What Are Annuities?

Welcome, everyone. My name is Tan and I am an independent CERTIFIED FINANCIAL PLANNER™ practitioner.

Today, we will learn about annuities and their purposes:
- An annuity is a contract between the client and the financial institution.
- The best types of annuities depends on the clients’ goals and objectives. Are the clients looking for growth, income, or both?
- Contribution can be a single lump sum or whatever amount you like.
- Income payments can be fixed or variable.
- Income payments can be lifetime for you or for both you and your spouse.
- Income payments can be a combination of fixed or variable and lifetime income for you or both you and your spouse.

Premium Funding Options
- Single premium immediate annuity (SPIA). One time deposit into the plan and you want income now.
- Single premium deferred annuity (SPDA). One time deposit into the plan and you want income in the future.
- Periodic premium deferred annuity (PPDA). You can contribute whenever and how much you want depending on the types of annuities and you want income in the future.

Annuity Payout Options
- Fixed period. 5-year, 10-year, 15-year, 20-year, 25-year fixed period annuity.
- For example, you picked 20-year fixed period annuity because you only want income for 20 years. After the 20 years, the contract ended.
- Fixed amount. You only want $3,000 a month and the insurance company will do the calculation to see how many payments you will receive based on the $3,000 monthly income you want.
- Straight life annuity. Lifetime income for the rest of your life.
- Joint and survivor. Lifetime income for you and your spouse lives.
- Life annuity with period certain. Let’s say you want life annuity with a 10-year period certain. If you passed away before the end of the 10th year, your beneficiary will continue to receive the payment until the end of the 10th year. If you live past the end of the 10th year, you will continue to receive the payout until you passed away. You can think of it as the end of the 10th year or your life, whichever is greater.

Different types of annuities are fixed, variable, equity-indexed, immediate, and deferred.

Fixed annuities characteristics
- The money is invested in the insurer’s general account.
- Insurer bears the investment risks.
- The insurer will guarantee a minimum interest rate.
- There is fixed growth where you can cancel the policy at the end of the term or renew it as you please.
- There is also fixed income where you receive a fixed income payments.
- This plan is suitable for conservative investors.

Variable annuities characteristics
- The money is invested in subaccounts. You can think of sub accounts as investment accounts.
- The contract owner of the plan pick the investments.
- The contract owner bears the investment risks.
- The income payments vary depending on the option you pick.
- This plan is suitable for higher risk investors.

Equity-Indexed annuities characteristics
- Investment returns are linked to an index, such as the S&P 500, Russell 2000, MSCI, etc.
- The contract owner of the plan pick the investments.
- The insurer guarantees a minimum return and the return is cap at a maximize.
- The income payments vary depending on the option you pick.
- This plan is suitable for moderate risk investors.

Immediate annuities characteristics
- Insurer bears the investment risks.
- The first payment generally begins one payment period following the premium or deferred which is sometime in the future.

Deferred annuities characteristics
- Who bears the investment risks depends on the types of annuities.
- You can receive lifetime income now, later, or never.
- One of the main objectives for this type of annuity is to defer the taxes.

Why do investors buy annuities
- They don’t want to run out of money.
- Predictability. Investors know they have a consistent income coming in every month to pay their bills.
- They don’t want to actively manage their portfolio to match their withdrawal rates to changing financial market conditions. What I mean is the financial market goes up and down and it’s unpredictable. Because of this unknown variable, you have to actively have the right mixture of investments in your portfolio and how much money you can withdraw out of your portfolio so you don’t run out of money. It’s a lot of work and it’s not guaranteed.

The best way to purchase an annuity
- The best way to purchase an annuity is to ask yourself, what are you trying to accomplish then pick the annuity and riders to accomplish that goal.
- The total fees of an annuity is important but what are you getting for the fees matter more.
- Does the annuity have up to 10% of the account value withdrawal free of surrender charges feature.
- The insurance companies are the ones that promises to pay you the lifetime income, so you want a solid company that can backup their promises. Remember guarantees depend on the company's financial strength and claims-paying ability.
- When you look at the illustration, you want to know what are the guaranteed. The hypothetical doesn't mean much because anyone can project a nice hypothetical illustration to make the annuity appealing.
- Shop around, talk to a professional, and take your time.

When you should not buy annuities
- Annuities are not for everybody. It really depends on your financial situation. One example is, I have a client who is a nurse and she is getting 75% of her 3 highest consecutive annual incomes. She has enough money to pay her bills, travel, and give money to her family. In her situation, she does not need any annuities. We built a low cost investment portfolio for her.
- You can achieve the same goal in a better way. For example, you have a long-term horizon and you want to grow your money but scared of a decline in the financial market, you might be better off building a low cost diversified investment portfolio than buying an annuity because you don’t have to pay for the extra cost that comes with an annuity.

Be cautious of:
- Annuities with high fees.
- Long surrender period and high charges.
- Poor participation rates, cap rates, floor, and spread rates if any.
- The premature distribution rules.
- Poor performing investments inside the annuity.
- Twisting and churning. If you are replacing an existing annuity with a new annuity, be sure to fully understand all of the advantages and disadvantages that come with the existing annuity and the new annuity.

Common questions on annuities
- Do annuities have high fees? It depends what type you buy. Normally variable annuities have high fees and fixed and SPIA have very low fees.
- Do I need my spouse to sign a waiver for single life annuity? From my experience, yes. A single life annuity provides the largest payout. The spouse must sign a spousal waiver witnessed by a plan official or notary in order to elect a single life annuity.
- What are the top low-cost annuities? The financial institutions are constantly updating and changing their annuity products to complete in the marketplace. Thus, you want to reach out to a professional and ask him or her to shop around for you.
- What are the disadvantages of an annuity? Buying the wrong annuity with high fees and a long surrender schedule.

Tax Treatment of Annuities
- To understand how annuity will be taxed, we have to understand how it’s being funded, who owns the annuity, and who will receive the income.
- A general guideline is, if we are funding the annuity with pre-tax dollars, such as money inside of a Traditional IRA or 401(k), all of the income coming out of the annuity will be taxable because we have not paid taxes on the money.
- Funding the annuity with after-tax dollars, such as money coming from a savings and checking accounts, income is considered partially return of principal and partially taxable income.
- Funding the annuity with Roth IRA and Roth 401(k), no tax on the income.
- Of course, everything has to be done correctly. We have to be careful with rules and exceptions.

Additional 10% Tax on Early Distributions
- I want to add this rule in the video because it’s important to know. This is directly from the IRS.
- “If you receive pension or annuity payments before age 59½, you may be subject to an additional 10% tax on early distributions, unless the distribution qualifies for an exception.
- The additional tax doesn't apply to any part of a distribution that's tax-free or to any of the following types of distributions:
- Distributions made as a part of a series of substantially equal periodic payments that begins after your separation from service.
- Distributions made because you're totally and permanently disabled.
- Distributions made on or after the death of the plan participant or contract holder, and
- Distributions made after your separation from service and in or after the year you reached age 55 (IRS 1).”

Exceptions to the additional tax of 10% withdrawal rule made before you reach age 59 1/2
- Purchased annuities before August 14, 1982.
- “It doesn't apply to any part of a distribution that is tax free (IRS, Page 33)”.
- Immediate annuity because it satisfied the substantially equal periodic payments exception, Internal Revenue Code §72(t)(1).

August 14, 1982
- If you purchased non-qualified annuities before August 14, 1982, withdrawals are first in, first out (FIFO) and no 10% penalty. Which means if you withdraw from your annuity, your principal is counted first then anything above your principal is considered taxable income.
- Withdraw is different from lifetime income. Lifetime income counts as part principal and part taxable income.
- If you purchased non-qualified annuities on or after August 14, 1982, withdrawals are last in, first out (LIFO). Which means withdraws counted as taxable income then principal.
- Here is the direct quote from the IRS. “If you bought your annuity contract before August 14, 1982, a different allocation applies to the investment before that date and the earnings on that investment. To the extent the amount withdrawn doesn't exceed that investment and earnings, it is allocated first to your cost (the tax-free part) and then to earnings (the taxable part (IRS 2).”

Non-natural person (like a corporation) owns an annuity
- Gains are taxed as ordinary income.
- Losses are treated as ordinary losses.
- No tax deferral.

There are other exceptions to the rules that I did not cover because I have not encountered any clients where the rules applied to them, such as August 14, 1982 rules. Please note that all of my videos are for educational purposes and you should talk to a professional before making any financial decision.

You need to fully understand the financial products you are planning to buy. If you have existing financial products, you want to understand what you have and how it works.

Questions to help you understand your annuity
- How does this annuity work?
- How is this annuity suitable for me?
- What can this annuity do for me and my family?
- What are the risks?
- What are the guarantees and how long do they last?
- What is the free look period after I purchased the annuity? The free look period is the right to cancel the contract without penalty and charges. The free look period is normally 10 or 30 days depending on the state and how old you are.
- What are the available riders and how much does it cost?
- What is the surrender schedule and fees?
- How much can I withdraw from the annuity without penalty each year?
- How will this annuity impact my tax liability?
- What will happen to the annuity if I am deceased?

How I use annuities with clients
- They are conservative, don’t want to lose money, and want to grow their money.
- They want lifetime income regardless of the financial markets.

You can visit the IRS Publication 575 to learn more about annuities.
https://www.irs.gov/pub/irs-pdf/p575.pdf

Thank you for watching. This is Tan, your trusted advisor.

References:
(IRS 1) https://www.irs.gov/taxtopics/tc410
(IRS 2) Page 5, https://www.irs.gov/pub/irs-pdf/p575.pdf

This material is for educational use only and does not constitute tax, legal, or investment advice. Information may be changed or updated without notice. Consult with a licensed professional regarding your personal circumstances.

Please do not excerpt or copy this information without prior consent from TAN Wealth Management.