5.5 Classification and Uses of Annuities
Annuity classifications are generally determined by the following factors:
- Method of premium payment: such as single premium, flexible premium, or periodic premium contributions.
- Funding type: whether the annuity is structured as a fixed annuity or a variable annuity.
- Timing of income payments: whether the annuity provides benefits immediately or at a future date (immediate vs. deferred).
- Selected payout option: such as life-only payments or annuity certain payment structures.
- Number of lives covered: whether the annuity is based on a single life or multiple lives, such as a joint annuity.
Annuity Uses
Before recommending or selling an annuity, it is essential to determine whether the product is suitable for the prospective purchaser. Suitability refers to the responsibility of the producer to evaluate whether the annuity appropriately meets the client's financial needs, goals, and objectives at the time of the sale.
When assessing suitability, the producer should consider several factors, including the prospective owner's age, income level, financial situation, risk tolerance, and intended use of the annuity. This evaluation helps ensure that the annuity product aligns with the client's long-term financial planning and retirement objectives.
Personal Uses
- Purchase Other Insurance: Annuities can be used as a funding source for other insurance products that a consumer may need. When an annuity accumulates a significant amount of tax-deferred earnings, the beneficiary who receives the annuity proceeds after the owner's death may be required to pay income tax on those earnings according to their tax bracket. This could potentially place the beneficiary in a higher tax bracket.
To address this issue, the annuity may be used—through systematic withdrawals or a settlement option—to fund the purchase of life insurance. The resulting life insurance death benefit is generally paid income tax free to the beneficiary.
For example, an individual might choose a 10-year period certain settlement option and use the resulting income payments to fund premiums for a universal life insurance policy designed to be fully paid up within 10 years. Similarly, the income generated from an annuity could be used to fund premiums for a survivorship life insurance policy or a long-term care insurance policy.
-
Education Funding: An annuity can be used as a financial resource to help cover the costs associated with a college education. Through systematic withdrawals or by selecting a settlement option, the annuity can provide a stream of income that may assist in paying for tuition, fees, and other education-related expenses.
-
Retirement Fund Accumulation – A deferred annuity held outside an Individual Retirement Account (IRA) allows earnings to accumulate on a tax-deferred basis. These earnings may come from current or guaranteed interest credits, excess interest linked to the performance of a market index, or returns generated by investments in a separate account, depending on the type of annuity. Premiums paid into a nonqualified annuity are not tax-deductible. An annuity held within an IRA (often called an Individual Retirement Annuity) may allow some or all of the contributions to be tax-deductible, depending on the individual's eligibility. However, because annuities already provide tax-deferred growth, placing an annuity inside an IRA does not create additional tax deferral, although it may offer other retirement planning benefits.
▪ Retirement Income – The funds accumulated within an annuity may be used to provide all or part of an individual's retirement income. The accumulated value can be converted into a settlement option that produces a lifetime income stream or income payments for a specified period that may end before the annuitant's death. Each annuity payment generally consists of two components: a return of the original premium and earnings. The portion representing the return of premium is not taxable, while the earnings portion is taxed as ordinary income. If the annuity was funded with tax-deductible contributions, then the entire income payment is generally fully taxable. Some annuities also offer an optional feature called a Guaranteed Minimum Withdrawal Benefit (GMWB). This rider allows the annuitant to withdraw up to a specified percentage of the account value each year, helping to protect retirement income even if market conditions reduce the annuity's value, until the original investment has been recovered.
- Long-Term Care Benefits – Many modern annuities offer riders that help cover some of the expenses associated with long-term care services. Like most riders, these benefits usually require an additional premium or cost.
Some insurers also offer combination products that integrate a deferred annuity with long-term care coverage. These policies may allow the annuity's single premium to be leveraged at a multiple, commonly two-to-one or three-to-one, to provide additional long-term care benefits. For example, a $100,000 single-premium deferred annuity might provide $200,000 to $300,000 in available long-term care benefits.
Typically, the annuity's accumulated value must be used first, and if additional care costs remain, the long-term care benefit becomes available. When annuity funds are used to pay qualified long-term care expenses, those amounts are generally received tax free under applicable tax rules.
- Lump Sum Structured Settlements – Large lump-sum payments, such as those received from legal settlements, lottery winnings, or inheritances, may be used to purchase a structured settlement through an annuity. The annuity then converts the lump sum into periodic payments, which can provide a guaranteed stream of income for a specified period or for the lifetime of the annuitant.
Business Uses
- Employer Sponsored Qualified Retirement Plans
- Although annuities are commonly purchased by individuals, they may also be used within corporate retirement plans. In these cases, they may be issued as a Group Annuity, which is a contract between an insurance company and an employer for the benefit of eligible employees. Each participating employee receives a certificate of participation. Under IRS rules, group annuities are typically associated with defined benefit pension plans.
- Businesses may use annuities to provide employee pension benefits, fund nonqualified deferred compensation arrangements, support qualified retirement plans, or structure periodic payments arising from liability claims or settlements, commonly referred to as structured settlements.
- When annuities are corporate-owned, they generally do not receive tax-deferred treatment. Interest earnings and investment gains are typically taxable to the corporation in the year they are earned.
- Annuities may function as either nonqualified savings vehicles or qualified retirement plan funding instruments. In nonqualified arrangements, contribution limits are generally determined by the insurer's acceptance limits. In contrast, when annuities are used within qualified retirement plans, contribution limits are governed by the Internal Revenue Code and the specific type of retirement plan.
- In addition to serving as funding vehicles, annuities may provide features not commonly found in other investment products, such as a guaranteed minimum death benefit, guaranteed minimum interest rate, lifetime income that cannot be outlived, and other optional riders and benefit enhancements.
Quiz
1. Which of the following is NOT one of the primary factors used to classify annuities?
A. Method of premium payment
B. Timing of income payments
C. Credit score of the annuitant
D. Number of lives covered
Correct Answer: C
Rationale: Annuities are typically classified by the method of premium payment, funding type (fixed or variable), timing of income payments (immediate or deferred), payout options, and number of lives covered. A purchaser's credit score is not a classification factor.
2. What is the primary purpose of a suitability review before recommending an annuity?
A. To ensure the annuity earns the highest possible return
B. To confirm the product matches the client's financial needs and objectives
C. To determine whether the insurer will approve the contract
D. To guarantee that the annuity will outperform the stock market
Correct Answer: B
Rationale: Suitability requires the producer to evaluate whether the annuity aligns with the client's age, income, financial situation, risk tolerance, and intended use. The goal is to ensure the product appropriately meets the client's financial objectives.
3. How may annuities be used to help fund life insurance?
A. By converting the annuity directly into a life insurance policy
B. By using systematic withdrawals or settlement option income to pay life insurance premiums
C. By transferring the annuity death benefit to an insurance company
D. By converting the annuity into a term policy automatically
Correct Answer: B
Rationale: Income generated from an annuity—through systematic withdrawals or settlement options—can be used to pay premiums on life insurance policies. This strategy may help provide beneficiaries with a tax-free life insurance death benefit instead of taxable annuity earnings.
4. Which statement best describes how annuities may be used for retirement income?
A. They eliminate all taxes on retirement income
B. They convert accumulated funds into a stream of income that may last for life or a specified period
C. They guarantee that investment returns will exceed inflation
D. They provide only lump-sum payments at retirement
Correct Answer: B
Rationale: Annuities are commonly used to convert accumulated savings into periodic income payments. These payments may last for the lifetime of the annuitant or for a specified period, depending on the settlement option selected.
5. Which statement about corporate-owned annuities is correct?
A. Earnings grow tax deferred just like individual annuities
B. Earnings are generally taxable to the corporation in the year they are earned
C. They can only be used for structured settlements
D. They cannot be used in employee retirement plans
Correct Answer: B
Rationale: Corporate-owned annuities typically do not receive the same tax-deferred treatment as individually owned annuities. Interest and gains are generally taxable to the corporation as income in the year they are earned.