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Understanding the Basics of an Annuity

S Rossi 2014
Stephen A. Rossi, MBA, CFA®, CFP®, ChFC®
Senior Vice President, Senior Equity Strategist
[email protected]
(585) 419-0670 x50677

Published on March 11, 2022 in the Rochester Business Journal

Annuities have been around for many, many years and can be considered an investment product with an insurance-like attribute. They can be in accumulation mode or annuitization mode, they can be immediate or deferred, and they can be fixed or variable. They can also be treated very differently for tax purposes, depending on whether the annuity is held in a non-qualified or qualified account. Here’s what you need to know about these products, and how they may or may not fit into your overall financial plan.

An annuity is considered an investment product, since an individual can typically buy different funds inside of the annuity that have bond-like or stock-like characteristics. These investments may grow over time and their combined market value is important in determining the annuity’s Guaranteed Minimum Death Benefit (GMDB), a feature associated with most variable annuities.

An annuity’s GMDB relates to its insurance-like characteristic. On the date an annuity is first purchased, its GMDB is typically equal to the amount of money invested. The annuity contract promises that the investor will never receive less than this amount at death. As the investments inside the annuity grow, its annual contract anniversary date also becomes significant, as it’s the only day of the year when the GMDB can be adjusted - here’s where the annuity’s insurance-like attribute comes into play.

You see, an annuity’s GMDB can only be adjusted upward over time, never down, as the investments inside the annuity continue to grow. By way of example, if you were to put $1,000 into an annuity contract today and purchase a basket of stock and bond funds inside of the contract, your initial GMDB would be $1,000 and you could never receive less than this amount at death, unless the insurance company sponsoring the annuity defaulted on its obligation.

If, on the first anniversary date of the contract, the investments inside the annuity appreciated to $1,200, the GMDB would be adjusted upward to $1,200 and you could never receive less than this amount at death. If the market then plummeted the following year, and the value of the investments fell to $900 on the second anniversary date of the contract, the investor’s GMDB would stay at $1,200. Again, an annuity’s GMDB can only be adjusted upward, never down, on each contract anniversary date, which is why is why this type of annuity is commonly referred to as a ratchet annuity. In this respect, annuities provide not only an investment platform, but a death benefit similar to a life insurance policy as well. Keep in mind, however, that a GMDB comes with a cost, a cost generally referred to as mortality expense.

Annuities can be in an accumulation phase – a time when investors contribute to the investments inside the annuity and enjoy the potential for growth - or an annuitization phase, which is when an investor begins to receive a series of fixed periodic payments from that point forward, based on the then-underlying value of the contract. When an investor annuitizes their contract in this manner, they are provided with several different payout options to choose from, ranging from fixed payments for the rest of their life (or joint lives with, say, a spouse), to payments for a guaranteed minimum number of years. The more risk the insurance company sponsoring the annuity takes on for the contract’s promised stream of periodic payments, the lower the amount of the promised periodic payments themselves. It should also be noted that, once annuitized, an annuity contract ceases to grow in value.

An immediate annuity essentially cuts out the accumulation phase of the contract and, instead, promises a series of fixed periodic payments immediately, in exchange for an upfront sum of cash. A deferred annuity includes an accumulation phase and may or may not include an annuitization phase. With a deferred annuity, the receipt of a promised stream of payments, based on the underlying value of the investments inside the contract, is deferred, either temporarily or permanently. Some annuity contracts are never annuitized, and the value of the underlying investments continues to grow on a tax-deferred basis for the entire life of the owner.

A fixed annuity typically involves an accumulation phase where an investor agrees to receive a fixed rate of return on their initial investment, until they either pass away or annuitize the contract. A variable annuity allows an investor to purchase funds with bond-like or equity-like characteristics inside the contract, which fluctuate in market value (up and down), depending on how those parts of the market perform. In most cases, the concept of a GMDB applies.

An annuity is a tax-deferred investment vehicle that can be purchased and held in a non-qualified account - think non-retirement account - or a qualified account, like a 401-K or an individual IRA. In the case of a non-qualified account, after-tax funds are contributed, and tax (at ordinary income tax rates) is only due for the year in which a withdrawal is made, and only on that portion of the withdrawal that hasn’t already been taxed.

When withdrawals are made from an annuity held in a non-qualified account while the contract is still in an accumulation mode, earnings come out first and are fully taxable. Once all earnings have been returned, principal comes out tax-free, since those funds were already taxed prior to the annuity’s purchase. When withdrawals from an annuity in a non-qualified account are made after the contract has been annuitized, the tax-free return of principal is spread out evenly over the annuitant’s life expectancy and only a portion of each periodic payment is taxable (at least until the annuitant’s life expectancy is reached), based on something called an exclusion ratio.

An exclusion ratio represents the sum of one’s net annuity investments (i.e. money in minus withdrawals) divided by the sum of all future life expectancy payments. Once an annuity contract has been annuitized, it represents the portion of each periodic payment that is excluded from tax. The remainder of each periodic payment is fully taxable. Also, if the annuitant outlives their life expectancy, the exclusion ratio goes to zero and 100% of all remaining periodic payments are fully taxable from that point forward.

In the case of an annuity held in a qualified account, pre-tax (not after-tax) money is initially contributed, and all withdrawals are taxed at ordinary income tax rates, whether the contract is in an accumulation mode or has already been annuitized. In addition, annuities held in qualified accounts are subject to Required Minimum Distribution (RMD) rules, as well as early withdrawal penalties.

Annuities come with several costs including annual account fees, sales loads – think additional fees, particularly if the annuity is cashed out within the first 5-7 years - mortality expense, and the ongoing operating expenses embedded in each of the investment funds offered inside the contract. Many consider the purchase of an annuity to be a more costly approach than the combination of investing more traditionally (i.e. outside of an annuity contract) and separately purchasing term life insurance, but the use of these contracts can make sense in some instances.

Annuities aim to provide a guaranteed stream of cash flows while you’re alive (like a pension) and are often used to fund essential expenses, in exchange for what will likely be a smaller pool of funds when you pass, due to the higher cost of owning them. Whether annuities are right for you or not will depend on several factors, including your specific goals, your investment time horizon, and your implicit and explicit tolerance for risk. A trained investment professional can help you with this decision, particularly as it relates to fulfilling all of your needs, wants and wishes.

This material is provided for general information purposes only. Investments and insurance products are not FDIC insured, not bank deposits, not obligations of, or guaranteed by Canandaigua National Bank & Trust or any of its affiliates. Investments are subject to investment risks, including possible loss of principal amount invested. Past performance is not indicative of future investment results. Before making any investment decision, please consult your legal, tax or financial advisor. Investments and services may be offered through affiliate companies.

Tax information presented is not to be considered as tax advice and cannot be used for the purpose of avoiding tax penalties. Canandaigua National Bank & Trust does not provide tax, legal, or accounting advice. Please consult your personal tax advisor, attorney, or accountant for advice on these matters.