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Chapter 13

The document provides an overview of individual annuities and individual retirement accounts (IRAs), detailing types of annuities such as fixed, variable, and equity-indexed, as well as their taxation and benefits. It explains the purpose of annuities in providing lifetime income and the different options available for payouts. Additionally, it discusses traditional and Roth IRAs, their tax implications, and the importance of managing withdrawal rates to ensure adequate retirement funding.

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0% found this document useful (0 votes)

12 views27 pages

Chapter 13

Uploaded by

mohdaizad115

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Annuities

and Individual
Retirement
Accounts
Agenda

• Individual Annuities
• Types of Annuities
• Longevity Insurance
• Taxation of Individual Annuities
• Individual Retirement Accounts
• Adequacy of IRA Funds

Copyright ©2014 Pearson Education, Inc. All rights reserved. 14-2

Individual Annuities

• 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

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Individual Annuities

• The fundamental purpose of an annuity is to

provide a lifetime income that cannot be
outlived
• The major types of annuities sold today
include:
– Fixed annuity
– Variable annuity
– Equity-indexed annuity

Copyright ©2014 Pearson Education, Inc. All rights reserved. 14-4

Types of Annuities

• A fixed annuity pays periodic income

payments that are guaranteed and fixed in
amount
– During the accumulation period prior to
retirement, premiums are credited with interest
– The guaranteed rate is the minimum interest
rate that will be credited to the fixed annuity
– The current rate is based on current market
conditions, and is guaranteed only for a limited
period
– A bonus annuity pays a higher interest rate
initially
– The liquidation period is the period in which
funds are paid out, or annuitized

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Types of Annuities

• Fixed annuity income payments can be paid

immediately, or at a future 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

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Types of Annuities

• 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

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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

Copyright ©2014 Pearson Education, Inc. All rights reserved. 14-8

Types of Annuities

• A variable annuity pays a lifetime income,

but the income payments vary depending
on common stock prices
– The purpose is to provide an inflation hedge by
maintaining the real purchasing power of the
payments
– Premiums are used to purchase accumulation
units during the period prior to retirement
– At retirement, the accumulation units are
converted into annuity units

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Exhibit 14.1 Examples of Monthly Income Annuity
Payments from an Immediate Annuity, $250,000
Purchase Price, Male, Age 67

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Types of Annuities

• 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

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Types of Annuities

• Some variable annuities pay enhanced

death benefits
– Some contracts guarantee the principal
– Some contracts periodically adjust the value of
the account to lock in investment gains through
a rising-floor death benefit, a stepped-up benefit,
or an enhanced earning benefit

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Types of Annuities

• Variable annuities contain the following fees

and expenses:
– Investment management charge
– Administrative charge
– Mortality and expense risk charge
– Surrender charge
• Total fees and expenses in most variable
annuities are high

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Types of Annuities

• An equity-indexed annuity is a fixed, deferred

annuity that allows the owner to participate in the
growth of the stock market and provides downside
protection against the loss of principal and prior
interest earnings if the annuity is held to term
• The participation rate is the percent of increase in
the stock index that is credited to the contract
• Insurers use different indexing methods to credit
excess interest to the annuity
• Some have a guaranteed minimum value at the
end of the index period

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Longevity Insurance

• Longevity insurance is a generic name for a

single-premium deferred annuity that begins
paying benefits only at an advanced age,
typically age 85
• They are low-cost annuities because there
are no cash values or death benefits in the
policy
• Once purchased, the funds cannot be
accessed

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Taxation of Individual Annuities

• An individual annuity purchased from a

commercial insurer is a nonqualified annuity
– It does not meet IRS code requirements
– It does not qualify for most income tax benefits
– Premiums are not income-tax deductible
– Investment income is tax deferred
– 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

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Taxation of Individual Annuities

• An exclusion ratio is used to determine the taxable

and nontaxable portions of the payments

Investment in the contract

Exclusion ratio 
Expected return
• Annuities can be attractive to investors who have
made maximum contributions to other tax-
advantaged plans

Taxation of Individual Annuities

• Example:
– Ben, age 65, purchased an immediate annuity
for $108,000 that pays a lifetime monthly
income of $1000.
– Based on the IRS actuarial table, he has a life
expectance of 20 years
– Expected return is 20 x 12 x $1000 = $240,000
– The exclusion ratio = $108,000/$240,000 = .45
– Each year, he receives $5400 tax free and
$6,600 which is taxable.