Understanding Deferred Annuity Designations

Annuity Designations

A person who buys a tax-deferred annuity must name his beneficiary, his annuitant, and his annuity account’s owner. It is the owner who makes the initial fund investment and decides when to start the payouts. He also has the right to change the beneficiary anytime he wishes. The life of the annuitant forms the basis in determining how much the payouts will be while the beneficiary will receive the payouts in case the annuitant dies. In general, the annuitant and the owner are one and the same person. If these are two different persons and anyone of them dies, the beneficiary will have to pay a huge income tax on his share of the payouts.

If the annuity is non-qualified, meaning that it is not invested in a retirement plan or individual retirement account, the beneficiary will have to pay ordinary income tax on the annuity account’s capital gains. However, if the contract is annuitized, a part of each payout may be tax-free. This is possible by computing the exclusion ratio and divides it by the tax liability over time.

A spousal beneficiary is a surviving spouse, who can be the new owner in case the annuitant dies. Income taxes can be deferred until the spouse dies. A non-spousal beneficiary can’t assume ownership of the annuity contract if the annuitant dies. Any benefits from the fund must be taken within 5 years but it is possible to annuitize the annuity within 2 months of the annuitant’s death. Payouts will begin within one year of the annuitant’s death.

If both spouses own the annuity for Medicaid planning purposes, the spouse who isn’t in the nursing home can annuitize the contract based on the life expectancy of the stay-at-home spouse. The annuity is exempted when determining whether the spouse is qualified for Medicaid. However, if any of the spouses dies before the annuitization of the contract, the Internal Revenue Service may require the beneficiary to withdraw the proceeds upon the death of the owner. The beneficiary will also have to pay the taxes while the surviving spouse won’t receive anything.

Some financial advisors suggest that the owner names a younger annuitant so that the payouts will be stretched out as well as the income tax liability for a longer period. However, if the younger annuitant dies before the owner, the beneficiary must withdraw the money from the annuity fund. For example, the husband is the owner, the wife is the beneficiary, and the son is the annuitant. If the annuitant dies, the beneficiary has to receive the proceeds and pay the necessary income tax like a non-spousal beneficiary. However, if the owner dies, the beneficiary can assume the annuity and continue to take advantage of tax deferral benefits for the annuity. If the spouse remarries, the new spouse must be named as beneficiary. If the original spouse dies, the new spouse can assume the annuity and continue the tax deferral.

If the owner of the annuity names a beneficiary who is not his spouse but maintains his son as his annuitant, the sister must withdraw the money from the annuity fund like the a non-spousal beneficiary in case the owner of the annuity dies.

If the person is the annuity’s owner, he must keep a record of his contributions. He must also check the annuity’s beneficiary, annuitant, and owner. It is best to review the annuity contract for any interpretation of the provisions on beneficiary distribution. There may be surrender charges if the non-annuitant owner dies but no charges when the annuitant dies. In addition, there may be a waiver on surrender charges if the annuitant, who isn’t the annuity’s owner, enters a nursing home.

If the person is the annuity’s beneficiary, he must check with the insurance company how much payouts he is entitled to receive under various payout systems like 10-year, 20-year, and lifetime options. He can also ask the insurer for the exclusion ratios so that he can find out about the after-tax consequences. He then compares the amount with the lump sum he may receive from the annuity. In addition, it is possible to claim a deduction for the estate tax equal to the value of the annuity fund.

What To Do Before Buying An Annuity


Before deciding to purchase an annuity, the person must first determine the need for it. If he’s nearing retirement age or is already retired, he needs a regular source of income. A fixed annuity can provide for this need. However, if he’s still young and saving for retirement, he can take advantage of an indexed annuity, a variable annuity, or a fixed annuity. If he wants to leave some wealth to his beneficiaries, he can consider a variable annuity with an attached death benefit.

If the person needs the money in the near future, he must first determine when he’ll need the money because an insurance company often charges surrender fees if an annuitant decides to sell annuity payments earlier.

Furthermore, he must ask his insurance agent about the annuity’s minimum guaranteed return. By knowing this, it is easier for the individual to plan in worst-case scenario. In addition, the person must learn about fees the insurance company charge for the annuity. He must also find out if the insurer charges upfront fees. In general, information about fees is found in the prospectus.

If the annuitant withdraws his money early, the insurance company usually charges surrender fees. In general, the longer the annuitant keeps his money in the annuity fund, the lesser will be the fees charged. The person must ask his insurance agent about surrender fees before signing up for an annuity fund.

Furthermore, an annuity can have an associated death benefit. A person must find out from his insurance agents the kinds of death benefits he can avail of. Lastly, he must learn about waivers he can take in he needs the money immediately. In some cases, an insurance company may waive the surrender fee in case of an emergency medical condition or if the annuitant has to be admitted to a nursing home.


What Are Fixed Annuities

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A fixed annuity stabilizes investment income and is most preferred by investors who aren’t working full time but have retired or are about to retire. It is an insurance contract which provides a fixed amount of income paid regularly for a specific period. A fixed annuity can have various options which can be added to a basic annuity for a fee.

A financial institution or insurance company offers fixed annuities which can either be availed by an annuitant by paying a lump sum or at regular intervals until the annuitant retires. The annuitant’s contributions are guaranteed to earn interest at a fixed rate during the accumulation phase. During the annuitization phase, the contributions less the payouts will continue to earn interest. If the annuitant dies before he can claim his annuity’s full amount, he passes the remainder of his money to the insurance company. However, he can opt to choose a beneficiary, depending on the type of annuity he selects.

When choosing a fixed annuity, it is important for the investor to know that he can negotiate the price of the annuity. In addition, the payouts can also differ between insurance companies. As such, it is best to compare various annuity products before selecting one.

Kinds Of Fixed Annuities

Fixed annuities can be term certain annuities and life annuities. A life annuity pays a fixed amount every period until the annuitant dies while the term certain annuity pays a fixed amount periodically until the annuity expires.

Life annuities have different types and differ by the type of insurance they provide the investor. Some life annuities change the payout structure in case something happens to the annuitant like early death or sickness. In most cases, if there are many insurance components, payouts can be longer over time once the annuity starts the annuitization process. In addition, the monthly payouts are highly dependent on the annuitant’s life expectancy. If the annuitant has a low life expectancy, he receives higher payouts. The price of a life annuity is the total amount of contributions in the annuity plus any premiums paid for the insurance components, if any.

A straight life annuity, on the other hand, has an insurance component which provides income until the annuitant dies. At the start of the annuitization process, it pays out a fixed amount periodically until the annuitant’s death. This type of life annuitant is cheaper because there is no other insurance component attached to it. A straight life annuity doesn’t pay anything to any beneficiary.

A substandard health annuity is a kind of straight life annuity which can be bought by a person with a serious illness. It is priced depending on the probability that the annuitant will die in the near future. If the annuitant has a lower life expensive, he will have to pay more for the annuity. Furthermore, he also receives lower payouts but the duration of payouts is increased.

A guaranteed term life annuity allows an annuitant to choose a beneficiary, who will receive the remaining benefits if the annuitant dies before the end of the agreed term. It is more expensive than the straight life annuity. In addition, the beneficiary receives a lump sum amount from the insurer when the annuitant dies. In this case, the beneficiary will have to pay income tax on the benefits he receives.

A joint life with last survivor annuity is an annuity which pays the annuitant’s spouse even when he dies. The remaining payments are passed on to the spouse. This annuity allows the annuitant to add more beneficiaries who will receive the payments when the spouse dies. The annuitant may even designate smaller payments to these additional beneficiaries. Because the payouts are distributed periodically, the spouse need not be burdened by huge tax payments. However, a joint life with last survivor is more expensive than the other fixed annuities because there are more insurance components.

Term certain annuities provides for a fixed payout periodically up to a particular date only. The insurance company doesn’t distribute the remaining payments to the annuitant’s beneficiaries in case of death. Because it has no additional insurance components, this type of annuity is cheaper. Moreover, this annuity doesn’t increase the income in case the annuitant’s health fails.

Capital gains in fixed annuities are tax deferred. Money is used in purchasing fixed annuities can be considered pre-tax income and be tax deferred. Fixed annuities can also be bought with after-tax money. Payouts can either be pre-tax or after-tax income, depending on the kind of annuity purchased. If the annuity is bought using pre-tax income, it can qualify for tax-deferral. This type of annuity is bought by retirement funds which have tax-exempt capital gains and the retirement plan from which the funds came from was qualified for tax-deferred status.

Annuities can also be purchased on intervals when the annuitant is still working. Contributions to these annuities are pre-tax income. An annuity which has been bought by after-tax money doesn’t enjoy tax-deferred status. A qualified annuity has tax-free capital gains and is only taxed when money is withdrawn from the fun. Capital gains on an unqualified annuity are tax-deferred and contributions are already after-tax. In both qualified and unqualified annuities, the annuitant’s beneficiary pays a hefty tax on the annuity income when the annuitant dies.

The annuitant must be wary about the effects of annuities on his beneficiaries. He is encouraged to seek the help of a financial advisor when he plans his estate. He can also make his own research so that his beneficiaries don’t have to be burdened by hefty taxes when he passes away.

Taxes Are the Most Significant Investment Expense You Will Pay

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Just as paying seemingly modest fees for money management every year can stunningly reduce your wealth over time, paying seemingly modest taxes every year can sharply impact your quality of life in retirement. Money that is not in a tax-sheltered retirement account (more on these below) is subject to four types of taxes:

  • Income taxes. Interest earned from bonds is taxed at the ordinary income rate, which can be as high as 35% at the federal level.
  • Capital gains taxes. If an investment is sold for a higher price than it was purchased for, the difference is termed a capital gain and is subject to tax. If the investment producing the gain was held for a year or longer, a special capital gains tax rate of (usually) 15% applies. If the investment was held for less than a year, it is taxed at the full ordinary income rate (up to 35%).
  • Dividend taxes. Dividends received from stocks are taxed either at the ordinary income rate or at a qualified dividend rate, which may be lower (currently 15% for most taxpayers).
  • State and local taxes. States usually do not differentiate between sources of income, so whatever you make from your investments will be taxed at the income rate (unless you are lucky enough to live in a tax-free state like Nevada, Texas, or Washington).

Be aware that tax rates have changed markedly in the past and are likely to increase in the future.

Together, these taxes act as a sharp brake on the amazing effects of compound interest, which we covered in Chapter 1. To see the huge potential impact that taxes can make, let’s assume that you are in the 33% tax bracket and have $100,000 invested in a long-term bond that pays out 6% interest a year. If you re-invest your proceeds every year, this money will actually compound at 6% inside a tax-sheltered account, growing to $575,000 over the course of 30 years. Outside a 401(k) or other tax-sheltered account, this money will compound at a true after-tax rate of only 4% (since 1/3 of the income will go to the government every year), growing to only $324,000 (see Figure 5). Once again, seemingly minor annual savings add up to a gigantic, $250,000 difference in final wealth over time.

Figure 5 – Tax-advantaged accounts can compound wealth at a much faster rate than regular accounts


The two major tax-advantaged account types that you must become familiar with to be an informed investor are the 401(k) and the Individual Retirement Account (IRA).

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