RMI Exam 3 Chapter 10 Notes Annuities IRAs Individual Annuities o an annuity is a periodic payment that continues for a fixed period or for the duration of a designated life or lives The person who receives the payments is the annuitant An annuity provides protection against the risk of excessive longevity o Fundamental purpose to provide a lifetime income that cannot be outlived The major types of annuities sold today include Fixed annuity pays periodic income payments that are guaranteed and fixed in amount o During the accumulation period prior to retirement premiums are o The guaranteed rate is the minimum interest rate that will be credited credited with interest to the fixed annuity o The current rate is based on current market conditions and is guaranteed only for a limited period o A bonus annuity pays a higher interest rate initially o The liquidation period is the period in which funds are paid out or o Payouts are a fixed amount o Downside of fixed annuity Little or no protection against inflation o Fixed annuity income payments can be paid immediately or at a future annuitized date An immediate annuity is one where the first payment is due one payment interval from the date of purchase A deferred annuity provides income payments at some future date A deferred annuity purchase with a lump sum is called a single premium deferred annuity A flexible premium annuity allows the owner to vary the premium payments o The fixed annuity owner has a choice of annuity settlement offers Most annuities are not annuitized Under the cash option the funds can be withdrawn in a lump sum or in installments A life annuity no refund option provides a life income to the annuitant only while the annuitant remains alive A life annuity with guaranteed payments pays a life income to the annuitant with a certain number of guaranteed payments o Types of Annuities An installment refund option pays a life income to the annuitant after the annuitant s death payments continue to a beneficiary until they equal the purchase price A cash refund option is similar but pays the beneficiary a lump sum A joint and survivor annuity pays benefits based on the lives of two or more annuitants The annuity income is paid until the last annuitant dies An inflation indexed annuity option provides periodic payments that are adjusted for inflation Variable annuity pays a lifetime income but the income payments vary depending on common stock prices o The purpose is to provide an inflation hedge by maintaining the real purchasing power of the payments o Premiums are used to purchase accumulation units during the period prior to retirement o At retirement the accumulation units are converted into annuity units o What is an Annuity Unit It is an accumulation unit a sub account of the retiree s total accumulated annuity These units represent a fixed share of ownership of the insurer s accounts portfolio When an insured person changes from accumulating wealth to spending it they draw on their saving o Variable annuities contain the fees and expenses that can be high Investment management charge Administrative charge Mortality and expense risk charge Surrender charge Equity indexed annuity A guaranteed death benefit protects the principal against loss due to market declines Typically if the annuitant dies before retirement the amount paid to the beneficiary will be the higher of two amounts the amount invested in the contract or the value of the account at the time of death Longevity Insurance a generic name for a single premium deferred annuity that begins paying benefits only at an advanced age typically age 85 o They are low cost annuities because there are no cash values or death benefits in the policy o Advantages Monthly benefits kick in when other assets may be diminished Low cost Can be purchased with an inflation hedge o Disadvantages Heirs lose money if the person dies during the deferral period i e no death benefit Once purchased funds are locked up so no access to emergency funds Taxation of Individual Annuities An individual annuity purchased from a commercial insurer is a nonqualified annuity o It does not meet IRS code requirements o It does not qualify for most income tax benefits o Premiums are not income tax deductible o Investment income is tax deferred o The net cost of annuity payments is recovered income tax free over the payment period but the amount that exceeds the net cost is taxable as ordinary income o An exclusion ratio is used to determine the taxable and nontaxable portions of the payments Exclusion Ratio Investment in the contract Expected return o Annuities can be attractive to investors who have made maximum contributions to other tax advantaged plans Individual Retirement Accounts IRA allows workers with taxable compensation to make annual contributions to a retirement plan up to certain limits and receive favorable income tax treatment o Two basic types of IRAs are Traditional IRA allows workers to take a tax deduction for part or all of their IRA contributions The investment income accumulates income tax free on a tax deferred basis Distributions are taxed as ordinary income The participant must have earned income during the year and must be under age 70 For 2016 the maximum annual contribution is 5 500 or 100 percent of earned compensation whichever is less For those over 50 maximum contribution is 6 500 A full deduction for IRA contributions is allowed under certain circumstances The full IRA tax deduction is gradually phased out as a person s modified gross income increases Taxpayers with incomes that exceed the phase out limits can contribute to a nondeductible IRA A spousal IRA allows a spouse who is not in the paid labor force or a low earning spouse to make a fully deductible contribution to a traditional IRA Distributions from a traditional IRA before age 59 are considered an early withdrawal and subject to a 10 tax penalty unless certain conditions apply e g death or disability Distributions from traditional IRAs are treated as ordinary income o Any nondeductible contributions are received income tax free o A formula is used to compute the taxable and nontaxable portions of o For 2009 the required minimum distribution rules were temporarily each distribution waived Traditional IRAs can be established at a bank mutual fund stock brokerage firm or insurer The IRA can be set up as either o An individual retirement account o An individual retirement annuity IRA contributions can be
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