Annuities are contracts issued by life insurance companies. Annuities are issued as either immediate annuities or deferred annuities. Investors that are interested in guaranteed lifetime income for their own life, or with another person as joint annuitants can invest a single premium into an immediate annuity contract. The immediate annuity contract will specify payments of monthly or annual income for life with the option of receiving the payments with a 3% annual cost of living adjustment. Investors can invest in a deferred annuity contract which provides for an accumulation period and a payout period. During the accumulation period, premiums are invested into the contract until withdrawals are made subject to contract provisions. During the payout period, contact owners can annuitize the account balance providing guaranteed lifetime income or make withdrawals as needed.
Funds invested in deferred annuities are managed by insurance companies and accumulate tax deferred until the funds are withdrawn or annuitized. The accumulated funds are subject to IRS tax rules according to a first-in, first-out (FIFO) tax treatment. For example, withdrawals are considered earnings first, taxed at ordinary income tax rates until you reach the principal invested at which time withdrawals are considered non-taxable return of principal. Taxation of income from an annuitized account balance is determined by calculation of the exclusion ratio to determine what portion of each payment is considered a return of principal and which portion is taxable at ordinary income tax rates. The exclusion ratio is calculated as total premiums paid divided by total expected payments based on the expected payout of the annuity contract.
Funds invested in annuity contracts issued and managed by life insurance are held in either the general account of the insurer or in separate accounts which are segregated from the insurance company’s general account. Assets held in the general account are subject to the claims of insurance company creditors which is the main reason an insurer’s credit rating is important when investing in a fixed annuity. State insurance funds provide for guarantees to contract holders of failed insurance companies, subject to certain limitations. Separate accounts managed by an insurance company are not subject to the claims of any creditors of the issuing insurance company. Variable annuities provide for investments in sub accounts which are similar to mutual funds. You can learn more about the differences between the two types of annuities below:
Annuities receive tax deferred status on accumulated contract earnings with an IRS rule that funds cannot be withdrawn prior to age 591/2 unless subject to a 10% premature withdrawal penalty. Furthermore, upon the death of the contract owner all of the accumulated earnings are subject to income tax, immediately. Many financial advisors caution investors about this potential tax trap for annuity contracts with sizable accumulated earnings. The benefits of tax deferral are more significant for investors with longer investment time horizons which require management of withdrawals during retirement to avoid any unexpected tax burdens for an estate.
A financial advisor can review your current annuity contracts and investment portfolio holdings and determine the appropriate use of annuity contracts based on your financial plan and investment policy statement designed to reach your True North.
