ANNUITIES: World serious movement of money taking place

June 27, 2023

The first fixed annuity was offered in the U.S. in 1759 to Pennsylvanian Presbyterian ministers and their families. At the time, annuities were vehicles of the wealthy and were slow to grow into the massive market they now represent.Benjamin Franklin-author, statesman, inventor established early annuity payments. Franklin was ahead of his time with the idea of deferred income payments.

Summary Points:
  • Annuity sales hit $310.6 billion in 2022, surpassing the prior annual record set in 2008 by 17%, according to LIMRA data.
  • Consumers were confronted with a confluence of factors: Stocks and bonds faltered, there was a lingering fear of recession and the Federal Reserve raised interest rates aggressively, boosting annuity payouts.
  • Significant amounts of money from bank CD’s have lead the way.
  • Annuities aren’t right for everyone. Some advisors generally recommend using certain types to provide a guaranteed income for necessities in old age like housing and utility costs.

When In Rome: The concept of annuities can be traced back to ancient Rome, where they were used as a form of insurance for government employees. In those early days, annuities were a simple concept: the government would pay an individual a fixed amount of money in exchange for a lump sum payment.

So why do some famous media “financial experts” deny the value of even thinking about annuities?  Have they ever had one for their plan? Do they realize annuities have changed since the late 1990’s, with all eyes on consumers and transparency?  And, despite all of this negativity they continue to set records for amounts of money moving into them since 2020.

One of the biggest benefits of annuities is their ability to grow on a tax-deferred basis. This includes dividends, interest and capital gains, all of which may be fully reinvested while they remain in the annuity.

Your investment grows without being reduced by tax payments, but that doesn’t mean annuities are a way to avoid taxes completely. Annuities are subject to taxation, and how they are taxed depends on various factors. The tax treatment of an annuity is determined by the type of annuity, the source of funds — meaning whether it is held in a qualified plan, like an IRA or 401k or 403b. Or, non-qualified plan, one where you paid your taxes pre-contribution.

What’s Your Life Expectancy? This is a factor not many are told about, it’s the grease that turns the wheels of the annuity engine. Here’s why – If an annuitant lives longer than his or her actuarial life expectancy, any annuity payments received after that age are fully taxable. That’s because the exclusion ratio is calculated to spread principal withdrawals over the annuitant’s life expectancy. Once all the principal has been accounted for, any remaining income payments or withdrawals are considered to be from earnings.

Simple Example:
  • Your life expectancy is 10 years at retirement
  • You have an annuity purchased for $40,000 with after-tax money.
  • Annual payments of $4,000 — 10% of your original investment — is non-taxable.
  • You live longer than 10 years.
  • The money you receive beyond that 10-year life expectancy will be taxed as income.

If you withdraw money from your annuity before you turn 59 ½, you may owe a 10% penalty on the taxable portion of the withdrawal. After that age, taking your withdrawal as a lump sum rather than an income stream will trigger the tax on your earnings. You’ll have to pay income taxes that year on the entire taxable portion of the funds. If it’s a qualified annuity (IRA), you will pay taxes on the full withdrawal amount. If it is non-qualified, you will pay income taxes on the earnings only.

Last-In-First-Out Tax Rules:

Non-qualified annuity withdrawals use last-in-first-out (LIFO) tax rules, which dictate that earnings are taxed first. Consequently, tax liability tends to be higher in the early years of annuity ownership. Once the amount withdrawn exceeds the amount of earnings, subsequent withdrawal amounts are considered a tax-exempt return on your principal.

Simple Example:
  • You invested $100,000 in an annuity that grew to $150,000, your gains would be $50,000.
  • If you then began making withdrawals from that annuity after age 59 ½, all withdrawn funds up to $50,000 would be subject to income tax.
  • Since it would be considered a return on your principal, you wouldn’t have to pay taxes on any amount withdrawn after that $50,000.

Roth IRA annuities are funded with after-tax dollars, so the withdrawals are not usually subject to income tax.

  1. See a qualified tax accountant for specifics as to how this relates to your situations.
  2. Then talk to a insurance or financial advisor who understands and actually has ongoing case work with insurance carriers and clients involving annuities.
  3. Ask your advisor for the financials from the insurance carrier as it pertains to the annuity you are considering (are they part of a Private Equity Firm? Where are they investing company risk-pool assets? ).
  4. Fees, fees, fees. All annuities have them, typically starting with a decreasing Surrender Charge Schedule (possibly over 3 to 15 years). Also, annual investment fees and optional rider fees.
  5. Bonuses – Yes, some annuities offer an upfront bonus on your money (possibly 3-9%), tied to a longer Surrender Charge. Not necessarily ‘bad’, or, ‘tricky’. You just need to understand the ground-rules on this option.
  6. Don’t be afraid to ask about the advisor/agent annuity commissions for each annuity recommended.
  7. Every year, the IRS updates Publication 575 to offer guidance on the taxation of distributions from pensions and annuities. The detailed document also explains how to report that income on your tax return. Other topics covered by Publication 575 include information on rolling over certain distributions from one retirement plan to another, how to report disability payments, how to report railroad retirement benefits, and how to determine which part of an annuity payment is tax-free. You can find Publication 575 on the IRS website.
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