MINI-COURSE SERIES
ANNUITIES Part VI
Copyright Š 2012 by Institute of Business & Finance. All rights reserved.
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RIGHTS The contract owner holds key rights under an annuity contract. While annuitant is living, the contract owner generally has the power to do the following: 1. 2. 3. 4. 5. 6. 7. 8. 9.
name the annuitant, annuitize part or all of the contract, choose (and change, prior to annuitization) the payout option, name and change the beneficiary, request and receive the proceeds of a partial or full surrender, allocate and transfer funds among different subaccounts, initiate and change the status of a systematic withdrawal, assign or otherwise transfer ownership to other parties and amend the contract with the issuing company's consent.
Changing the Annuitant Note that "change the annuitant" was not included in our general list of rights. Some annuity contracts specifically allow the right to change the annuitant and some do not. If the owner of the contract is not a natural person, a change of annuitant is treated the same as the death of an owner for income tax purposes, which means that certain distributions are required to be made from the contract. Therefore, even if the contract specifically allows owner to change the annuitant, care should be taken in naming the annuitant when the owner is a non-natural person in order to avoid the possibility that unfavorable tax consequences may be incurred.
Duration of Ownership Note also that we introduced the general list of owner's rights with the clause "while the annuitant is living.� Under many (but not all) annuities, the owner's rights in the contract cease when the annuitant dies and one of two things happens: either the value of the annuity is paid to the beneficiary or the beneficiary becomes the new owner, if the spousal continuation rule applies. This does not present a problem where the owner and the annuitant are the same person. But as mentioned, care must be taken in those situations where the owner and annuitant are different parties. Let us look at one example.
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Let's say that under John's deferred annuity, the maximum annuity starting age is 80. However, John is 75 years old and wants to obtain income via systematic withdrawal rather than annuitization. In order to maintain the annuity in its deferral period, John names his 40-year old son as the annuitant, though he retains ownership of the contract so that he receives regular income. If John's rights would cease in the event of his son’s death, John will lose control in the event his son predeceases him. To avoid that risk, John could also name himself beneficiary under the contract. Under such an arrangement, John would incur income taxes on the earnings if the annuity value were paid to him in the event of his son’s death (now named as the annuitant), but at least those funds would not be paid to a different party. The son could be named a contingent beneficiary to receive the proceeds in the event of John's death. Under other contracts, the owner's rights do not automatically cease when the annuitant dies. If the owner is not the annuitant and the annuitant dies first, some contracts provide that the owner automatically becomes the annuitant. Other contracts provide for a period of time in which the owner can name a new annuitant, after which, if a new annuitant is not named, the owner becomes the new annuitant.
Purchaser, Others as Owner In most cases the purchaser of the contract names herself as owner. Sometimes the purchaser names another party as owner, such as a trust. For example, trust ownership may be used when the purchaser wishes to make a gift to a minor. Certain forms of trust ownership may shift income and estate taxation of the contract’s death benefit away from the purchaser. However, the purchaser may be liable for gift taxes on the value of the annuity and / or premiums paid on it. In any case, by giving up ownership of the contract, the purchaser also gives up all contractual rights to control the annuity. A purchaser could name a trust (e.g., living trust) as owner and still retain control over the trust, but such a trust would not shift income or estate tax away from the purchaser. Purchasers should consult tax and legal counsel before giving ownership of an annuity to anyone other than themselves.
Taxation of Owner In general, it is the owner of who is taxed on amounts disbursed from the annuity during the annuitant's lifetime. This is true even if someone else is receiving annuity benefit payments: naming another person as annuitant does not shift tax liability away from the owner. Only a gift or other transfer of ownership can do that. However, you should note that under some contracts, once the contract is annuitized, the annuitant automatically becomes the owner.
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With certain exceptions, if the owner is not a natural person, the annuity does not provide income tax-deferral on accumulations. The major exceptions to the nonnatural person rule are a trust acting as agent for a natural person (e.g., a living trust), an IRA, qualified plan or the estate of a deceased owner.
Death of Owner: Required Distribution Federal tax law requires certain distributions be made from a non-qualified annuity if any owner of the contract dies. If the owner of the contract is not a natural person, then annuitant will be considered owner for purposes of the rule. If this is the case, a change of annuitant is treated the same as the death of an owner for tax purposes. Required distributions are as follows: If an owner dies after the annuity starting date, assuming he or she is not also the annuitant, any remaining payments due under the annuity must continue to be made at least as quickly as payments were being made prior to owner’s death. If the owner dies before the annuity starting date, entire value of the annuity must either be distributed within five years of owner’s date of death or annuity value must be annuitized within one year of owner’s date of death (see spousal exception).
Spousal Exception There is one exception to the rule requiring distributions in the event of an owner's death. If the beneficiary of the annuity is the surviving spouse of the deceased owner, the surviving spouse is permitted to become the owner. Distributions will not be required until the surviving spouse's subsequent death.
Effect of Rules on Joint Ownership These rules are designed to prevent the use of joint ownership to obtain tax deferral on annuity earnings over more than one lifetime, except in the case of married couples. For example, suppose Ed purchases a deferred annuity with $100,000 at age 65 and names his daughter Tamara, age 40, as joint owner. Ed does not need income, so he lets earnings accumulate tax-deferred until his death at age 75. At that point, if the annuity had credited 8% each year, the annuity would contain $115,892 of as-yet untaxed earnings. Since the law requires distribution when an owner dies, Tamara cannot continue the contract. Otherwise, Tamara could continue to accumulate and defer taxation of those annuity earnings for the remainder of her life, or even longer if she named another joint owner.
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The required distribution rules apply to contracts issued after January 18th, 1985. For contracts issued today, there are only a few situations that might call for joint ownership of an annuity. In the case of married couples, the effect of joint ownership for purposes of successor ownership is best obtained by having one spouse as owner and other spouse as beneficiary. In the event of owner's death, surviving spouse can become owner under the spousal exception rule and avoid any then required distribution or taxation. If joint ownership by a married couple is desirable for other reasons, be sure each spouse names the other as primary beneficiary; for the spousal exception to the required distribution rules to apply, the surviving spouse must be the designated beneficiary of the contract. If someone other than the surviving spouse is the designated beneficiary, or even if the spouse is the beneficiary along with another person, then even if the surviving spouse is a joint owner, the spousal exception is lost.
Other Joint Ownership Considerations Consumers may say they desire joint ownership because they are under the misconception that joint ownership of an annuity is like a joint bank account. It is not. With a joint bank account, either of the persons named on the account can make a withdrawal from the account independent of the other. However, with joint ownership of an annuity, the signatures of both owners are required to exercise the rights of ownership. Further, if a withdrawal is taken, both joint owners generally receive a 1099 form, each for one-half the amount of the withdrawal. This means each joint owner assumes the tax liability for one-half of every withdrawal, even if the entire withdrawal was spent by only one of the owners. Any joint owner under age 59 1/2 would also be liable for the 10% penalty tax on any taxable amount of his or her portion of the withdrawal, unless an exception applied. The desirability of joint ownership in light of these complexities should be carefully reviewed before naming more than one owner to an annuity. Joint ownership of IRAs and qualified retirement plans is prohibited.
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FIXED-RATE ANNUITIES VS. GOVERNMENT BONDS The table below compares fixed-rates with yields offered by government bonds. The yields shown are as of the first trading day of the year. Bond values and yields change almost daily. For example, from 1986-2010, 5- and 10-year government bonds suffered a loss of principal six times (40% of the time); the biggest loss was 2009, when 20-year bonds declined 18.3% in value and 5-year bonds lost 4.4%. The value of a fixed-rate annuity can only increase each day.
Annuity Yields vs. U.S. Government Bond Yields 5-Year Annuity
5-Year Bond Yield
Annuity > Bond
10-Year Annuity
10-Year Bond Yield
Annuity > Bond
2000
6.7
6.5
6.7
6.6
2001
6.3
4.8
6.4
4.9
2002
5.2
4.5
5.7
5.2
2003
4.4
3.0
5.1
4.1
2004
3.8
3.4
4.5
4.4
2005
3.8
3.6
4.3
4.2
2006
4.5
4.3
4.9
4.4
2007
5.2
4.7
4.8
4.7
2008
5.0
3.3
5.4
3.9
2009
5.2
1.7
6.0
2.5
2010
4.0
2.6
4.4
3.8
2011
3.7
2.0
4.4
3.4
2012
3.6
1.6
4.0
1.9
(sources: U.S. Treasury Dept. and Annuity Rate Watch)
For the period 2000-2011, 5-year annuities averaged 5.3% vs. 4.0% for 5-year bond yields; 10-year annuities averaged 5.7% while 10-year government bond yields averaged 4.7%. Over the past five years, annuities have yielded 32% more than their 5-year government counterparts; 21% more in the case of 10-year bonds.
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THINGS TO DO Your Practice The table on the previous page shows that fixed-rate annuities have provided yields higher than similar maturing U.S. government bonds—for each of the past 12 years. Moreover, the annuity provides tax diversification and planning opportunities not found with treasuries. In fact based on other historical data covering different time periods, there is no indication that this trend is likely to change in the future. The advisor may need to rethink his/her conservative investment strategy (growth and/or income) in light of these realities—and the fact that the potential for principal erosion (by owning government or other quality bonds) is far greater than how much further interest rates can fall (creating bond profits). The Next Installment Your next, and final, installment, Part VII, covers four topics: investor behavior, risk evaluation, EIA factors to compare and the dividend discussion. You will receive Part VII in a few days. Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about its designation programs: o o o o o
Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)
IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.
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