annuities allow partial withdrawals during the accumulation phase and, thus, have no distribution requirement. This is important to an analysis of the taxation of annuity benefits (discussed later).

Fixed vs. variable: Annuities can also be classified as either fixed or variable. A fixed annuity earns a fixed and stated rate of return. A variable annuity has several options for allocating invested funds. Typically, there is a series of mutual-fund-type investment options (subaccounts), as well as one, or possibly more, fixed accounts. For example, a contract might have a six-month or a one-year fixed account, in addition to the variable subaccounts.

Variable annuity vs. mutual fund: In a variable contract, investors allocate their money among a variety of investment subaccounts. The subaccounts behave like mutual funds and are usually managed by mutual fund managers. Typically, the owner has a choice of subaccounts, ranging from extremely conservative to extremely aggressive options, and assumes the risk of such investments. Because the contract owner assumes the risk, variable annuities are not suitable for everyone. However, for the long-term investor for whom a variable contract is suitable, variable annuities have many desirable features. Often, an investor will choose between investing money in a variable annuity and purchasing mutual funds. A major advantage of a variable annuity is tax deferral. Mutual fund dividends are immediately taxable, while variable annuity dividends paid by the funds in the subaccounts are not.

Most variable annuity contracts offer portfolio reallocation at defined intervals. For example, suppose an individual wants to invest 50% in domestic equities and 25% in international equities, with the balance in government bonds. Over time, the composition of the annuity contract will vary based on market performance. On a periodic basis (e.g., quarterly or annually), subaccount shares will be bought and sold to maintain this allocation. As long as the reallocation is done within the annuity contract, it should not trigger current taxable capital gain or loss.

Many variable annuity contracts offer performance and income guarantees that cannot be provided by mutual fired portfolios. For example, a contract might provide that money invested in the annuity for a period of time will earn a guaranteed minimum rate of return. Alternatively, a contract might provide that after a certain number of years, there will be a guaranteed minimum payment to the annuity holder, once distributions begin.

Variable annuity contracts also have disadvantages. One is cost. In purchasing mutual funds, a client pays one level of fees, those imposed by the mutual fund. In a variable annuity contract, investors pay both contract and subaccount fees. Performance and income guarantees in variable annuity contracts cost money as well.

Variable annuities require a careful analysis of fees versus the potential benefits. Keeping in mind today's relatively low capital gain rate, it might be acceptable to invest in a mutual fund portfolio, pay any capital gain taxes on reallocation and forgo a variable annuity's tax deferral.

Risk: A distinction between variable and fixed annuities is investment risk. An insurance company assumes the risk of a fixed annuity's invested capital. Conversely, with variable annuities, owners assume the risk in their choices of subaccounts.

Whether immediate or deferred, fixed annuities are guaranteed by the companies issuing them. If an issuing company faces a financial hardship, fixed-annuity contract holders could find their investments at risk. Thus, a careful investigation of the issuer's financial strength should be undertaken before purchasing an annuity. The holders of variable annuity contracts do not face the same risk, because the underlying subaccounts are not the insurance company's obligations, as noted above.

Annuity Structures

There are four parties to an annuity--the contract owner, the annuitant, one or more beneficiaries, and the issuing insurance company that provides the annuity contract.

The contract owner decides how much to invest and also names the annuitant and the beneficiaries. The annuitant (who, in many cases, is the contract owner) receives monthly payments. The annuitant's life expectancy determines the amount of such payments.

The beneficiaries receive the contract's value (if any) after the annuitant's death. Annuities provide various options for paying the benefits. In many cases, there are no death benefits available to beneficiaries.

Thus, life expectancy clearly plays a major role in an annuity's performance--the greater the annuitant's life expectancy, the smaller (generally) the monthly payments. More importantly, if the annuitant dies early during the distribution phase, much of the investment could be lost. This is one of an annuity's inherent risks. To counter this, annuities can provide optional forms of death benefits to beneficiaries in the event of the annuitant's premature death.

One example is that benefits can be paid on a joint and survivor basis. The monthly payment is payable not only for the annuitant's life, but also for the beneficiary's. Typically, a spouse is the beneficiary; in such case, a joint and survivor annuity provides fixed payments as long as either spouse is alive. In addition to annuitized payments to a beneficiary for life, annuities can also provide either annuitized payments for a limited number of years, or a lump-sum payment to the beneficiary. This mitigates the loss resulting from an annuitant's premature death. For older adults, these provisions can supply necessary financial support later in life.

Fixed immediate annuity: As the simplest type, a fixed immediate annuity is appropriate in a variety of eldercare situations. For example, a 70-year-old retiree who rolled her $250,000 IRA into a fixed immediate annuity could receive equal monthly payments of $1,674 for the rest of her life, under current interest rates. Or, a 55-year-old who wishes to take a guaranteed income stream into retirement (as a safety net for the balance of a portfolio) may convert, say, $500,000 from his portfolio and purchase a fixed immediate annuity. As a result, he could receive a guaranteed monthly payment of $2,585, under current interest rates.

Fixed deferred annuity: Similar to an immediate annuity, a fixed deferred annuity provides specific benefits guaranteed by the underlying insurance company. However, deferred annuity payments do not begin until value has accumulated or time has passed. For example, in anticipation of retirement, a 50-year-old business owner might purchase a deferred annuity at face value. The contract will grow at a guaranteed rate and, at a specified time (perhaps, age 65), it will begin to pay equal monthly payments to the business owner to supplement retirement income.

Because the issuer guarantees the fixed rate of return in an annuity, the rates of return are relatively conservative. A variable annuity, however, may be appropriate for investors who want an aggressive approach (especially those with a longer life expectancy) and the ability to shelter or defer income from current taxation.

Taxation of Annuities

The taxation of annuity contracts and related payments can be complex and confusing. A complete discussion of all aspects of taxation of annuity distributions is beyond this column's scope. For immediate annuities, every payment received consists of both income and return of invested capital. The latter is tax flee, until the entire basis in the contract is recovered. After that, the entire payment is taxable; see Sec. 72(b). Generally, when annuity payments begin, a taxpayer will need to calculate an exclusion ratio.

Example 1: E, age 65, purchased an annuity with $10,000 of after-tax funds. The annuity will pay her $1,200 a year for life. According to IRS tables, the multiple for E is 20.0 (see Regs. Sec. 1.72-9, Table V), meaning that she is actuarially expected to live another 20 years. Thus, E's life expectancy is 85 years (65 + 20.0). To calculate the exclusion ratio for E, the total expected return she will receive (i.e., $24,000, or 20 years x $1,200) is divided by E's $10,000 cost, resulting in an exclusion ratio of 41.67%. Thus, 41.67% of each payment E receives for the first 20 years of payments will be excluded from tax.

Note that after the 20th year, any future payments E receives will be fully taxable, because she will have received her entire original investment back by that time.

Similarly, once a deferred variable annuity contract has been annuitized, the taxation proceeds under the same rules as for immediate annuities, illustrated above. Note: the basis in the contract is the original investment (plus subsequent additions, less periodic withdrawals), not the value of the contract on the date that it is annuitized. Also, in the case of an IRA annuity, the taxpayer's basis is zero, unless the IRA was originally nondeductible.

As was mentioned previously, one of the attractive features of a deferred annuity is the deferral of income recognition. However, this deferral may come at a price, because, similar to IRAs, deferred annuities are subject to early withdrawal penalties when withdrawals occur prior to age 59 1/2 (under Sec. 72(q)), unless an annuitant qualifies for a penalty exception, such as the Sec. 72(t) provisions for lifetime payments.

In addition, there is another potential penalty on deferred annuity contracts--a surrender charge levied by the annuity issuer. To encourage investors to leave money in the contract as a long-term investment, insurance companies generally impose charges on withdrawals in the early years. For example, in the first year, there might be a 6% surrender charge on withdrawals; in the second year, it could be 5%, and so on. As a mitigating factor, contracts usually permit 10% of their value to be withdrawn in a given year with no surrender charge.

Exchanges and Sales

One question that often arises with clients that have older annuity contracts is how they can convert these into more current (and often more flexible) contracts.

Under Sec. 1035(a)(3), an annuity owner can effect a tax-free exchange of annuity contracts. In such an exchange, the basis in the original contract carries over to the basis of the new contract, regardless of any cash involved, but any internal build-up escapes current taxation.

Example 2: S purchased a variable annuity contract in 2001 for $100,000. Presently, the contract is worth $300,000, and has no surrender charges. S exchanges this variable annuity contract for a new one. The new contract has a $300,000 value, while S's basis in the new contract is still $100,000.

Importantly, the $300,000 in the new variable annuity contract is subject to surrender charges if withdrawn by S in its initial years. This is one of the major disadvantages of tax-free exchanges of variable annuity contracts--the appearance of new surrender charges after the surrender period has expired on the old contract. Thus, if S wished to withdraw $40,000 from the contract, she should have done so before exchanging it for the new one, to avoid surrender charges.

State requirements: CPAs working with older clients should make them aware of the problem of exchanging annuity contracts. Some unethical agents will encourage clients to exchange contracts, instituting a new surrender period and providing the agent with a new commission. Many states, including New York and New Jersey, have imposed substantial pre-exchange reporting requirements to combat this practice. Often, the exchange of variable annuity contracts can make financial sense, however. Current annuity products generally have lower administrative and mortality expenses, which, over time, can yield a higher contract value to the annuity holder. However, for older adults, the time it may take to recover the cost savings is generally insufficient to outweigh the increase in potential surrender charges of a new contract.

If a variable annuity contract is sold, the gain or loss is ordinary; see Rev. Rul. 61-201. Thus, in some cases, an underpefforming annuity contract should be sold rather than exchanged, the tax loss taken, and a new contract purchased with the remaining cash. Any surrender charges incurred in selling the old contract count as part of the loss on the sale.

Example 3: In 2004, J purchased a variable annuity contract for $300,000. It has a present value of $180,000. If she sells the contract, she will incur a 6% surrender charge. On the other hand, if she exchanges the contract, the new contract would have a $169,200 basis ($180,000 x 94%) and she would not recognize a loss. If, instead, J sells the contract for $169,200, she would recognize a $130,800 loss, resulting in a tax benefit of $32,700 in the 25% tax bracket. J could then buy a new contract for $169,200. Clearly, J would be better off selling her old contract and purchasing a new one, rather than exchanging contracts.

Other Considerations

Age of investor: For older adults, annuities can be an important part of an investment portfolio. Fixed annuities are generally appropriate for conservative investors, because they provide stable, guaranteed monthly income payments, shielding the annuity owner flora market and investment risks.

For younger adults, variable annuities may provide a tax-deferred mechanism to accumulate wealth, availing them of professional money managers and tax benefits. Once retirement age is reached, they can choose to let the contract continue to grow or start taking benefits. Benefits can be derived either from their variably invested portfolio, or they can covert their contracts into fixed immediate annuities, which would provide fixed income streams.

Limited payouts: In addition to providing lifetime benefits, annuities with limited (generally shorter) payout periods can be purchased. For example, a client who wishes to have his or her portfolio (exclusive of the annuity contract) grow over a 10-year period can purchase an immediate 10-year fixed annuity. This would provide income for the next 10 years and allow for undisturbed growth in the balance of the portfolio.

Retirement accounts: Questions often arise regarding the suitability of annuity contracts within IRAs and pension plans. As noted above, contract owners pay annuity companies for the privilege of having their money invested on a tax-deferred basis. Because an IRA or pension investment is, by law, tax-deferred, there is no reason to incur these additional costs by placing annuities inside otherwise tax-deferred investments. Nonetheless, many investors feel that the other benefits of variable annuities (i.e., professional money management, and income and benefit guarantees) make such investments suitable.


Annuity products are an extremely misunderstood tool--and rightly so. They carry obviously significant questions and uncertainties and clearly are not for everyone. However, given the right fact pattern, they can be a useful tool when advising clients.

For further information about this column, contact Mr. Minker at (212) 790-5826 or, or Mr. Schulman at (845) 928-7336 or


Marc J. Minker, CPA/PFS

Managing Director, Private Client &

Family Office Services

Mahoney Cohen & Company

New York, NY


Michael David Schulman,


Schulman CPA, An Accountancy

Professional Corporation

New York, NY
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Author:Schulman, Michael David
Publication:The Tax Adviser
Date:Jan 1, 2006
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