What is an Annuity

Annuities are, by far, one of the more confusing retirement options available today. While it is certainly true that many insurance brokers would prefer to keep you in the dark, in this article I will attempt to bring to light a few of the more common ‘realities’ associated with purchasing an annuity for retirement. So let’s get to it.

Annuities were once touted to be the best investment blanket for individuals that were retired, or about to retire. An annuity is simply a legally binding contract between the purchaser and the insurance company where the insurance company agrees to provide specific guarantees, usually financial in nature, in exchange for the premiums paid by the purchaser.

I know both my grandparents had annuities when I was younger but I never really knew what that meant until later on in life. The one thing I distinctly remember them telling me was that annuities were easy investments to get into but were a real pain to get out of!

Where can I Buy an Annuity

When it comes to investment options, the consumer truly has a wide range of viable alternatives. An investor could, in fact, elect to:

Buy a certificate of deposit (CD) from their local bank
Buy a bond or treasury note from the United States government
Buy a municipal bond from their local city
Buy a bond from a publically traded company

Annuities are extremely similar to the options above in that the investor can simply buy an annuity from an insurance company, brokerage firm, or even some banks.

What is the Difference Between these Investments

All things being held constant, the primary difference between an annuity and bonds/CDs is the commissions paid to the seller. This is, perhaps, why annuities come so highly recommended by brokers. While percentages do vary, investors should expect to pay a commission of around 5% on day one.

Can More than One Person Purchase an Annuity Together

The person the purchases the annuity is generally referred to as the owner. This individual can make changes to the policy anytime they want. For instance, they may want to change the beneficiary of the policy. An annuity can even be owned by more than one person simultaneously. This is commonly used for business partners where the owners can actually stipulate who can step in an own the policy in the event of their death.

What is the Difference Between the Annuitant and the Beneficiary

Perhaps the most confusing issue regarding annuities is simply understanding the difference between the annuitant and the beneficiary. To help simplify things a bit, the annuitant is the person being insured by the contract. This person has absolutely no control over the money invested unless the annuitant is also the owner of the policy.

The beneficiary, on the other hand, is the person that will actually receive the money once the annuitant dies. The owner actually stipulates the amount left to the beneficiary. One thing to keep in mind is that the annuitant and the beneficiary cannot be the same person. This only makes sense because you cannot leave money to yourself once you pass away.

Typically, annuities are structured in that the owner and the annuitant are the same person with someone else being designated as the beneficiary.

Non-Qualified versus Qualified Annuities

In order for an annuity to be considered non-qualified it must have been purchased with after tax dollars. If an individual purchases an annuity for retirement, through their IRA for example, the annuity will be considered a qualified annuity; that is, purchased with before tax dollars. Since all annuities serve to defer income recognition until the money is withdrawn, the distinction of being non-qualifies versus qualified only comes into play when the money is withdrawn.

Tax Treatment for Non-Qualified and Qualified Annuity Contracts

If the annuity is consider to be non-qualified, the beneficiary must pay income tax only on the portion withdrawn above the amount deposited. Unfortunately, non-qualified annuities are taxed using the LIFO method of accounting.

In a nutshell, this simply means that any gains including interest that your account has earned are considered to be the last funds deposited into your account and are, therefore, the first dollars that must come out. It is a simply way to make sure that you get taxed on all of the account appreciation. Once you have withdrawn all of the earnings, any subsequent withdrawals can be made tax free.

If it is a qualified annuity, income tax must be paid on all of the money. Another thing you need to consider is that if the annuitant dies with money remaining in the annuity, the beneficiaries are responsible for paying tax of any gains not previously taxed.

What is an Annuity Surrender Charge

Most of the annuities being sold on the market today have something called a surrender charge, or surrender period, built into the policy. During this surrender period, which typically last anywhere from 5 to 10 years, the owner has to keep most of their investment in the policy. Some annuities will allow you to withdraw 10% of the accumulated value each year but will charge you a surrender charge for any amount above 10%.

For example, that at age 60, you invest $40,000 in a non-qualified annuity that is paying you 4%. At the end of that first year, your account is worth $41,600. In order to pay your bills, you estimate that you will need to withdraw $10,000. You can take out $4,160 with no penalty but you will have to pay approximately $400 to withdraw the remaining $5,840 (the surrender charge is generally around 7%).

This, of course, does not even address the tax implications associated with this withdrawal. You will, in fact, owe tax on $1,600 (which is your accumulated value less your original deposit). Furthermore, in order to be able to freely withdraw funds from your annuity, the federal government has mandated that the person withdrawing the funds need to be at least 59 ½ years old or they will be subjected to a 10% early withdrawal penalty.

This article has attempted to help you better answer the question, what is an annuity. In our next few articles we hope to dig a little deeper and discuss a few of the more specific annuity withdrawal rules and regulations; as well as the various types of annuities being sold today.