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Tax Qualified Annuities Before
beginning, please read the following instructions:
Exam
CHAPTER 1: Annuities In General
CHAPTER 1: Annuities In General All
annuities have many things in common, so this chapter deals with items
that are generally applicable to all annuities even though there may be
individual exceptions. Terminology may change from company to company as
well as descriptive content, but as a product class, they are similar. An
annuity is basically a contractual agreement between an annuity owner and
an insurance company. The owner makes purchase payments in exchange for
certain benefits and privileges. All annuities are generically known as
tax-deferred annuities. As a product class, there are two general types of
annuities: variable and fixed. Annuities share the following features:
Originally, annuities were created to provide an income stream for a specific period of time or during one’s lifetime. Unlike life insurance, which creates an estate and protects against dying too soon, annuities liquidate an estate and protects against living too long. During the accumulation
phase, the annuity owner would deposit with the insurance company a
one-time or periodic premiums to build up a nest egg and then at a
designated time would annuitize the policy. Annuitization describes the
event when the policy owner basically surrenders the accumulated policy
value in exchange for a calculated amount for a specific timeframe or over
the annuitant’s lifetime. Today, however, it seems times have changed. More people are interested in annuities as savings or investment alternatives as well as the guarantees and tax benefits. Annuities are perceived more as accumulation vehicles instead of income vehicles because less than two percent are annuitized into an income stream while the rest are left to heirs. As with any savings or
investment, safety lies with the issuing entity. For annuities, safety
lies with the strength of the issuing insurance company. One can determine
an insurance company’s financial strength by looking at its rating from
A. M. Best Co., Inc., which has been providing
financial strength ratings and evaluations for insurance companies since
1899. On the default side of things, each state has its own insurance guaranty act that protects, up to a certain dollar amount, each insured of an insurer that becomes insolvent. The dollar limits depend upon the type of policy, for example, net life insurance death benefits ($300,000), net cash values for life insurance ($100,000), and net cash values for annuities ($100,000). Liquidity can be perceived from two perspectives. In its purest sense, liquidity refers to the ease and speed in which an asset can be converted into cash. In a general sense, it is the same without incurring loss. Notwithstanding surrender charges and an insurance company’s ability to withhold cash payments for up to six months, which is rarely done, an annuity is fairly liquid. The only real hurdles are completing the insurance company’s required paperwork and going through their logistical process, which can sometimes be slow. There are many types of
risks savers and investors are concerned about; however, some of those
risks are either mitigated or nonexistent in annuities. All annuities,
fixed and variable, have some sort of guarantees. Even variable annuities
have an option whereby the principal and interest is guaranteed, if
available, just like any other fixed annuity, but the annuity owner must
expressly choose that option. Of lesser importance, fixed annuities are subject to interest rate risk. Even variable annuities with a fixed component are subject to interest rate risk. Since annuities are usually very competitive with other interest bearing accounts, this is not a major issue. Fixed annuities are not exposed to investment risk like other investments - which is the risk inherent in the individual investment itself - because the principal and interest are guaranteed by the strength of the insurance company. Variable annuities, on the other hand, are subject to investment risk just like the risks associated with investing in mutual funds. Fixed annuities are also not subject to market risk like other investments. Market risk is the risk of loss associated with a large number of assets like the stock market. Some states have enacted legislation pertaining to the suitability of the sale of annuities to seniors and has become such a big issue in the VA market that the NASD is taking a closer look at this practice. How does one determine if a particular VA is more suitable than the next, providing a better cost/benefit scenario? Of course, opinions in the investment industry are fairly diverse. One can only assume, if he dare, that in an efficient market all investments have similar risk-adjusted performance. If this is the case, one may want to go beyond the accumulation phase and look at the annuitization phase. Since risk is tied to suitability, then risk-adjusted performance makes for an inefficient measuring rod for switching purposes. The annuitization phase highlights contractual guarantees, which for purposes of comparison can discount various payout scenarios to present value benefits. From this point, one can include hard costs such as mortality expenses, surrender charges, etc. However, one must realize that annuitization of a VA is a rarity. Anyway, one needs to wisely pick his medicine just in case it comes under NASD scrutiny. A replacement can sometimes be a confusing and complex topic, especially for potential clients. This has led to the heightened concern of regulators who are more closely monitoring business practices of companies and agents. Most companies have already taken a proactive role in issuing internal guidelines and suggested practice requirements for their agents. Insurance companies do not encourage or condone replacing existing annuities as a mode of doing business if such replacements are not in the best interests of the client. Each state has its own set of insurance regulations dealing with replacement. The following is a generalization of when a replacement occurs:
AND
If all policies currently owned by the client remain as is after the new purchase is made, a replacement has not occurred. In order to comply with
replacement regulations, insurance professionals should generally engage,
at a minimum, in the following procedures:
None of this should lead
one to conclude that all replacements are bad, which can be quite the
contrary. One must look and compare all aspects of the new versus the old,
considering the short-term and long-term benefits to the client. Such
factors to consider may include:
Exam CHAPTER 2:
Features and Benefits Annuities have many features and benefits that other alternatives do not. Depending upon one’s risk tolerance, investment objective and planning needs in general, annuities are probably going to have a fit in one’s financial profile to some extent. The following is a list of the common attributes found in annuities but not found in other saving or investment vehicles. Unlike investments, annuities have some sort of guarantee for the return of principal or premium payments, less applicable surrender charges, assuming one is past the initial free-look period. Of course, this guarantee lies with the strength of the insurance company that issued the policy; and, is further guaranteed by the insurance company’s state of domicile’s Insurance Guarantee Association (now that’s a mouthful). Annuities are not, however, insured by the FDIC, which will probably not be a point of contention with most annuity buyers. Even though it is uncommon for insurance companies to become insolvent, it has happened in the past and will probably happen again. Nonetheless, because of the protection afforded by each state’s guarantee association, it is unlikely an insured would lose money if he followed through with the association’s claims procedures and stayed the course. Fixed annuities have two interest rate guarantees. The first is the minimum interest rate that the contract guarantees to never fall below. The second is the current interest rate that is guaranteed during a specific period, usually one year. Some annuity contracts guarantee a stated interest rate from one contract year to the next. For example, if the date of an annuity contract is July 4, the stated interest rate will be guaranteed until the following July 4 and will be credited to all contributions made during that time. Other companies guarantee the rate for one year per contribution. For contributions made in the month of January, the stated interest rate is guaranteed until the following January. For contributions made in February, the interest rate is guaranteed until the following February, and so on. The source from which the contributions came is irrelevant. The current interest rate is based on the company’s portfolio rate. An insurance company can invest in a wide range of securities, but most are invested heavily in investment grade corporate and government bonds. The weighted yield of this portfolio is what drives the interest rate of a fixed annuity, which is a little below the company’s portfolio rate. This guaranteed interest rate could either be the nemesis or savior of the fixed annuity market. During the bull market of the 90s, investors abandoned traditional fixed products and sought after their sexier cousins, variable annuities, and equity indexed annuities. The bears showed up in 2000-02, so traditional fixed products found favor with investors once again. This was short lived, however, because the Feds drove down interest rates in an attempt to jumpstart the economy. Up through 2005, interest rates have been the lowest in decades, so the likelihood of rates rising and fixed annuities being restored to an honorable position is likely. On the default side of the equation, in 2014 the youngest of the baby boom generation will turn 50. With this being the wealthiest generation of all time, they are sure to restore some of the glamour fixed products have lost to the equities arena. All annuities have some sort of death benefit, which is typically defined as the amount that is payable as a result of the death of an owner before the maturity date or annuity date. The amount of the death benefit is usually the accumulated value excluding any surrender charges. Since an annuity is also considered a life insurance product, the amount paid bypasses probate and goes directly to a named beneficiary. If there is more than one owner, ownership passes to the remaining owners. Unlike variable annuities and many other investments, fixed annuities don’t charge fees. Normal fees from investing can come in the form of administrative fees, operating fees, management fees, etc. This does not mean that insurance companies don’t pass along their costs, they just don’t show up as a fee and one cannot discern otherwise. Fixed annuities also don’t have a mortality expense for death benefit guarantees, as do variable annuities. The general tax rule states that loans from “qualified employer plans,” which includes certain annuities, are considered distributions and therefore taxable. In regards to this rule, qualified employer plans include 401(a), 403(a), 403(b) and government plans. However, there is an exception to the general rule in IRC 72(p)(2), which only applies to certain tax qualified plans. It allows loans that are the lesser of (1) $50,000 or (2) the greater of the annuity’s surrender value or $10,000. Policy loans are to be repaid within five years, per the terms of the loan agreement, unless the loan is for the purchase of a home that is to be used as the principal residence of the borrower within a reasonable time. One of the most popular aspects of an annuity is that the earnings grow tax-deferred, whether it is non-qualified or tax-qualified. In performing a comparative analysis, clients and advisors are interested in the bottom line, that is, what are the after tax results of any given investment. For example, if an annuity were earning 6%, what would be the after-tax equivalent for an alternative such as a mutual fund? The quickest measuring tool is to take the annuity yield and divide it by 1 minus the tax bracket. If a client is in the 25% tax bracket and the annuity in consideration is earning 6%, the taxable equivalent would be 8.0% (.06 / (1-.25)). On the other hand, if one had a taxable investment that earns 10%, the equivalent tax-deferred yield would be the taxable yield multiplied by 1 minus the tax bracket. In this case, the tax-deferred equivalent would be 7.5% (.10 x (1-.25)). Of
course, when considering annuities, one is usually more interested in just
the bottom line, such as lifetime income, survivor income, guarantees,
safety of principal, tax planning, etc.
In a manner of speaking, annuities have triple compounding because
they earn interest on (1) the principle, (2) interest on accumulated
interest, and (3) interest on deferred taxes.
Interest bearing investments or saving vehicles earn interest either on a compound or simple basis. Annuities earn compound interest. The difference between compound and simple interest can be staggering, for example, let’s consider the following investment, excluding taxes.
It doesn’t take a rocket scientist to figure out that compound interest is the only way to go. In 30 years, the total difference is $182,194, which is derived solely from the additional interest earnings. Some
folks think that the tax-deferral of annuities is not advantageous because
taxes ultimately have to be paid. It is true that taxes have to be
eventually paid, but because annuities have triple compounding, the net
after-tax result will always be higher. Triple compounding means that
interest is earned upon the principal, deferred interest and deferred
taxes. Let’s use the same scenario as above and compare the taxation of
the results at the end of the 30-year period to paying taxes along the
way.
Now, there needs to be some additional observations. It is very rare for an annuity owner to cash out an annuity upon maturity and pay all the tax at once. If you have heard of such an instance, you may be the first. In fact, less than 2% ever annuitize the contract while the remaining pass on to beneficiaries who have various options depending upon the tax status of the annuity and relationship to the owner/annuitant. Assuming the remote chance that one did cash out, the tax rate would of course be slightly lower than 28% (actually 26.74%). Well, let’s move from a tax rate scenario (above), the rate at which the whole amount gets taxed, to a tax bracket scenario. The 2007 IRS table shows that our appropriate tax bracket is 33% for a taxable income between $195,850 and $349,700. More specifically, the tax is $43,830 plus 33% of the amount over $195,859. Using their formula, and assuming all of the $332,194 in interest is taxable income, the most that one could be taxed is $88,824, which varies little from our tax rate example above ($93,014). In the IRS’ 2007 tax bracket system (Schedule Y-1, Married filing jointly or Qualifying widow(er)), the first $15,650 of taxable income is taxed at 10%. From $15,650 to $63,700, the amount is taxed at 15%. From $63,700 to $128,500, the amount is taxed at 25%. From $128,500 to $195,850, the amount is taxed at 28%, and so on. This ratcheting system continues until it peaks at the 35% bracket for amounts over $349,700. If we convert our result to an equivalent tax rate, it would be 26.74% (88,824 / 332,194). The Internal Revenue Code (IRC) allows annuity owners to exchange one annuity for another without suffering any tax consequences. Like the advantages of tax-deferral, annuity owners are not hindered from closing out one annuity in order to open up another that may be more in line with the owner’s objectives. However, in order to not give the perception of being in constructive receipt of the money for other purposes and to stay within allowable time frames, it is best for any exchange to take place between the insurance companies and leave the annuity owner out of the process. Upon death, all assets of a deceased person are subject to a state’s probate laws unless some provision is made in the titling, ownership or otherwise to bypass probate, which is the default way of settling an estate. Annuities have beneficiaries and any such designation bypasses probate and the death proceeds go straight to the beneficiary regardless of the terms of any will or trust. Even though the death benefit may vary from company to company, generally, it is the accumulated value at the date of death void of any applicable surrender penalties. For contracts that have these features, an immediate interest rate is credited to any new premium received by the insurance company, is part of the contract guarantees and subject to surrender charges. Premium bonuses and agent commissions have an inverse relationship; that is, the higher the bonus to the annuity owner, the lower the commissions to the agent. Premium bonuses also have a compounding effect. For example, a $100,000 premium with a 6% bonus will start earning interest on $106,000 instead of $100,000. At a 5% crediting rate, the first year annualized return will be 11.3% instead of 11%. Another type of bonus is one that pays a small bonus each contract year such as 1% a year for the next 10 years, which is payable on the contract date and each subsequent policy anniversary. For example, a $100,000 annuity with ABC Annuity Company is credited $1,000 when the contract is issued as well as each policy anniversary up to a maximum number of years. One advantage of a bonus is that it may be used to offset a surrender charge incurred from surrendering an unsuited annuity and exchanging to one more suited to the annuitant’s needs. For example, Client A has received an inheritance and no longer needs his variable annuity. He surrenders his variable annuity from ABC Annuity Company and incurs a 5% surrender charge, but his new fixed annuity pays a 6% bonus. On the downside, one should be aware of the new company’s crediting history. As the bonuses get higher, beware that crediting rates after the first year may be significantly lower than an existing annuity or one with lower or no bonus. As with any perceived freebie, there is always a trade-off. Higher bonuses usually have strings attached such as longer surrender periods, higher surrender charges and forced annuitization to keep the bonus. For equity indexed annuities, an additional tradeoff may be lower participation rates. Consequently, surrendering in the early years with such a scenario can be very costly. For the agent, the trade-off is usually a reduction in commissions. Forced annuitization is an exception to the rule, but a costly feature nonetheless. Of the few annuities that do require annuitization to receive bonus credits, or index credits with EIAs, the penalties for doing otherwise can be very draconian and should be avoided. In order to be deemed compliant, the typical minimum payout is five years but may be longer. A MVA is an adjustment made to the annuity’s cash value, depending upon whether interest rates have risen or fallen since the contract’s inception, when the annuity is surrendered or money withdrawn before its guaranteed term or period has expired. For annuities with this feature, they are usually offered with various time periods in which a specific interest rate is guaranteed; and, when they mature, they can automatically be renewed for the same or another guaranteed period. Comparatively speaking, the effect of a market value adjustment is like a bond, which has a principal adjustment as interest rates move up or down. If interest rates have risen since the start date, the adjustment will be negative. If interest rates have fallen since the start date, the adjustment will be positive. When one surrenders an annuity early or makes withdrawals, surrender charges and amounts are known. However, a MVA is the only cost of surrendering or withdrawing early that is an unknown. All annuities charge a penalty if part or all of the policy is withdrawn during the surrender period, which is a specific number of years in which a penalty would apply. Once the surrender period has passed, no charges apply to any surrender. Of course, surrender charges are inapplicable if the policy is annuitized or cashed in by reason of the owner’s death. Why do annuities have surrender charges and other investments do not? When an insurance company issues an annuity policy, they pay commissions to the underwriting agent, buy securities that will cover the guarantees and have overall operating expenses. In case an owner cashes out early, the insurance company wants to ensure that these costs are recovered. The amount of the penalty is based on the number of years that have elapsed since the receipt of premium payments or the contract date and is typically a percentage of the premium payments or accumulated value. The policy may have a table of surrender charges shown on the data page. If the policy is completely surrendered, the company may require the policy to be returned and reserves the right to defer payment of any surrender for up to six months. In order to forego paying a surrender charge, policies allow an amount to be withdrawn without penalty, called a penalty-free withdrawal. The dollar amount of the surrender charge will be determined by multiplying the applicable surrender charge percentage by the withdrawal amount in excess of the penalty-free withdrawal. For example, if a policy allows up to 10% of the policy’s accumulated value to be withdrawn per contract year, then any amount over 10% will be subject to the surrender charge. There are typically two different ways in which companies apply surrender charges. The first is based upon policy year. For example, if a withdrawal exceeds the penalty-free withdrawal amount, the applicable surrender charge or percent is determined by the contract year in which the withdrawal takes place. The second is based upon each payment received. For example, every premium submitted, the initial and any subsequent premiums, is subject to a surrender charge.
Nursing Home / Terminal Illness Waivers Many policies allow penalty free withdrawals if the annuity owner is confined in a hospital, hospice facility or nursing facility. Confinement must be for a minimum number of days, say 60 consecutive days, for example. The insurance company will require documentation from a physician that the confinement was medically necessary and due to an injury or sickness. Social Security (SS) benefits make up a substantial portion of most retirees’ income. Prior to 1984, SS benefits were not taxable, but since SS issues are a political ping-pong, the Social Security Act was amended in 1983 to pave the way for SS taxation. Unless an item is excluded by law from taxation, the IRS says that generally all income is taxable. One of the exclusions is tax-exempt interest from municipal bonds; however, this interest is included in determining whether SS benefits are taxable. The only exception to current taxation and SS taxation is interest earnings from annuities. One just needs to move as much money as reasonably possible from other investments or saving vehicles into annuities to eliminate or mitigate the effects of SS taxation. This topic will be discussed more later. Exam CHAPTER
3: Purchase Options There are many ways to purchase an annuity along with various tax strategies and consequences. Any annuity purchaser must become knowledgeable with each of the options to determine which one best fits his needs. Also note that each of the options below is not applicable to all annuities. Generally, there are two types of annuities, fixed, which includes equity indexed annuities, and variable. Fixed annuities are probably the simplest in the annuity arena and are either deferred or immediate as it relates to the timing of annuity payments to the annuitant. In terms of taxation, they are either non-qualified or tax-qualified. Fixed annuities do not have market risk because they are not invested in the stock market. Annuity owners don’t share in any investment risk because the insurance company assumes that as it manages its own investment portfolio. Assuming the definition of interest rate risk includes the loss of principal due to interest rate fluctuations, fixed annuities are not subject to interest rate risk. VAs have many of the same features and guarantees as a fixed annuity by offering an optional fixed account that works the same way. VAs also have features similar to mutual funds with the same risks and opportunities, potential for loss and gain. In fact, many VAs offer multiple investment accounts for investors to choose from and some are exact imitations of existing mutual funds. These investment accounts, known as separate accounts or sub-accounts, appear and operate just like mutual funds. In a VA, it is the annuity owner who bears the investment risk burden, not the insurance company. The introduction of VAs was the insurance industry’s way of crossing over and competing with non-guaranteed investments. A deferred annuity is either a fixed or variable annuity that has an accumulation phase of at least one year. This is more of a descriptive term meaning that it is allowed to earn interest and then annuitize at least a year later. Typically, however, annuity owners have their annuities deferred for their whole lifetime. Deferred relates to the postponement of making income payments to an annuitant as well as the deferment of paying taxes on interest. Deferred annuities have withdrawal penalties applicable during the first few years of the contract if one withdraws an amount above a specific percentage, which is the penalty-free withdrawal. Of course, there are exceptions to this rule, such as when the contract is annuitized and the annuitant receives monthly income payments or the owner or annuitant dies. The vast majority of annuities, whether fixed or variable, are deferred annuities. An IA is either a fixed or variable annuity that generally has no accumulation phase because it is annuitized shortly after a one-time single purchase payment is made. The annuitant may start receiving payments within a month of the issue date or sometime later, generally before the end of the first year. Annuitization is exchanging the initial purchase payment for an income stream for a specific timeframe or as long as the annuitant lives. Since deferred annuities make up the bulk of all annuities, only a small percentage of annuities are considered immediate. Flexible Premium Deferred Annuity (FPDA) A FPDA refers to the manner in which payments are made to a deferred annuity. It can be funded with one or more purchase payments with the most common being periodic payments. They can also receive irregular payments at the whim of the annuity owner. Irregular and one-time payments are subject to minimum dollar amounts; however, if the annuity owner agrees to regular and periodic payments, the minimums are much lower. Generally, an FPDA must be in effect for a year before any penalty free withdrawals can be made. Single Premium Deferred Annuity (SPDA) A SPDA refers to the manner in which payments are made to a deferred annuity. In this case, it is funded with a single one-time purchase payment. Other than that, it is identical to the FPDA. Single Premium Immediate Annuity (SPIA) A SPIA is funded in the same manner as a SPDA, a single one-time purchase payment, and immediately or within the first month, the policy is annuitized and the annuitant starts receiving annuity payments. A non-qualified annuity is either (1) a deferred or immediate annuity and either (2) a fixed or variable annuity that is funded with after-tax dollars. A paycheck is the best example of after-tax dollars. A non-qualified annuity gets no special tax treatment other than being tax-deferred just like any other annuity; and, there are no contribution limitations. However, the interest earnings are still subject to the pre-59½ withdrawal penalty, but they are not subject to the required minimum distribution rules. A tax-qualified annuity is either (1) a deferred or immediate annuity and either (2) a fixed or variable annuity that takes advantage of some special taxing privilege found in the Internal Revenue Code. All tax-qualified annuities are funded with pre-tax dollars, usually made from an employee’s personal savings, payroll deduction or an employer’s contribution made of behalf of an employee. There are various types of tax-qualified annuities each with its own set of applicable statutes and contribution limitations. As with any annuity, the earnings grow tax-deferred; and, all money is subject to the pre-59½ withdrawal penalty and required minimum distribution rules. Since contributions to a tax-qualified annuity have never been taxed, any withdrawal or annuity payment is subject to regular income taxation. Exam CHAPTER 4: Parties to the Annuity
Contract The owner is any person or entity that purchases an annuity, is named in the application as owner or on record as owner in the most recent change, and has complete or shared ownership rights in the policy. An owner also includes any person or entity that succeeds to ownership as stated under any death of owner provision. If there is more than one owner, the joint owners are usually spouses and exercise ownership rights jointly. The owner may or may not be the annuitant. The owner has exclusivity in exercising the rights given by the policy. The owner may make any changes in a policy by typically sending a written request to the company in compliance with policy provisions. Prior to the maturity date and prior to a death that causes payment of a death benefit, the owner generally has the right to, but is not limited to:
The annuitant may also be the owner and is the person on whose life the annuity benefits are based by using age and sex to determine the amount and duration of payments. There may be a secondary, or contingent, annuitant who will receive the benefits of an annuitant if the primary annuitant dies. When annuity payments begin, changing annuitants is disallowed. Upon the death of an annuitant while the owner is living, any surviving joint annuitant will become the annuitant; otherwise, it will fall on the contingent annuitant. If there is no surviving annuitant, the owner will automatically become the annuitant if the owner is an individual. If there is no surviving annuitant and there are joint owners, then the joint owners become joint annuitants. In the event that the owner is an entity and joint annuitants have been named, the joint annuitants are usually spouses. An entity can be any party of an annuity contract except annuitant. The beneficiary is the person(s) designated by the owner to receive death benefits in case the owner or annuitant dies before the annuity date. There may be more than one class of beneficiary, such as primary beneficiary and secondary (contingent) beneficiary. There may also be more than one person in each class. Beneficiary designations can be changed at any time by sending a request to the company in a manner prescribed in the policy provisions. If more than one beneficiary is named, each named beneficiary will share equally in any benefit or rights granted by the policy, unless indicated otherwise under the beneficiary designation or other written instructions. The beneficiary can also be an irrevocable beneficiary in whose interest cannot be changed without his consent. All rights of the beneficiary end if death occurs before the annuitant and his interests pass to the remaining beneficiaries. If the owner dies and there is no joint owner, the beneficiary may become the owner of the policy. If there are multiple beneficiaries of the same class, they may become joint owners. If settlement option payments have begun that guarantees payment for a certain period of time, the beneficiary will receive the death benefits if the annuitant dies before the expiration of the period certain. If no beneficiary is named or surviving, any death benefit will be paid to the owner or the estate(s) of the owner(s). The insurer makes a contractual agreement with the owner or investor of an annuity product The insurer designs the contract to meet its needs and there is no haggling between the insurer and owner in determining the contract’s terms. Basically, the insurer allows the owner to pick the annuitant, beneficiary and how his money is to be invested. Of course, this is exclusive of fixed annuities or any other annuity in which the owner invests in a fixed component. Even in those cases where the owner chooses his investment options, his choices are still limited to the options offered by the insurer for the particular product in question. In the annuity contract, the insurer defines all the rights, guarantees, benefits, restrictions and options applicable to the parties of the annuity contract: insurer, owner, annuitant and beneficiary. The insurer is responsible for investing assets, either for their own general account or any special account chosen by the owner. For the general account, the insurer will invest as well as manage this account, which usually consists of investment grade corporate and U.S. Treasury bonds. For the special account, the insurer administers these accounts in conjunction with an investment company that provides the investment expertise. Some insurers perform both tasks. Exam CHAPTER 5: Tax Qualified Annuities ERISA · TEFRA · REA · TRA '86 · The Revenue Act of 1987 · TRA '97 Profit Sharing Plan · Pension Plan · Keogh Plan · Traditional IRA · ROTH IRA Simplified Employee Pension · SIMPLE IRA · Tax-Sheltered Annuities 401(k) Plan · Deferred Compensation Plans · Deemed IRAs There are several laws that have shaped the way tax qualified annuities are purchased and handled. Since laws are progressive, what is written about them today will change in the future. Nevertheless, here is a rundown of some of the significant pieces of legislation and how they have affected and transformed tax qualified plans. The Employee Retirement Income Security Act of 1974 (ERISA) Prior to ERISA, there were many problems with tax-qualified plans in the non-government (private) sector. ERISA addressed many of these problems, such as establishing guidelines for non-discrimination and defining fiduciary responsibilities. Previously, plans could be heavily weighed toward key employees causing the bulk of any retirement benefits accruing to such employees. ERISA made all interested parties, trustees, the company and its officers, personally accountable for investment performance. ERISA also established the Pension Benefit Guarantee Corporation, which is a federal agency that guarantees retirement income payments to private sector employees involved in defined benefit plans. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) Prior to TEFRA, partnerships and sole proprietors had limited access to tax qualified retirement plans, namely, the Keogh plan. TEFRA established parity for all. The Retirement Equity Act of 1984 (REA) Before REA, spouses did not have any survivor or living benefit protections. For married employees participating in defined benefit plans, REA imposed joint and survivor benefit options. The Tax Reform Act of 1986 (TRA ‘86) TRA overhauled the guidelines for discrimination testing, vesting schedules and distributions. If accrued benefits of key employees exceed 60 percent of the total for all employees, the plan will be considered top heavy and must use an accelerated vesting schedule. In an attempt to meet non-discrimination guidelines, an employer may elect to classify employer contributions (non-elective and matching) as elective if the following vesting schedule is used, which is otherwise required for employer contributions.
Employee elective contributions may not be distributed prior to any of the following events:
This piece of legislation changed the contribution rules for defined benefit plans to ensure that they were properly funded. The Taxpayer Relief Act of 1997 (TRA ’97) This act expanded the Pre-59 ½ Premature Distribution Penalty Rules for IRAs as well as increasing eligibility limits. The IRA became known as the Traditional IRA after this act introduced the Roth IRA. Tax qualified annuities can be acquired by the individual or the employer on behalf of the employee. For employer plans, they are either defined benefit plans or defined contribution plans. In defined benefit plans, contributions are only made by the employer into the plan to guarantee the employee a specific amount of retirement income, which is based on a formula determined by the company and usually takes into consideration the employee's age, years of service and average income for the last three years. In a defined contribution plan, both employer and employee may contribute on the employee’s behalf. There are no retirement income guarantees, but rather a guarantee that certain contributions will be made. A money purchase plan is a type of defined contribution plan in which employer contributions are required. Annuities may fund any type of plan. By their nature, all annuities are tax deferred, meaning that all interest earnings have never been taxed, and are known as tax-deferred annuities or TDAs. A TDA also functions on the LIFO (last in, first one) method of accounting; therefore, withdrawals will be considered as interest earnings first and principal last. This allows the IRS to get their share of the taxes before anything else takes place. TDAs fall into two distinct categories. One is where premium payments have already been taxed and the second is where they have not been taxed. In the first category where premium payments have already been taxed, these are called non-qualified annuities or NQ TDAs. Since taxes have already been paid on premiums and they have not been granted any special tax considerations, there are no contribution limitations. The second category are those whereby premiums are afforded special tax considerations and are labeled tax-qualified annuities or TQ TDAs, which come in various forms and contribution limitations. Generally speaking, since any tax-qualified retirement plan can be funded with annuities, we’ll discuss the most popular and familiar. A profit sharing plan is the generic name for any tax qualified retirement plan where contributions are based on employer profits. The employer maintains accounts for each eligible employee and makes contributions to such accounts based on predetermined formulas. Of course, the employer can make contributions whether profitable or not, but this does allow some flexibility in the matter. Employer contributions are tax-deductible to the employer and tax-deferred to the employee. A pension plan is the generic name for any tax qualified retirement plan where contributions are required to be made on behalf of eligible employees. The employer maintains an account for each employee and makes contributions in order to meet either a predetermined contribution limit (defined contribution) or retirement benefit (defined benefit). Keogh is a generic name for any employer provided tax-qualified retirement plan that has at least one self-employed participant. Based on this description, it is a personal retirement plan for the self-employed and his employees. TRADITIONAL INDIVIDUAL RETIREMENT ANNUITY (IRA) Generally The acronym, IRA, may refer to either an Individual Retirement Account (IRC 408(a)), which is funded with an investment vehicle other than a life insurance contract, namely an annuity, or an Individual Retirement Annuity (IRC 408(b)), which is funded with either an annuity or endowment contract issued by an insurance company. For endowment contracts, one may not deduct an amount allocable to the cost of life insurance (IRC 219(d)(3)). Contribution Limitations Tax-deductible contribution limitations are determined under IRC 219 and are generally limited to the lesser of (A) the deductible amount or (B) includible compensation. There are various opinions as to what is meant by the words "includible compensation." The code specifically defines it as "compensation includible in the individual's gross income." Well, one needs to realize that some employees (school teachers for example) can make pre-tax contributions to other tax-qualified plans on a payroll deduction basis and the contributions do not show up as gross income, only the net amount does. This net amount is includible compensation. The
deductible amount has two components. The first component is the general
limitation per the following schedule:
There is also a cost-of-living adjustment integrated with this component (IRC 219(b)(5)(C)). Generally, after the year 2008, the $5,000 cap is increased by an amount (minimum of $500 and in increments of $500) derived by multiplying $5,000 by an adjustment determined under IRC 1(f)(3). The second component is a catch-up provision for those who have attained the age of 50 by the end of the taxable year. The deductible amount may be increased per the following schedule:
Of course, tax-deductible contributions are disallowed once an individual attains the age of 70 ½ by the end of the taxable year. Contribution Phase-out – based on participation in other Pension Plans Anyone with earned income may contribute to an IRA; however, if an individual or the individual’s spouse is an active participant (IRC 219(g)(5)) in an employer provided pension plan, then contributions may be reduced. The amount of the percentage reduction is based on the following formula: the taxpayer’s adjusted gross income (AGI) minus the applicable dollar amount divided by $10,000 ($20,000 for joint returns beginning in 2007).
Example: For 2007, John and Mary Public, ages 46 and 45 respectively, have an AGI of $94,000. John participates in his employer provided pension plan so his IRA contributions are subject to the phase-out rules. His reduction is 55% ((94000 – 83000) / 20000). Since the normal contribution limit is $4,000, he can only make an IRA contribution of $1,800 (4000 x (1-.55)). One's contribution cannot be reduced to less than $200 unless the limitation has been completely phased out, which occurs when one's compensation exceeds the applicable dollar amount by $10,000. If the phase-out rule applies to an individual solely because the individual's spouse is an active participant in an employer provided pension plan, then the applicable amount shall be $150,000. This exception provides that one spouse shall not be penalized because the other spouse is an active participant. Generally Unlike Traditional IRAs, a Roth IRA is not subject to the required minimum distribution rules; and, contributions are not tax-deductible and may continue past the age of 70 1/2. Distributions are also tax-exempt if they meet the following conditions.
Contribution Limitations Contribution limitations are determined under IRC 219 and are generally limited to the lesser of (A) the contribution amount or (B) includible compensation, which is further reduced by (C) the aggregate of contributions made to all other individual retirement plans, except employer contributions under a SEP or SIMPLE IRA plan, for the same year. The contribution amount for Roth IRAs is
the same as for Traditional IRAs and has two components. The first
component is the general limitation per the following schedule:
There is also a cost-of-living adjustment integrated with this component (IRC 219(b)(5)(C)). Generally, after the year 2008, the $5,000 cap is increased by an amount (minimum of $500 and in increments of $500) derived by multiplying $5,000 by an adjustment determined under IRC 1(f)(3). The second component is a catch-up provision for those who have attained the age of 50 by the end of the taxable year. The contribution amount may be increased per the following schedule:
Contribution Phase-out – based on Modified Adjusted Gross Income The maximum contribution may be further reduced by a specific percentage, which is based on the following formula: the taxpayer’s modified adjusted gross income (see Publication 590 for details) minus the applicable dollar amount divided by $15,000 ($10,000 for joint returns or married individuals filing a separate return).
Example: For 2007, Bill and Sue Jones are age 50, respectively, and have an AGI of $158,000. Her Roth IRA contribution is reduced by 20% ((158000 – 156000) / 10000). Since the normal contribution limit is $5,000, which includes $1,000 under the catch-up provision, she can only make a Roth contribution of $4,000 (5,000 x (1-.2)). Simplified Employee Pension, aka SEP-IRA (IRC 408(k)) Generally, a SEP is a high-powered IRA for the self-employed person and his employees (other than excludable employees) and may make contributions on behalf of each employee who -
The SEP is basically setup as a Traditional IRA in which the employee owns and controls the contributions made on his behalf. It is executed via a formal written agreement, which must be provided to each eligible employee, and must be setup by or for each eligible employee. Although not required every year, contributions for any given year may not discriminate in favor of any highly compensated employee, that is, contributions must be based on a written allocation formula that specifies -
Since a SEP is considered a defined contribution plan (IRC 415(c)), 2008 contributions are limited to the lesser of (a) 25% of the employee’s compensation (20% of net earnings from self-employment) or (b) $46,000 (2008), which includes elective deferrals. Employees may be given the option to increase contributions through an elective deferral via a salary reduction agreement. If there are other defined contribution plans, the limit to all plans is the lesser of $46,000 or 100% of the employee's compensation. Savings Incentive Match Plan for Employees – SIMPLE IRA (IRC 408(p)) An employer with 100 or fewer employees who meet certain eligibility requirements can set up a SIMPLE plan for each eligible employee and must decide whether contributions, which are only allowed under a qualified salary reduction agreement, will be matching or nonelective. An eligible employee, including self-employed persons, is one who earned at least $5,000 during any of the 2 preceding years and is reasonably expected to earn the same in the current year. The employer also has the option of reducing or eliminating the eligibility requirements. Eligible employees may elect to have the employer contribute part of their compensation (a salary reduction contribution) into a SIMPLE IRA, the payment of which is expressed as a percentage of compensation and may not exceed the applicable dollar amount, which is $10,500 for 2008 (IRC (p)(2)(E)). The employer is also required to make a matching contribution, dollar-for-dollar, not to exceed the applicable percentage of compensation, which is 3 percent. Example. Jack and his employee, Bob, elect to contribute to a SIMPLE IRA. Bob earns $32,000 annually and wants to contribute 6%. Jack, as the sole proprietor, earns $75,000 and wants to contribute 7%.
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