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Beneficiaries Annuity contracts allow the owners to name beneficiaries. One of the reasons that annuities are attractive to investors is because they have a built-in death benefit. Just like the EIA has a minimum guaranteed value, an annuity contract states that if the value of the contract is less than the original premium, minus any withdrawals or loans, the owner’s beneficiary upon the owner’s death shall receive the original premium amount. However, if the annuity is valued at more than the original premium amount, the beneficiary will receive that larger amount. For example, James Client invests $100,000 in a deferred variable annuity. Four years later, Mr. Client dies. Prior to his death, he hadn’t taken any money out of the annuity. His beneficiary for the annuity, his daughter, claims the annuity, which is now valued at $89,000. Because Mr. Client hadn’t taken any money out of the annuity, his daughter receives $100,000—the original premium amount. Original lump-sum premium = $100,000 Withdrawals = $0 Value of death = $89,000 Beneficiary receives = $100,000 (All amounts are hypothetical.) Original lump-sum premium = $100,000 Withdrawals = $0 Value of death = $122,000 Beneficiary receives = $122,000 (All amounts are hypothetical.) If the beneficiary of the annuity owner is the surviving spouse, that person is entitled to treat the annuity as his or her own under the current tax law. The spouse would become the new owner of the annuity. Recently, annuity issuers have come up with different ways to calculate the minimum guaranteed death benefit, which help out the owner’s beneficiary. One example is the reset death benefit, which has a five-year standard. So, using our previous example, if Mr. Client invests his $100,000 in the variable annuity on July 1, 2001, the value would be reassessed on July 1, 2006, again on July 1, 2011, and so forth, for the life of the contract as long as Mr. Client didn’t annuitize it. The highest of these amounts, including the original premium, becomes the new guaranteed death benefit. The benefit can always go higher, but not lower. Another calculation method for the death benefit is a step-up or ratchet basis. The step-up basis works the same way the reset death benefit does, except instead of waiting five years between reevaluations, there is only a one-year wait. Therefore, the value of the contract would be reassessed on July 1 of every year, rather than every five years. Some variable annuities that offer the step-up basis do so on a quarterly time frame, thus increasing the chance of an even higher death benefit. Finally, some insurers offer a certain escalation of death benefit amounts, which may be three to five percent per year. This type of “roll-up” death benefit works this way: When the annuity owner dies, the beneficiary receives the greatest amount of either the total premium paid, the current contract value, an assumed three percent annual return, or the top death benefit on a specified anniversary date. “Roll-up” death benefit: Original premium = $100,000 Contract value at death _$137,000 Assumed 3% annual return on contract = $112,550 Death benefit on July 1, 2003 (specified anniversary date) = $109,000 Beneficiary receives _$137,000 Be sure you know which type of death benefit your contract allows. That way you’ll have an accurate concept of what to expect. Plus, the annuity contract may specify that the death benefit not exceed a certain amount, age, or percentage of the original premium. Loans and Withdrawals Annuities may also allow for loans or withdrawals by their owners. However, for those owners who wish to take out a loan against their annuity (or just withdraw money) and who haven’t reached age 591/2, there will be the 10-percent IRS early withdrawal penalty. There are some exceptions to this rule, though. Individuals may take substantially equal periodic payments in the case of the owner’s disability or death, or for the purchase of an immediate annuity. Exchanges The IRS also allows for a tax-free exchange of nonqualified annuities (i.e., those not within an IRA). This is known as a 1035 exchange, and must be from one annuity to another. Should the owner be dissatisfied with the internal subaccounts, service, or performance of the annuity, he or she will be able to exchange it for a different annuity. This works not only from annuity to annuity within one company, but also across different companies. However, there may be some surrender charges for the older annuity. Many times, the annuity owner differs from the annuitant. I’ve seen this happen when the wife’s trust owns the annuity, but the annuitant is the husband. It’s the annuitant whose life expectancy determines the timing and amount of the payouts, should the annuity be annuitized. Annuities Not Held by Natural People Annuities may be held by entities, rather than natural people. However, for tax purposes, any deferred annuities would not be treated as annuities and, thus, wouldn’t be tax-deferred. Any gain made on the annuity would be taxed to the owner as ordinary income. This includes any annuities held by corporations, charitable remainder trusts, and certain other entities. This doesn’t include annuities held by an estate because the owner has died, any annuities held by trusts or other entities acting on behalf of a natural person, annuities within qualified retirement plans, tax-sheltered annuities, or IRAs and immediate annuities. Expense Charges Annuities, both fixed and variable, may have a management or expense charge associated with them. This charge is levied by the insurer and is an annual fee, which is usually billed on a quarterly basis. These charges can be contract charges, which generally are fixed for the life of the contract, and operating expenses, which may vary from period to period. Contract charges protect the insurer from excess mortality and expenses charges, which may include administrative and sales costs, risk charge for death benefits, and insurer profits. The operating expense charge covers the cost of investment management fees and administrative costs of managing the particular subaccount funds available. Fees vary from annuity to annuity and between companies. All applicable fees will be disclosed in your annuity contract. Surrender Charges Finally, annuities will have some sort of sales or surrender charge. This can be an up-front sales charge or a back-end load. If the insurer deducts a charge when the premium is paid, thus resulting in a lower amount of money being invested, this is a front-end load. However, insurers generally impose a surrender charge, rather than charge the investor up front. Surrender charges are generally charged only if the owner takes more than 10 percent of the annuity value out during a calendar year for the first few years of the annuity contract, like 7 or 10. Many variable annuities allow you to take the earnings out, which may be a larger number than 10 percent. Surrender charges are levied on a declining scale basis. For example, you purchase an annuity for $100,000. This annuity’s surrender charge schedule is for 10 years. After the tenth year, you would be able to draw out as much of the contract’s value as you wished. This is actually a contingent deferred sales charge, since it isn’t levied unless you pull out more than the allowable maximum. More commonly, though, it is called a “back-end load.” Back-end loads are designed to discourage the annuity owner from transferring his or her money to a different company, or taking it out altogether. There are some insurers who don’t charge any type of sales charge. These annuities are akin to no-load mutual funds. HOW ANNUITIES WILL HELP Annuities are great for investing your after-tax dollars on a taxdeferred basis. Think about it. If you could put away money and then not be taxed on the growth, might your overall nest egg grow faster? Annuities help people shelter their money from the government for a time, even if it is a limited time. Plus, for annuities outside an IRA, there is no limit to the amount of money that can be sheltered. Annuities inside an IRA are subject to the regular contribution limits. Annuities also provide a level of comfort for people who are concerned that they may outlive their money. They also provide a good way to help your money grow tax-deferred. Another advantage to annuities is the guaranteed death benefit. The disadvantages associated with annuities are the internal expense charges, surrender charges, and the possibility of limited subaccount fund availability within variable annuities. While annuities sound like a great investment, they’re not for everyone. Be sure the annuity you decide on is in line with your financial goals and objectives.
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