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March 16, 2020


Last updated: June 29, 2024

Annuity payments and taxation

By: Securities Institute Staff

In our previous article we reviewed the three ways for purchasing an annuity contract. Let’s move forward here, and get a little bit more detailed about some of the specifics regarding the operation of the annuity’s separate account. When an investor contributes money into a variable annuity product, that money goes into the separate account and the separate account is a portfolio inside the insurance wrapper. This where the money is invested when investors or annuitants make contributions into the account.

When reviewing these separate account, you’re going to need to be familiar with two different terms here– accumulation units, and annuity units. Accumulation units are what investors own during their deferred phase of the annuity contract. When they are making contributions into the annuity contract or leaving money there to grow, they own accumulation units. The number of accumulation units vary as the investor makes regular contributions. And as distributions are sent into the separate account for the investor they are used to acquire more accumulation units.

So accumulation units vary in number, and they also vary in value. As the value of the securities in the separate account go up and down, the value of the accumulation unit also rises and falls. Now when someone goes from the accumulation or deferred phase to the payout phase, investors exchange their accumulation units for annuity units.

When the investor annuitizes a contract, they surrender their accumulation units that represent their ownership in the separate account, and they acquire annuity units. These annuity units are fixed in number, and the value varies. So once an investor annuitizes the contract, the number of annuity units remains fixed. For example, if an investor had 5,000 annuity units, they would always have 5,000 annuity units. And  the investor would be receiving the distributions from that contract in the form of monthly payments based on the number of annuity units they owned.

In our previous article, we reviewed how someone would acquire an annuity. Let’s take a look at how someone would receive money from the annuity contract when they annuitize. Once an individual annuitizes their contract, they have to select a payout option. 

Now when someone selects a payout option, it can never be changed, no matter what. Repelled up since collected are as follows:

  1. Life only
  2. Life with period certain
  3. Joint with last survivor

Life only option

With a life only option, the investor is guaranteed to receive payments for their life only. This option will give the investor or the annuitant the largest monthly payment.

Let’s say an investor has placed $400,000 into an annuity contract, and they annuitize at retirement. They receive their first check, and perhaps it’s $4,000. And they have selected a life only option. They walk down to the mailbox, and they see this check for $4,000, and they’re very excited. And they go over to their local bank and deposit that check. If, the investor walks off the curb, and gets hit by a bus, and is killed, unfortunately,in this scenario, that will be the only check that is paid out on that contract. The annuity company, or the insurance company in this scenario, would keep the rest of the money. So a life only payout option will generate the largest monthly payment for the annuitant, but there’s a significant amount of risk there to the family should the person pass away unexpectedly.

Life with period certain

The next  largest monthly payout, in size, would be generated by the life with period certain option. So the life-only option will generate the largest monthly payment. The life with a period certain option will generate the next largest monthly payment. If we go back to our example, where the gentleman had his first $4,000 check and he was hit by a bus after depositing it, had he selected a period certain of, say, 10 years, on his annuity contract, checks would go to his estate until 10 years had passed. Now it’s life or a period certain, whichever is longer. So had this gentleman not been hit by a bus after depositing his first check, and it took him 25 years to pass away, well, then the checks would cease upon his passing. So it’s life or period certain, whichever is longer.

Joint with last survivor

Now another Payout option for an annuity contract is a joint with last survivor– traditionally  this will be established by two spouses. And the annuity company will continue to pay out on that contract until the last party passes away. if one spouse is significantly younger than the other, that will impact the value of the payment because  the annuity company will be looking at the life expectancy of the youngest person on that contract.

 Cash or unit refund

 an investor could also do a cash or unit refund. Investors are not required to annuitize  and can take a lump sum distribution from the annuity contract. investors who select this option could then reinvest the money in another account or vehicle.

These are the types of payout options you’re likely to see on your exam.

Now let’s compare a variable annuity contract and a mutual fund  and look at the different features associated with each investment.  Now with a variable annuity, it has no maximum allowable sales charge. FINRA feels the maximum sales charge is whatever is indeed reasonable. So there’s no hard-and-fast rule as to what the maximum allowable sales charge is for a variable annuity contract. With a mutual fund, the maximum allowable sales charge is 8 and 1/2% of the public offering price, or 8 and 1/2% of the total payments.

Both variable annuities and mutual funds have investment advisers to manage the portfolios. They both have custodian banks to hold the portfolios and both have transfer agents that issue units or shares, as the case may be, and handle the name changes. with each investment investors also have voting rights.

Variable annuities and mutual funds both have a management team in place. With a variable annuity contract, they’re referred to as a board of managers. And with a mutual fund, they’re referred to as a board of directors.

Let’s look at some of the significant differences between a variable annuity contract and a mutual fund. With a variable annuity, the growth or the distributions received into the investor’s account are tax-deferred, meaning they are not currently taxed. The money is allowed to grow, free from federal income taxes, until it is withdrawn. With a mutual fund, the reinvestments and  dividends are currently taxed, even if reinvested into the mutual fund portfolio. So that’s a big difference right there. The variable annuity will allow the money to grow, tax-deferred, while the money in a mutual fund, when it grows, is currently taxed by the Internal Revenue Service. A variable annuity can promise someone income for life, where a mutual fund may not.

The costs and fees are a big consideration for many investors. The costs and fees with a variable annuity are significantly higher than they are for a mutual fund. The variable annuity investment contains significant costs and expenses that the investors need to be aware of prior to making that investment. Mutual fund expenses tend to be relatively low when comparing them to an investment in a variable annuity contract.

Another major difference between a variable annuity contract in a mutual fund is liquidity. Liquidity for a variable annuity is low, meaning investors don’t have a lot of access to their money.  In the initial years, during what they call a surrender period, Should an investor wish to withdraw the money during that period of time, the investor will be subject to penalties and costs. With the mutual fund, liquidity is very, very high. Investors can access it whenever they like without any penalties or excessive fees. Further, any type of random withdrawal from a variable annuity will also have tax implications for the investor, while the tax implications from the withdrawal of a mutual fund contract would be relatively low.

This is a great comparison  between variable annuities and mutual funds. This information will go a long way to helping you answer questions correctly on your exa.m

The Assumed Interest Rate, or the AIR. 

When an individual annuitizes their contract, the insurance company sets an earnings target, known as an AIR. And this is used to determine the amount of return that the separate account would have to earn in order to keep the individual’s payments consistent throughout their life.

Now let’s go back to our individual who annuitized their contract, and their first payment was $4,000. How do we know what the person will receive throughout the course of their life? Well, the separate account has to perform at a rate that is sufficient enough to keep these payments consistent for what  the annuity company expects to be the duration of this individual’s life. And The annuity company is going to set this AIR as a benchmark, and perhaps they set it at 4%. So the insurance company or annuity company says, Mr. Annuitant, in order to keep your checks consistent at $4,000 per month, the separate account has to earn a rate at least of 4%.

Let’s take a look at what happens to this individual’s payments given different levels of performance for the separate account. Perhaps the first month after the contract has been annuitized, the individual receives his first check, and it’s based on a performance of 6%. So that first month, the separate account performs very well, and it performs at a rate equal to 6% per year. The individual’s check is going to go up. And maybe it goes to $4,100. So the separate account outperformed the AIR, and the individual’s check increased. Now in the second month, perhaps the separate account performs very well, and it performs at an annualized rate of 7%. Well of course the individual’s check will go up once again. So maybe his check goes to $4,200.

Now in the third month, the separate account performs at an annualized rate of 5%. And here’s kind of the test point you want to be on the lookout for. What is going to happen to this individual’s check? Well this individual’s check, in the third month, is actually still going to go up, because the separate account still outperformed the AIR. So maybe his check goes to $4,250 this month. Because the separate account still outperformed the AIR, the check is still increasing in value. You are never measuring the return or the performance versus the previous month. It’s always the performance of the separate account versus the AIR.

In the fourth month, perhaps the separate account does not perform well, and it performs at a rate equal to 2% per year. Well certainly 2% is less than 4%, so now this individual’s check is going to fall, and perhaps it’s $4,100 this month.

And finally, in the fifth month, the separate account performs at a rate equal to the AIR of 4%, and the person’s check remains consistent from the previous month.

So if you’re presented with questions on the AIR on your exam, make sure you’re always measuring the performance of the separate account relative to the AIR to determine where the individual’s check is going from the previous month, whether it’s up or down. You never compare the performance to the previous month’s performance. It’s always versus that AIR. So if the separate account continues to outperform the AIR for a significant period of time, well then the investor’s check will continually increase. Should the separate account perform poorly for a significant amount of time, and underperform the AIR, the individual would see their check fall for a long period of time as well. So some good test points there for you on the assumed interest rate for your exam.

OK, that was a very comprehensive example of how the value of the payment received by an annuitant can change in relationship to the performance of the separate account. Now we need to look at a few other factors that can influence the amount of the payment that the investor will receive.Well, clearly the account value is going to be a significant consideration. Has The investor placed $50,000 in this account or  has the investor placed $500,000 into this account? Clearly the investor who has placed more money in the account will have a larger payment.

The payout option selected — remember, we talked about how the different payout options will impact the monthly payment, life only would generate the largest payment, and then you’d have the life with period certain, and then the joint with last survivor would give you that smallest payment, but it would be able to protect your spouse for their lifetime as well.

The age of the investor when the contract is annuitized will also impact the size of the payment. An Investor who is 60 years old when they annuitize, will receive a smaller check than an investor who is 70 years old when they annuitize. The older you are, the greater your payment is going to be, because the shorter your life expectancy is. The gender of the annuity can also impact the size of the monthly payment. If you are a man, you are tending to live a few years less than most women, so therefore your check will be larger. So saying that another way, the life expectancy of a man isn’t as long as the life expectancy for a woman, therefore the check for the man will be larger because The insurance company figures  it will have to pay men for a shorter period of time. A female tends to outlive a man by several years, so therefore her check will be a little bit smaller, in anticipation of having to pay her for a little bit longer.

The mortality risk for an annuity company is that the individual lives far beyond their life expectancy. So if someone annuitizes a contract at 65 years old, and they’re still out there kicking at 102, the annuity company is still paying these people. So the mortality risk for the annuity company is that the person lives for a very, very long time. And under the terms of the contract, they’re required to keep paying them. And then finally, the performance of the separate account versus the AIR. That I think we did a very good job in that previous section detailing the impact of the performance of the separate account versus the AIR. And when looking at these things in total, these are the factors that affect the amount of the payment that will be received by the new annuitant when they begin withdrawing the money from the contract. 

Random withdrawals

A random withdrawal is done by an investor who simply needs money for a particular reason. And we need to take a look at the tax implications here. So let’s say an investor has put $20,000 into their annuity contract. And over the period of years, maybe the annuity value for this investor has grown by $5,000. So  $20,000 was deposited, and $5,000 is the growth in the account over the period of time.

Now let’s say this investor or this annuitant is driving down the road, and their car breaks down, and they say, you know what, I’ve had it. I can’t keep fixing this car. I need a new car. They go down to the car dealer, and make a deal with them to purchase a new car. And they need a $5,000 down payment. And the only money they have right now is in this annuity contract.

So this investor is going to be forced to do a random withdrawal in this scenario. And there’s some tax implications you need to be aware of. This growth over the period that the money has been there has not been taxed. Remember, a variable annuity contract allows the money to grow, tax-deferred. And the IRS says that any random withdrawals from an annuity contract are done on a LIFO basis, and that’s Last In, First Out. And the IRS says the last thing in, is indeed the growth.

So the investor who withdraws $5,000 from this annuity contract will be taking the $5,000 from the growth. It will be subject to taxation or to tax. And if the individual is under 59 and 1/2, the individual will have to pay another 10% penalty tax. Random withdrawals from a variable annuity contract are done on a LIFO basis. Saying that another way, the growth is the first thing to come out of the annuity contract. So the IRS says, you’re taking the growth out, and we’re taxing you on it. Because the IRS wants their money when? They want it now.

Now if the individual was needing $6,000 to purchase that new car, $5,000 would come from the growth, and be subject to tax, and $1,000 would be coming from the $20,000 they had already deposited into the contract. This $1,000 would be returned to the investor, tax-free, because they’ve already paid taxes on it. Variable annuities are non-qualified plans. The money goes in after taxes. So they’ve already paid taxes on that $20,000. So if they ever needed that, they would get that back tax-free.

The tax implications when someone annuitizes a contract  are also highly testable. What an investor receives a payment from their annuity, part of their payment is the return of principal, and part of their payment is the distribution of growth. The exclusion ratio will tell the investor how much of each payment is the return of their cost base or their deposits, and they get that back tax-free. The portion of that payment that is considered to be distribution of earnings or growth is subject to taxation. And the investor would look at the exclusion ratio that they receive in the paperwork from their annuity company at the end of the year.

We hope that this article has helped you understand the operational and tax implications regarding variable annuity contracts.

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 The Securities Institute of America