mini-course series - income (part 7)

Copyright © 2012 by Institute of Business & Finance. All rights reserved.

MINI-COURSE SERIES

RETIREMENT INCOME

Part VII

RETIREMENT INCOME 1

PART VII

IBF | MINI-COURSE SERIES

EQUITY-INDEXED ANNUITY

As previously described, EIAs guarantee minimum interest earnings but links excess

earnings to increases in an identified equity (or bond) index. Because of the guarantees, it

is generally not considered a security and therefore can be sold by agents who are not eq-

uity licensed. The workings of an equity-indexed annuity (EIA) can be quite complicated

and it is important for the agent to understand the product. Market conduct and EIA dis-

closure are important issues. Because they can have so many “moving parts,” the follow-

ing discussion provides, at best, only a general outline of EIAs. Individual contracts can

vary greatly. Next generation products are being introduced with new features and new

complexities.

The EIA is particularly attractive to individuals who are concerned about the safety of

principal but who want the opportunity to experience market-related gains. Ideally, they

should be an easily understood product that provides the benefits of market appreciation

without the risk of losing principal. In reality, they are likely to be faced with an array of

products that are difficult to fully understand.

Both single premium and flexible premium contracts have been introduced. There are

usually no sales charges (front-end loads), management fees or mortality costs. There are

often large penalties for early withdrawals. Both level and declining surrender charges

are used. Contracts are linked to the growth of an index over a period that can range from

one to 10 years, although four to seven years appear most popular. This is referred to as

the “term” of the contract or the policy period.

While growth can be linked to the performance of virtually any index, the large majority

of EIAs use the S&P 500 Index. Virtually all EIAs that use the S&P refer to the version

that excludes dividends. The other (rarely used) is the total return version and determined

using dividend reinvestment.

Central to the indexed annuity is a guarantee of principal at term end. This is done

by taking a set percentage of the purchase amount and accruing interest at a given percent

for the contract term (e.g., 90% of a $100,000 deposit plus 3% over seven years). The

reason that most contracts use 90% of deposit and 3% for earnings is due to state law

minimum guarantee requirements for fixed annuities. Most contracts use one of three dif-

ferent methods to determine contract gain. For example, assume that upon issue of a con-

tract with a six-year term the S&P 500 Index was 700. Thereafter the index stood as fol-

lows:

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PART VII


Using the point-to-point method the gain is calculated using the beginning point of 700

and ending point of 880 (880 - 700 = 180 ÷ 700 = .2571). In contrast, the high-water mark

method, also known as the discrete look-back method, uses the highest point of 904 (904

- 700 = 204 ÷ 700 = .2914). The ratchet method, also known as the annual reset method,

calculates gain by adding up the sum of annual gains (11.57 + 6.79 + 0 + 5.83 + 3.79 =

27.98). A drop in the index is counted as zero. Unlike the other methods, this locks in

gains and annually resets the starting point of the index.

Earnings for high-water mark and point-to-point are not credited until the end of

the term, thus there is no compounding of interest earned. Averaging can be done daily,

monthly or annually. The usual effect of averaging is to increase the rate in a decreasing

market and reduce the rate in a rising market (e.g., averaging the monthly gains the first

year would likely result in less than 11.57% gain).

A cap (maximum rate) may be set on annual gains in the contract. The participation

rate is the percentage of the index movement that will be credited (this can vary widely

from 40% to over 100%). Some contracts guarantee the participation and/or cap rate for

the term of the contract.

Liquidity features can include nursing home/hospitalization/terminal illness waivers, par-

tial surrenders and penalty-free withdrawals (e.g., 10% per year). However, loans are not

usually allowed. At the end of contract term the owner can: (1) renew for another term

(2) make a tax-free exchange into another fixed or variable annuity, (3) surrender the

contract without penalty or (4) annuitize the contract.

End Of Year 1 2 3 4 5 6

S&P Index 781 834 823 871 904 880

Point-To-Point - - - - - 25.7%

High-Water Mark - - - - 29.1% -

Ratchet (28%) 11.6% 6.8% 0% 5.8% 3.8% 0%

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PART VII


TAXATION OF ANNUITIES

Premiums Generally, premiums paid into an annuity are only deductible if they represent contribu-

tions to a qualified retirement plan or traditional IRA.

Cash Value Build-Up Provided the annuity contract meets the requirements of Internal Revenue Code Section

72 and a “natural person” owns the annuity, interest or other earnings on the funds inside

the annuity contract will not be currently taxed. However, if the owner is a corporation,

or other entity that is not a natural person, the earnings on contributions made after Feb-

ruary 28, 1986, are subject to current taxation.

One broad exception to this rule is when an annuity is held by a trust, corporation or other

“non-natural” person as an agent for a natural person, in which case the annuity is not

subject to current taxation. There are additional exceptions to this non-natural rule with

other types of annuities.

Withdrawals The taxation of withdrawals from or partial surrenders of an annuity depends upon the

date that the annuity contract was first entered into:

1. Entered into after August 13, 1982—Amounts received are taxed under “interest first

rule,” meaning that they are taxable to the extent that the cash value exceeds the invest-

ment in the contract (i.e., treated as distributions of interest first and thereafter as recov-

ery of cost).

2. Entered into on or before August 13, 1982—Amounts received are taxed under “cost re-

covery rule,” meaning they are not taxable to the extent of the annuity owner’s invest-

ment in the contract made on or before August 13, 1982 (i.e., treated as recovery of pre-

August 14, 1982 cost and thereafter as taxable interest).

Different rules apply to amounts received under qualified retirement plans, Section

403(b) annuities and Individual Retirement Arrangements.

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PART VII


Premature Distribution Penalty Tax Subject to certain exceptions, any dis-

tribution from an annuity prior to the

taxpayer (payee) having reached age 59

½ is subject to a 10% penalty tax on

the taxable portion of the annuity payment. For example, assume that the annuity holder

purchased an annuity for $25,000 and thereafter surrendered it at age 55 for $32,000. The

amount subject to ordinary income taxes and the 10% penalty tax is the gain of $7,000

(32,000 – 25,000 = 7,000).

One exception commonly used to avoid this 10% penalty tax allows for penalty-free

payments to a taxpayer of any age, provided they are part of a “series of substantially

equal periodic payments” that are made at least annually for the life of the taxpayer, or

for the joint lives or joint life expectancies of the taxpayer and a designated beneficiary

(e.g., a joint and survivor annuity). However, payments not subject to the 10% penalty by

reason of this exception may be subject to recapture if the series of payments is modified

(other than by reason of death or disability).

Benefit Payments The rule governing income taxation of payments received from an annuity is designed to

return the purchaser’s investment in equal tax-free amounts over the annuity’s payment

period. The balance of each payment must be included in income. Therefore, each pay-

ment is generally part nontaxable return of cost and part taxable income.

Expected Return—To calculate the annuity’s exclusion ratio, expected return is divided into

the investment in the contract. If payments are for a fixed period or fixed amount with no life

expectancy involved, the expected return is equal to the sum of the guaranteed payments. If

payments are to continue for one life or multiple lives, the expected return is determined by

multiplying the sum of one year’s annuity payments by the life expectancy of the measuring

life or lives. The life expectancy multiple or multiples are obtained from a series of Annuity

Tables provided by the IRS.

Exclusion Ratio = Investment In Contract

Expected Return

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PART VII


Exclusion Ratio With Fixed Return—This ratio identifies the portion of the annuity pay-

ment not taxed (i.e., that portion representing basis in the contract). It is expressed as a frac-

tion, or as a percentage, and is determined by dividing the investment in the contract by its

expected return. For example, assume that a contract holder purchases an annuity for

$100,000 and elects an annuity certain paying $1,200 per month for 10 years. The expected

return for a fixed period or fixed amount with no life expectancy involved is the sum of the

69.4%. (It is rounded to the nearest tenth of a percent.)

Exclusion Ratio = 100,000

144,000 = 69.4%

This means that 69.4%, or $833 of every monthly payment is excluded from income (1,200

balance of $367 is included as income (1,200 – 833 = 367).

Exclusion Ratio With Life Expectancy—Assume the contract holder is age 58, purchases

an annuity for $100,000 and elects to receive a life annuity paying $700 monthly for life (i.e.,

a single life “pure” annuity). The expected return is determined by multiplying the $700 per

month payment by 12 to arrive at the yearly payment of $8,400 and then multiplying this

amount by the contract holder’s life expectancy (25.9 years). The expected return is $217,560


Expected Return

This means 46.0% ($322) of every monthly payment may be excluded from income (700

.460 = 322). The balance of $378 is included in income (700 - 322 = 378). The yearly

is after December 31st, 1986, this exclusion ratio applies to payments received until the in-

vestment in the contract is fully recovered.

Once the cost has been recovered, all payments are fully includable in income (i.e., the ex-

clusion ratio no longer applies once the annuitant reaches his life expectancy). In this exam-

ple, the contract holder is fully taxed on the monthly payment of $700 after 311 months of

payments (100,000


217,560 = 46.0%

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PART VII


Exclusion Ratio With Guaranteed Payments—Assume the contract holder is age 58, and

purchases an annuity for $100,000, electing to receive a life annuity paying $550 per month

for life with payments guaranteed for 20 years (i.e., a single life 20-year-period-certain annu-

ity). The expected return is determined by multiplying the $550 monthly payment by 12 to

arrive at the yearly payment of $6,600 and then multiplying this amount by the contract hold-

er’s life expectancy (25.9 years) obtained from the unisex Table V (Ordinary Life Annuities -

One Life -

170,940).

Before calculating the exclusion ratio the investment ($100,000) must be reduced to ac-

count for the value of the guarantee. The percent value of the guaranteed refund is 9%

(from IRC Table VII for age 58 and 20 years). This is multiplied by the unadjusted in-

vestment in the contract ($100,000) to determine the value of the refund feature ($9,000).

The value of the refund feature is then subtracted from unadjusted contract investment to

determine the adjusted investment ($91,000). The exclusion ratio is 53.2%.


Expected Return


170,940 = 53.2%

This means that 53.2% ($293) of every monthly payment may be excluded from income

(550 - 293 = 257). The

r-

agraph above, if the annuity starting date is after December 31st, 1986, once the invest-

ment in the contract has been recovered all payments are fully includable in income.

Estate Taxation of Annuities The estate taxation of an annuity will typically differ depending upon whether the annuity

is in the accumulation phase or distribution phase.

1. Accumulation Phase—The value must generally be included in the annuity own-

er’s gross estate. If the decedent furnished only part of the annuity’s purchase

price, the estate includes only a proportional share of the annuity’s value.

a. Owner is also the annuitant—The value of the annuity death benefit is included in

the owner’s estate.

b. Owner is not the annuitant—If the owner dies first, then the value included in the

owner’s estate is apparently the amount that it would cost to purchase a comparable

annuity contract. If the annuitant dies first, the annuity death benefit is generally not

included in the gross estate of the annuitant, but it is a taxable gift from the surviv-

ing annuity owner to the beneficiary.

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PART VII


2. Distribution Phase—The following assumes the “annuity holder” is both owner

and annuitant. If payments were made under a straight life annuity, payments

cease upon the annuity holder’s death; there is no remaining property interest,

nothing is passed to survivors and nothing is included in the annuity holder’s es-

tate.

The value of any survivor benefits is included in the annuity holder’s estate. Bene-

fits passing to a surviving spouse generally qualify for the marital deduction.

Gift Taxation of Annuities If an individual purchases an annuity, names herself as the annuitant and immediately

gives the annuity contract to another person, the value of the gift is considered to be the

amount of premium paid for the annuity.

If the contract is held for a period of time after it is purchased, then the gift tax value is

the single premium that the life insurance company would charge for an annuity provid-

ing the same benefits on the life of a person who is the same age as the annuitant when

the gift is made. These gifts will not be subject to gift taxes if they are less than the annu-

al exclusion amount. Premiums paid on the annuity will also qualify for the annual exclu-

sion. An individual who pays premiums on an annuity contract owned by another indi-

vidual is considered to make a gift of the premium amounts.

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PART VII


THINGS TO DO

Your Practice

Talk to insurance clearing houses that offer a wide range of products from a number

of different companies. Ask internal and external wholesalers what alternatives to

EIAs they recommend.

Determine what kind of tax savings you can create for some of your clients you be-

lieve would be good candidates for annuitization.

Learn

Are you ready to take your practice to the next level? Contact the Institute of Business

& Finance (IBF) to learn about one of its five designations:

o Annuities – Certified Annuity Specialist® (CAS

®)

o Mutual Funds – Certified Fund Specialist® (CFS

®)

o Estate Planning – Certified Estate and Trust Specialist™

(CES™

)

o Retirement Income – Certified Income Specialist™

(CIS™

)

o 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 [email protected].

mailto:[email protected]

mini-course series - income (part 7)

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