Choosing an Annuity: What Accountants Need to Know [CPA Journal, The]

An annuity is a special kind of insurance contract that can be a very useful tool for creating income for individuals when they retire, as well as in certain other situations, Annuities represent one of the very few ways an individual can get a check for life. The types of annuities available have proliferated over the years. These instruments often come with liquidity restrictions; significant fees; surrender charges; and varying rights, riders, and endorsements, making them difficult for most potential purchasers to understand. Many individuals frequently tum to their accountants for assistance when considering an annuity. CPAs can use the following basic information to help their clients choose the annuity that will be right for them. Understanding annuities may become more important than ever, considering recently proposed IRS regulations that would make annuities more flexible and useful for retirees,

Annuities are first and foremost income-producing instruments, so the first question an accountant should ask potential purchasers is whether they need income now or income later. The answer to this question will dictate the kind of annuity that will be appropriate for them.

If Income Is Needed Now: Immediate Annuities

If an individual needs income now, then she is a candidate for an immediate annuity. The most common type of immediate annuity requires only a single premium payment or deposit, after which it produces a regular stream of income, usually on a monthly basis. This type of annuity is called a single-premium immediate annuity (SPIA).

When individuals purchase a SPIA, they are giving their money to an insurance company in exchange for the promise of regular payments of income in the future. Once the initial premium payment or deposit is made, these funds can no longer be accessed by the purchasers, even if their financial situation changes. Naturally, most individuals do not want to lose control of their money; many often feel that by purchasing a SPIA, they have transitioned from being millionaires to pensioners. In the right situation, however, a SPIA can be an attractive investment choice, because it can provide regular payments of income over long periods of time or for the remainder of one's life.

Income factors. The amount of the monthly income mat an owner can receive from a SPIA after making the initial premium deposit depends upon the following four factors discussed below:

* The settlement option chosen

* The individual's age

* The individual's gender

* The prevailing interest rate.

The settlement option, also known as the income choice, is a main determinant of how much income a buyer will receive from a SPIA. There are many settlement options available. A few of the most common settlement options are as follows:

* Period certain. The owner elects a period of years called the "guaranteed period," during which he will receive monthly income; however, all income payments will cease after the end of the guaranteed period. Should the owner die before the end of the guaranteed period, the monthly income will be paid to the owner's beneficiary for the remainder of the guaranteed period.

* lifetime income. Monthly income payments will be paid during the owner's lifetime and will cease upon death.

* Period certain and lifetime income. Monthly income payments will be made during the guaranteed period. If the owner dies before the end of the guaranteed period, income payments will then be made to the owner's beneficiary for the remainder of the guaranteed period. Should the owner live beyond the end of the guaranteed period, however, he will continue to receive monthly income payments until death.

* Installment refund and lifetime income. Income payments will be made during the owner's lifetime; however, if he dies before tile total of the income paid equals or exceeds the initial premium payment, then regular income payments will continue to be made to the owner's beneficiary until the total payments equal the initial premium.

* Cash refund and lifetime income. Income payments will be made during the owner's lifetime; however, if he dies before the total of the income paid equals or exceeds the initial premium payment, then the difference will be paid to the owner's beneficiary in a lump sum.

A lifetime income settlement option can also be crafted as a joint and survivor settlement option, whereby income payments, in whole or in part, can continue to be made to a survivor after the death of one of the annuitants. The joint and survivor settlement option is frequently selected by spouses, but there is no requirement that the joint annuitant be a spouse. Buyers can use the joint and survivor income choice with children and sometimes grandchildren. (There may be gift tax ramifications in such cases.) By selecting a joint and survivor settlement option, the primary annuitant will receive lower monthly income payments than if an individual lifetime income settlement option had been chosen.

Insurance companies report that buyers often select the lifetime income with a 10-year period-certain settlement option. This may not necessarily be the best option for everyone, however; it depends upon an individual's situation, and it usually pays for an advisor to analyze the amount of income that an individual could receive under several settlement options before making a decision.

An individual's age also affects the level of income payable under a SPIA; the younger an annuitant is, the smaller the income payments will be. The annuity company assumes that a young person will live longer than an older one and will collect more income payments under the annuity. Unlike life insurance, an individual's health is not a factor typically considered by the annuity company. In some cases, however, if a buyer is in exceptionally poor health and selects the lifetime income option, a higher payout may be negotiated with some annuity companies, depending upon the individual facts and circumstances of the situation.

An individual's gender also impacts the level of income payable from a SPIA; mortality tables have historically shown mat men generally die at earlier ages than women. As a result, men will usually get higher payouts under a SPIA than women would get at comparable ages.

Lastly, the level of prevailing interest rates also affects the level of income payments under a SPIA. The annuity company invests the premium payment or deposit it receives from the buyer in the bond market; if the rates available to the annuity company are low, then the annuity company will only earn enough to be able to make smaller income payouts.

The returns on lifetime income settlement options tend to exceed those available to individuals in the bond market. These higher returns are due to the fact that payouts are based on the assumption that many annuity holders will die before reaching their life expectancy. In short, insurance companies use the funds remaining from those who die sooner than expected to pay those who live longer than expected. A rule of thumb frequently cited is to wait until age 75 before purchasing a SPIA because, at mat time, a buyer will have a good idea of the general level of her health and life expectancy; thus, she can realistically evaluate whether a lifetime income settlement option is appropriate.

Tax considerations. Other factors to consider when choosing a SPIA are estate taxes and income taxes.

Estate taxes will apply to SPIAs if the income payments continue after death. If the annuitant selected a lifetime income settlement option and payments ended upon death, there is nothing left to be subject to estate tax. When such payments continue after the death of the owner, however, the present value of these payments to the recipient, as calculated by the annuity company, will be included in the owner's taxable estate. If a spouse will receive the survivor income, then this amount may be sheltered from estate taxes because of the marital deduction.

The income tax treatment of income from a SPIA that has been purchased with nonqualified funds is generally straightforward. The rule is that if the total of all income payments to the owner will be greater man the deposit or premium payment, the difference will be treated as ordinary income. When income is to be paid over a period certain, this amount is fairly simple to calculate. There is an exception to mis rule in rare situations for some annuities purchased in connection with certain court-approved structured litigation settlements. When income is to be paid out for life, however, the uncertainty of the number of payments an individual will ultimately receive means that the total of these payments is impossible to determine accurately. As a result, the IRS has devised a formula for determining the amount of periodic income that is subject to tax based on taxpayer's life expectancy. The formula results in the calculation of an "exclusion ratio," whereby a portion of each income payment is excluded from taxation and treated as a return of the original premium. While the annuity company will make these calculations at the inception of a SPIA, accountants might want to familiarize themselves with this calculation. IRS Publication 939, General Rule for Pensions and Annuities, contains the details on how to make the calculation.

SPIAs purchased with qualified funds will be treated differently for income tax purposes. The exclusion ratio concept does not apply, as all payments received will be treated as taxable income.

There are some tax traps for the unwary. If a SPIA is purchased and owned by an individual, but the payments are made to someone who is not a spouse, mese payments will be taxable to the owner, not the recipient of the income. Likewise, the ownership of SPIAs by trusts or the contribution of SPIAs to charities can raise complex tax questions beyond the scope of mis article. An individual and his accountant should seek specialized tax advice for such situations.

Another factor to consider when choosing a SPIA is that, in certain states, SPIAs purchased with nonqualified funds may be sheltered from certain creditors. Of course, SPIAs held in IRAs and qualified plans have always enjoyed protection from creditors. Such protection would probably not be available if a SPIA were purchased with a view to avoiding Medicaid look-backs, or in connection with a fraudulent transfer to disadvantage creditors. If an individual particularly desires protection from creditors for a SPIA the purchase should be reviewed by legal counsel familiar with state law.

Hedging against inflation. As noted above, many people resist purchasing a SPIA because they don't want to lose control of their money. A second objection to the purchase of a SPIA is the effect of inflation on future income payments. The effect of cost-of-living increases may not be that significant if the prevailing level of inflation is low and an individual is very old. But when inflation becomes persistent and the buyer is young or in good health with a long life expectancy, then even low levels of inflation can adversely affect future purchasing power. Generally, annuity companies do not provide inflation protection and do not increase future income payments to take account of a toss in purchasing power due to inflation; however, there are SPIAs available that offer various cost-of-hving adjustments for future income payments. Buyers will find mat a SPIA with inflation protection will either require a larger initial deposit than a SPIA without such protection, or that the income payable under the SPIA will begin at lower levels than those obtainable from SPIAs without such inflation protection.

A technique often used to deal with the risk of inflation is investment of only a portion of nonqualified funds into a SPIA and selecting the period-certain option (e.g., for 10 years). This permits the owner to live on the income from the SPIA during the guaranteed period, while qualified funds continue to compound on a tax-deferred basis during mis period. After the guaranteed period, investors can deal with cost-of-living increases by using their qualified funds.

Obviously, the loss of control over the funds used to purchase a SPIA is a good reason not to invest all of one's funds in such annuities. Once an individual has made a decision to invest in a SPIA, however, it may be advisable to divide up the funds allotted for mis purpose and to diversify by buying several SPIAs from different insurance companies, thereby avoiding the common mistake of putting all of one's eggs in one basket.

If Income Is Needed Later: Deferred Annuities

If an individual does not need income immediately but needs income later, then different types of annuity contracts, called deferred annuities, should be considered. Deferred annuities mat provide for only a single, initial premium payment are often referred to as single-premium deferred annuities (SPDA). Deferred annuities are usually classified by how the earnings on aie premium deposit are calculated during the period when income is not needed, called the accumulation phase or deferral period, which will be discussed below.

First, accountants should note that the estate tax and income tax treatment of deferred annuities is somewhat different from that of immediate annuities.

Estate taxes will generally apply to deferred annuities. If the annuity is in the deferral period when the owner dies, the death benefit payable to the policy beneficiary will be included in the owner's estate. The death benefit is generally the amount of the premiums invested, less any withdrawals, plus the earnings generated by such premiums. (It is also possible to buy enhanced death benefit riders, particularly for variable annuities, discussed below.) If the deferred annuity has been annuitized, however, then the same estate tax rules that applied to SPIAs, discussed above, will apply.

Generally speaking, funds invested in deferred annuities in the form of premiums can be returned to annuitants free of tax because they represent a return of investment capital. All gains earned on the investment of these premiums will be taxed at ordinary income rates, but only when actually paid to the annuitant; mis means that earnings held inside a deferred annuity that are not paid out can grow on a taxdeferred basis. Withdrawals from a deferred annuity prior to age 59 Vi may be subject to a 10% income tax penalty unless the payment is made because the owner died, because the owner became disabled, or because the payments are being made in a series of substantially equal installments scheduled for the owner's lifetime or joint life expectancy of the owner and beneficiary.

When an individual finally elects to receive income from a deferred annuity, there are two rules governing taxation. If the owner annuitizes the balance in the annuity - that is, gives up control of the money in exchange for income to be paid over time - the income tax treatment will be identical to that of SPIAs discussed above. If, however, the owner chooses to take money out of the annuity without annuitizing the balance in the annuity, through either a surrender of the policy or a partial or total withdrawal, then the rule is that all funds initially withdrawn will be assumed to be earnings and will be taxed at ordinary income tax rates. After all earnings have been paid out, however, the remaining amount that is distributed will be considered a tax-free return of premium - in short, a type of last-in, firstout (LIFO) treatment.

There are very complex tax rules applicable to deferred annuities that are owned by irrevocable trusts, and, in general, it is advisable to avoid naming irrevocable trusts as owners or beneficiaries of deferred annuities unless the reasons for doing so are clear and expert tax advice has been received to confirm those structures. In addition, it is usually best to avoid joint ownership or co-ownership of an annuity (not to be confused with a joint and survivor settlement option) and avoid situations where the owner and annuitant of a deferred annuity are different individuals. (Many annuity companies have internal mies forbidding that practice.) Likewise, the rules surrounding the sale of deferred annuities and the gifting of deferred annuities (as well as the gifting of SPIAs) are very complex, and such transactions should be done only after getting expert tax advice.

Basic Types of Deferred Annuities

Fixed annuity. These annuities pay a percentage return based upon the amount of the initial premium for a fixed period of time; however, like the SPIAs discussed above, fixed annuities pay low returns during periods of low interest rates.

There are two common types of fixed annuities, based upon the length of time that the rate of return is guaranteed.

The first common type of fixed annuity typically has a contract term of three to 10 years, but the rate of return on the invested funds is guaranteed for only the first year of the contract After mat initial one-year term is up, the buyer has to trust that the annuity company will pay her a competitive return for the remainder of the term in relation to prevailing interest rates. Annuity companies will often post a target return that they will try to meet during the term. Sometimes they provide for a guaranteed minimum annual return after the first year; mis type of annuity is often offered with a very high "bonus" rate of return for the first year of the contract in order to attract buyers. But these contracts frequently have higher surrender charges, which can extend over a longer time period to make up for mis extra return to contract holders.

The second common type of fixed annuity is fiequenüy called the multiple-year guaranteed annuity (MYGA). These contracts specify a fixed rate of return for every year under the contract. The return will never be less, nor will it be more, than the specified return. Annuity companies offer various contract lengths.

Unlike with a SPIA the owner of a fixed annuity can withdraw her initial premium at any time, subject to significant penalties that generally decrease over time, called surrender charges. In most contracts, however, an owner can usually withdraw a small amount - normally 10% of the balance in the annuity - in any year without any penalty. The presence of these surrender charges and their persistence over a substantial portion of the contract term should encourage individuals and their advisors to consider fixed annuities as long-term investments.

It should be noted mat one does not have to withdraw the annual earnings generated in a fixed annuity, but can instead leave mem with the annuity company inside the annuity contract to continue to accrue interest on a tax-deferred basis. As discussed above, income taxes on the earnings from a fixed annuity are only due when the income is actually paid out In addition, the tax-deferred interest income retained inside an annuity is not included in the calculation of the Alternative Minimum Tax (AMT) or taxability of Social Security benefits.

There are several strategies to consider when contemplating purchasing fixed annuities. like SPIAs, it is often desirable to diversify the risk of an annuity company's creditworthiness by dividing up funds and buying annuities issued by different annuity companies. Unlike with SPIAs, however, purchasers of fixed annuities might consider "laddering" their investments by investing in annuities with varying terms, because annuitants will eventually receive their investments back in cash. Of course, the risk inherent in laddering is that when funds become available for reinvestment, they may not be able to be invested at attractive rates, depending upon the available returns in the capital markets at the time.

There is also a strategy sometimes used to take advantage of the relatively high interest rates offered by annuity companies for the first year that funds are deposited into a fixed annuity. After the initial year has passed, the owner can make a tax-free exchange pursuant to Internal Revenue Code (IRC) section 1035 and transfer the balance in the annuity, including the accrued earnings, without income taxation, to either a SPIA (if she needs income immediately) or to a fixed index annuity or variable annuity, if the owner believes that these contracts have greater potential for growth depending upon conditions in the capital markets prevailing at that time. But this only makes economic sense when surrender charges on this kind of transfer are avoided; this would occur only when the transfer is made into a SPIA or a fixed index annuity or variable annuity issued by the same annuity company that issued the fixed annuity.

Accountants who practice in New York might find that few of their clients will come to them with questions about fixed annuities. The offerings of fixed annuities in New York tend to be less attractive than those in other states because New York State regulatory authorities require annuity companies to provide a higher level of reserves against these policies than insurance regulators in other states. On the other hand, this restrictive regulation provides a measure of protection to annuity purchasers. In addition, annuities sold to New York residents by New York-licensed insurance companies are provided a measure of protection of up to $500,000 of coverage through the Life Insurance Company Guaranty Corporation of New York (LICGC) if the issuing insurance company becomes insolvent This corporation is owned by New York-licensed insurance companies and is funded by assessments against them in cases of member insolvency. The existence of this coverage is not widely known, because section 7718 of the Life Insurance Company Guaranty Corporation of New York Act forbids mention of this coverage in connection with the sales and solicitation of insurance policies. More information can be obtained from the New York State Department of Financial Services (formerly the New York State Insurance Department) at www.dfs.ny.gov.

Fixed index annuity. These annuities, sometimes called index annuity or equity indexed annuity, pay a return during the deferral period based upon the performance of a particular asset or index, usually an equity-based index such as the S&P 500. Today, there are many indexes available to choose from under these contracts. There is usually no guaranteed minimum annual return on these annuities, but in years when the selected index has not posted a gain, or has lost money, owners will not incur any loss (nor will they register any gain). This can protect capital in difficult market environments. There is, however, always a cap on the index's return that will limit the amount of the owner's gain, should the index go up substantially; in other words, the annuitant is giving up some investment upside in exchange for eliminating downside capital loss. In addition to a cap, some fixed index annuities will also credit only a portion of the gain in the chosen index. This is called the "participation rate."

The measuring period for the performance of fixed index annuities is usually one year, often beginning with the contract's inception date. Some contracts may use different measuring periods, often called "point to point" contracts, which can vary from the period of one year to the entire life of the annuity, from its inception date until it matures many years later.

Investors choosing fixed index or equity indexed annuities should keep in mind that the contract will not be credited with the dividends that are generated by the equities (if an equity index is being used) underlying the selected measuring index. Only the raw change in the index during the measuring period will be utilized. This is because the annuity companies do not actually own die securities in the index; rather, they are investing in the index by using index options or other instruments to mimic the returns of the index. To the extent that these instruments throw off any dividends, these are retained by the annuity company to absorb part of the cost of renewing such options.

As with fixed annuities, buyers often deposit money into a fixed index annuity during periods of high market volatility and then conduct a tax-free exchange, pursuant to IRC section 1035, into a variable annuity if they believe mat doing so will give them a greater return in light of current conditions in the capital markets. Again, significant surrender charges will apply unless the buyer performs this exchange with the same annuity company that issued the fixed index annuity.

Because fixed index annuities are subject to significant surrender charges, they should be treated as long-term investments. Withdrawals from some of these contracts prior to maturity can also have serious adverse consequences; under the provisions of some contracts, the equity-based rate of return will be applied only to contracts mat remain in full force until maturity. If surrendered prior to maturity, the surrender value of many of these contracts could be based upon only a minimum guaranteed rate. Again, as with fixed annuities, the laddering of fixed index annuity contracts utilizing contracts with different surrender charge expiration dates may be advisable. As mentioned above, the risk in laddering is that when funds become available for withdrawal, they may not be able to be invested at a desirable rate of return based upon prevailing rates of return in the capital markets.

It is not difficult to believe that fixed index annuities are really a kind of investment vehicle and not a simple accumulation instrument like fixed annuities. This has not escaped the attention of the SEC, which tried to institute Rule 15 IA to regulate fixed index annuities as if they were securities. When challenged in court, mis rule was set aside; subsequently, the Dodd-Frank Wall Street Reform and Consumer Protection Act included the Harkin Amendment, which affirmed mat such fixed index annuities were insurance products and not securities. Nevertheless, variable annuities, discussed below, are considered securities by the SEC, and insurance salespersons must be registered with the SEC to sell securities before they can offer variable annuities to their clients.

In 2010, the National Association of Insurance Commissioners issued a model regulation aimed at making sure that certain annuity products were suitable for clients purchasing them, primarily because consumers had difficulty evaluating the very complex nature of fixed index annuities as well as variable annuities (discussed below). This model regulation has been adopted in most states and requires mat insurance agents take both a four-hour course on purchaser suitability and courses in individual insurance company annuity products before they can sell such products. In New York, however, New York State Insurance Department Regulation 187 (11 NYCRR 224), which became effective on June 30, 201 1 , does not require that insurance agents take a four-hour general course on annuities, but it does require that insurance agents take individual, product-specific training before recommending certain annuities to clients. According to the regulation, the determination of the suitability of certain annuity products must take into account the following factors: the client's age; annual income; financial situation and needs; financial experience; financial objectives; intended use of the annuity; financial time horizon; and existing assets, including investments, as well as life insurance holdings, liquidity needs, liquid net worth, risk tolerance, and tax status.

As is the case with fixed annuities, discussed above, accountants who practice in New York might find that few of their clients will come to them with questions on fixed index annuities. The offerings of fixed index annuities in New York tend to be limited because New York State regulatory authorities require annuity companies to provide a higher level of reserves against these policies than regulators in other states. As discussed above with regard to fixed annuities, however, this restrictive regulation, along with coverage under the LICGC, does provide a measure of protection to annuity purchasers not available in other states.

Variable annuity. A variable annuity permits individuals to invest their money in subaccounts that are themselves invested in fixed-income and equity securities (usually mutual funds or index-based portfolios) managed by professional asset managers. Unlike a fixed index annuity, owners can experience a loss depending on the market performance of the particular subaccounts they have invested in. Of course, if the value of their subaccounts goes up, the annuity company will place no cap on the gains, and owners can get the full benefit of their investment increases, net of the fees charged by the variable annuity.

Today, most variable annuities are sold with certain contractual amendments called living benefit riders. These riders permit the annuitant to receive income for life based on what is often called the contract's "benefit balance." The benefit balance is initially equal to the premiums paid into the contract, which is then increased by a set "bonus" percentage each year (which can be computed either as simple interest or compound interest, depending on the annuity company). The benefit balance will increase steadily over time, but can be decreased by any withdrawals from the contract. On the other hand, the "account balance," which is equal to the initial premium paid into the contract less withdrawals, reflects the actual gains and losses in the subaccounts, net of fees.

The benefit balance can also "ratchet" up to match the amount in the account balance if the amount in the account balance exceeds the amount of the benefit balance at certain times of measurement (e.g., the anniversary of the initiation of the contract), or the amount can be ratcheted up to whatever the highest account value (i.e., the high-water mark) was during the preceding measuring period, usually one year.

Although the account balance represents the amount that can be withdrawn in cash (subject to surrender charges if not left on deposit long enough), the benefit balance can only be used to calculate what the monthly income would be if the annuitant were to elect to withdraw the funds pursuant to the living benefit rider. This gives owners the potential to receive income for life even if their account balance would fall to zero as a result of poor investment performance.

There are two main types of living benefit riders - a guaranteed minimum income benefit rider (GMIB) and a guaranteed minimum withdrawal benefit rider (GMWB). Contracts with either of these riders permit the annuitant to receive lifetime income based on the amount of the benefit balance (even if the account balance is zero). In the case of a GMIB, one must annuitize the benefit balance to receive lifetime income. Having done so, annuitants will receive an amount of monthly income based on their age at that point in time, using certain annuitization factors that can be obtained from tables contained in the contract. Such tables may provide for age setbacks, whereby the monthly income payments will be based on the annuitant's age but adjusted as if they were actually younger.

In the case of a GMWB, annuitants can receive income based on the benefit balance, and the amount will be solely dependent on their actual age at the time they initiate payments under the contract. Owners never have to annuitize these contracts. The GMWB is presently the most commonly sold type of variable annuity rider.

In the case of both GMIBs and GMWBs, many annuity companies will restrict the subaccount investments available in such contracts when these riders are selected. Sometimes the companies will limit the percentage of the account balance that can be invested in equities, or they will reserve the right to unilaterally change the allocation of the subaccounts to more heavily favor fixed-income investments if they believe market volatility warrants it.

Why would an individual want to purchase a living benefit rider? Buyers sometimes view the presence of these riders as an opportunity for them to invest a portion of their money somewhat more aggressively than they would ordinarily, because they could still receive a check for life even if their investments decline substantially in value; however, accountants may want to do some careful analysis with respect to these riders in order to determine realistic return assumptions, because at a future time a client might be able to receive more lifetime income from a SPIA than from a variable annuity.

A variable annuity, while giving owners unlimited upside with respect to their investments, also comes with significant fees to pay for these features. While even fixed or fixed index annuities are burdened with fees, their returns are quoted net of all fees, so a close analysis of contract fees may not be necessary. But the annual return in a variable annuity must not only provide for a return on investment, but also pay for the contract's fees, which generally include an annual contract fee, a fee for mortality and expenses, a fee for contract administration, a fee for any rider included with the contract (e.g., the living benefit rider), and asset management fees for the subaccount managers. If the total of all these fees is very high, then the return on the investments within the variable annuity has to be higher still to offset these fees and to increase the account balance (and potentially the benefit balance). Individuáis and their advisors should give careful consideration and compare fees between available annuity products before committing to a variable annuity.

Variable annuities (as well as fixed index annuities) can be considered for both qualified and nonqualified funds, even though one of the benefits of putting money into an annuity - namely, the tax-deferred compounding of returns - is already available to qualified funds in IPvAs, 401 (k) accounts, and pension plans. Nonetheless, the income guarantees within these annuities can make mem attractive for qualified funds. Most annuity companies have structured their products to be "RMD [required minimum distribution] friendly" by permitting required minimum distributions to be made from these contracts without surrender charges, even if these amounts exceed normally permitted withdrawals. Of course, all payments received from variable annuities purchased with qualified funds will be taxed at ordinary income tax rates. Recent IRS regulations, discussed below, may make it easier to purchase annuities in retirement accounts.

As discussed earlier, at an owner's death, the beneficiary of a variable annuity will receive the amount of the account balance teremiums plus net investment gains, less withdrawals) unless an enhanced death benefit was selected at the contract's initiation (some riders will pay out the amount of the benefit balance on death, but there is generally a substantial charge for such a feature). This amount will be included in the decedent's taxable estate. More importantly, it will not be subject to a stepup in basis; instead, beneficiaries will inherit the funds in a variable annuity at the decedent's basis and pay income taxes on all withdrawals above such basis.

Most variable annuities today are "owner driven" contracts as opposed to "annuitant driven" contracts. The primary difference between the two types of contract is how the contract is treated upon the death of either the annuitant or the owner in the accumulation stage (once annuitized, the estate tax ramifications are similar to SPIAs, discussed above). For annuitant-driven contracts, a beneficiary spouse usually has three basic options: cash out; have the funds paid out over a period of time; or do a switch out, whereby the spouse's name is put on the contract and it continues (called spousal continuation). In the case of a nonspouse beneficiary, the alternatives are very similar: cash out, have the funds paid out over a period of time (this option must be selected within 60 days of death), or a deferred cash out where the beneficiary may defer the payment for up to five years from the date of death. Owner-driven annuities are somewhat different in that if the contract owner passes away, the death benefit is payable to the beneficiary, regardless of who the annuitant is. The death benefit can come in the form of a cash payment, an annuitization of the balance in die contract, or spousal continuation (if die spouse was listed as a beneficiary). If die annuitant dies, however, die owner immediately becomes me new annuitant, and she can then select a new annuitant if she so chooses.

The account balances in deferred annuities (but not benefit balances) can be exchanged on a tax-free basis (subject to applicable surrender charges) for other types of annuity contracts, but not for life insurance contracts, pursuant to IRC section 1035. Conversely, die cash value in a life insurance policy can be exchanged for any type of annuity contract.

One more point for a potential buyer to consider in the purchase of a deferred annuity is die projected lengtii of die deferral period before income is needed; this could affect me selection of me type of annuity. Unfortunately, mere are no easy rules of thumb in this area. The longer the deferral period, the better die possibility of building value in die annuity. Any potential growdi is, however, subject to prevailing rates of return in the capital markets. The important thing to understand when evaluating any annuity is to determine when the potential buyer will need income in die future and to find the right product to meet this income need.

The Hybrid Proposal

Beginning in 2009, the federal government modified several rules concerning retirement plans (e.g., IRAs and 401 [k] plans), such as providing for automatic enrollment in such plans, with a view toward helping Americans retire more comfortably. One issue that the government has addressed recently has been longevity risk, or die risk of retirees oudiving their assets. In early February 2012, the Treasury Department and the IRS issued a number of proposed regulations and rulings intended to make lifetime income-producing instruments available to retirees within the framework of existing retirement plans and accounts. Of particular importance was the proposal to create a hybrid type of annuity combining die characteristics of both a deferred annuity and a SPIA. This new type of annuity is called a qualified longevity annuity contract (QLAC). These annuities would be available in certain retirement plans and retirement accounts, such as IRAs and IRC section 457 plans (but not Rodi IRAs or defined benefit plans).

A QLAC would be purchased when an individual initially retired and then would be converted to a SPIA with a lifetime income stream tìiat would begin at any time before the participant's 85di birthday. The income choice for tins annuity could be eitiier an individual lifetime income settiement option or a joint and survivor settiement option. If a joint and survivor settiement option were selected, then a surviving spouse would be permitted to receive a lifetime income, provided die income payment that die survivor received did not exceed 100% of die income payment received by die initial retiree. In die IRS' s proposed rule (REG-1 15809-11, Internal Revenue Bulletin 2012-13), the amount of retirement funds dial could be used to purchase QLACs would be limited to 25% of die total amount of die participant's retirement accounts and no greater dian $100,000 in die aggregate. But die amount invested in QLACs would be excluded from required minimum distribution calculations under Treasury Regulations section 401(a)(9)-6, which would permit mese funds to grow tax-deferred until die income payments under die annuity commenced. Should diese proposed rules become final, accountants will need to work with clients to determine die appropriate level of QLACs that tiiey should maintain in their retirement accounts.

A Complex Instrument

Annuities are useful financial tools that can provide individuals with needed income for their lifetimes from qualified as well as nonqualified funds, but they are complex instruments that come with liquidity restrictions; significant fees, surrender charges, and varying rights; and riders and endorsements, making them difficult for clients to understand. As a result, clients frequentiy look to their accountants for help in identifying the right annuity for their needs. Accountants can help prospective buyers understand if and when an annuity might be suitable for them and can tiien help them choose die right annuity contract to achieve their goals.

It is often desirable to diversify the risk of an annuity company's creditworthiness by dividing up funds and buying annuities issued by different annuity companies.

COMMON USES OF IMMEDIATE ANNUITIES

* Immediate annuities can be useful retirement vehicles, particularly for older retirees in times of low inflation. Getting a monthly check from an annuity company is one of the few ways to get a check for life (other than Social Security, or a pension plan, which few people now have).

* Immediate annuities are a good way to meter out payments resulting from a windfall or an inheritance. When individuals receive a windfall or inheritance, it is a sad fact that these funds are usually dissipated in a short period of time. It is difficult to resist the impulse to purchase luxury items or to deny the requests of children and other relatives for down payments on new homes, as well as other uses. The purchase of an immediate annuity can provide a stream of income for life, depending on the settlement option selected, and, in some cases, protection from creditors. Wills can also be drafted with instructions that certain bequests be used to purchase single-premium immediate annuities (SPIA) for potential spendthrift legatees.

* Immediate annuities can also have a role in estate planning. Life insurance trusts are often used to house insurance policies. Upon the insured's death, the proceeds of the life insurance in these trusts will be excluded from the decedent's taxable estate. Sometimes individuals purchase SPIAs at the time they purchase their life insurance policy and match the income payments from the annuity to the premiums due on the insurance policy. Properly structured, this makes it virtually certain that the premiums will be paid on the insurance policy up to the insured's death, even if the individual's overall financial situation were to be adversely affected by future events. Note that in order to avoid potential gift tax issues, the SPIA should be owned directly by the insured in this situation and not owned by the life insurance trust.

A variable annuity permits individuals to invest their money in subaccounts that are themselves invested in fixed-income and equity securities (usually mutual funds or index-based portfolios) managed by professional asset managers.

COMMON USES OF DEFERRED ANNUITIES

* Fixed annuities are often used as substitutes for certificates of deposit from a bank. In periods of low interest rates, insurance companies often provide a stream of income greater than that provided by banks, and this income is taxdeferred until withdrawn in cash from the annuity. Bank CDs are insured by the Federal Deposit Insurance Corporation (FDIC), while fixed annuities are not; however, most state insurance commissioners require annuity companies to maintain adequate reserves against their future liabilities to clients. (The New York State Commissioner of Insurance requires more reserves than most states.) New York residents who purchase deferred annuities from New York-licensed insurance companies also have insurance protection of up to $500,000 through the Life Insurance Company Guaranty Corporation of New York (LICGC). Note that while this coverage under the LICGC is not available to the separate account investments in variable annuities, the protection does extend to guaranteed minimum death benefits and guaranteed living benefits in variable annuities.

* Fixed index annuities are often used in periods of high equity volatility because those contracts will not subject owners to investment losses in exchange for giving up some investment upside. But all returns in a fixed index annuity will be taxed at ordinary income tax rates, as opposed to the capital gains tax rates available on a portfolio invested directly in mutual funds or directly in equity or fixed-income securities.

* While variable annuities are primarily income instruments, they can be used in other ways. Some individuals may want to invest a small portion of their overall investment portfolio in a variable annuity because they think they can invest it more aggressively than they would ordinarily, because the living benefit rider will make a lifetime income stream available to them even if investment performance is disappointing.

* All deferred annuities can be utilized for qualified funds, even though they already benefit from tax-free compounding. The availability of income guarantees, as well as "RMD [required minimum distribution]-friendly" contracts, can make these annuities attractive investments.

Annuities arc useful financial tools, but they arc complex instruments that come with liquidity restrictions; significant fees, surrender charges, and varying rights; and riders and endorsements, making them difficult to undentand.

Bruce L. Resnik, JD, CPAJPFS, is a senior financial advisor with Summit Financial Resources, Inc., New York, N.Y., and a registered representative with Summit Equities Inc., member FINRA/SIPC. For more information, see www.bruceresnik.com.