Tax deferred annuities
One of the requirements for a valid contract is consideration. Originally, the idea was to provide an income that the annuitant could not outlive. There are three parties to a typical annuity : annuitant, annuity owner, and beneficiary. The annuitant was previously defined as the person on whose life the terms of the annuity are measured. The annuity owner is the person who has all the incidents of ownership, the rights to the policy. The annuitant and annuity owner can be the same person, but not necessarily. For example, a wife can own a policy on her husband as the annuity.
The beneficiary is the person who will receive the death benefit of the annuity when and if it is paid out by reason of death of the annuitant. The death benefit of an annuity is different from the death benefit of a life insurance policy. It is usually the accumulated premiums plus any interest earned. There is no mortality element in most annuities. There can be an additional death benefit, especially in variable annuities. Because of the special rules for tax deferral, as well as how individual insurance companies draft their contracts, the ownership arrangements are critical to accomplishing your planning objectives.
II. Why buy an annuity
There are two primary reasons to buy an Tax-deferred annuities: income and tax-deferred growth. Objectives will determine which type of annuity best suits the needs. There are several other factors that will also enter into the equation. The configuration of the annuity depends on mathematical calculations based at least in part on the following :
The annuitants age : the annuitants life is the one on whom the payouts are measured. Because talking about an income for life, it will matter to the insurance company if the annuitant is 40 years old or 80. It probably matters to the annuitant too, especially if it is the 80-year-old.
The annuitants sex : Gender matters. There have been complaints and litigation in the past regarding the unifying of rates for males and females for insurance and annuities. It had been the norm to have separate rates because the life expectancy is different for the two groups. Females will pay more for an annuity income because they are expected to live longer. For the same reason, they pay less for life insurance.
Principal sum: The amount of money invested in the annuity will obviously be a factor. The more invested the more the income potential.
Credited interest. The interest rate used by the insurance company will make a difference, just as the principal sum will. The higher the credited rate, the more to annuitize or accumulate.
Expenses . The expense charges of the insurance company will impact the policy. The lower the companys expenses, the greater the opportunity to improve your payout under the annuity.
III. The basic types of annuities:
There are several ways to classify annuities:
By premium method
By the annuity starting date
By the investment characteristics
By the options available
Tax-deferred annuities can be funded in two ways, a single premium or periodic premiums. A single premium policy does not usually allow for subsequent premiums to be deposited. A periodic premium policy does allow that freedom. Most periodic premium policies are flexible premium policies, although some contracts can require fixed and level premiums over time.
Annuities classified by the starting date of payments can be either immediate or deferred. The immediate annuity begins payments to the annuitant right away; usually a month after the premium is deposited. A deferred annuity accumulates principal and interest for payment at some future date. The two reasons for buying an annuity is either income or tax-deferred growth.
IV. Tax-defferred annuities:
Tax-deferred annuities, which are underwritten by insurance companies, come in two forms fixed and variable, and are essentially supplemental retirement plans.
A fixed annuity is a fully guaranteed investment contract. Principal, interest and the amount of the benefit payments are guaranteed. In other words, the money in a fixed-income annuity is legally protected, should the insurance company become insolvent. There are two levels of guaranteed interest for a fixed annuity: current and minimum. The current guarantee reflects current interest rates and is guaranteed at the beginning of each calendar year. The minimum guarantee is simply a predetermined lowest rate.
A variable annuity, like variable universal life insurance, is designed to provide a hedge against inflation through investments in a separate account of the insurance company, consisting primarily of common stock. If the portfolio of securities performs well, then the separate account performs well, so the variable annuity, backed by the separate account, also will do well.
Variable annuities are generally clones of popular mutual funds with an insurance wrapper. Investors may either pay a one-time lump sum to purchase an annuity or they may make installment payments. The interest, dividends, and capital gains accumulate on a tax deferred basis until they are paid out to the investor. Again, if an annuity investment for twenty years, since it can easily take that long before the benefits of tax deferrals outweigh the added costs of the annuity.
V. Modified endowment contract(MEC):
Policies, such as single-premium contracts, that fail the test are classified not as insurance but as modified endowment contracts, often known as Modified Endowment Contracts (MECs). Under the law, the accumulated earnings come out first, so the investment is treated as taxable earnings, and the any amounts withdrawn is treated as a withdrawal of money he put in. The tax treatment is similar to that for an IRA or qualified retirement plan in that the earnings are taxable at current rates, and if the person is under age 59, he is subject to a 10% tax penalty as well. If a policy holder assigns or pledges the policy as collateral for a loan, it is treated as a distribution for tax purposes.
VI. Modified endowment contract revisited:
If investors need money during their lifetime, withdrawals from either a deferred annuity or a modified endowment contract will subject both to income tax and to a 10% penalty if they are under age 59, but many people do not make lifetime withdrawals, preferring to leave the money untapped, if they can afford to do so, so that it can go to their heirs. In that case, a MEC is preferable to an annuity. The Tax-deferred annuities is merely tax-deferred, not tax-free. In contract, under the tax laws a MEC is treated like insurance. Not only is no income tax due on the buildup, but also beneficiaries must receive a death benefit that is greater than the cash value, and that death benefit will be tax free to them.
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