If you take the time to look it up, the dictionary defines an annuity as “the annual payment of an allowance of income.” Spin that into the broader world of the financial sphere, however, and you’ll arrive at something

Take that one step further into estate planning and you’ll start hearing advisors talk about annuities as a means for wealth transfer and intergenerational giving. So how did something so simple begin to sound so complicated? And what does it all mean, with tax season upon us, for your clients? Learn some of the basics (and a few of finer points) of annuities, taxation and the knowledge that can help you coach your clients through both.

Annuity primer
Perhaps the most basic way of explaining the entire family of products under the annuity heading is this: An annuity is a guaranteed stream of income. Annuities originally were designed as immediate products, meaning an investor paid a one-time premium and that benefits were scheduled to begin flowing soon thereafter, usually within one year from the initial payment of premium.

Over the years, the types and number of different annuity options have proliferated, and so has their status as they relate to taxation. At present, the benefit of annuities is that – assuming they are non-qualified (i.e., they are not IRAs) – the funds in them grow tax deferred. And they grow that way indefinitely.

So why are annuities sometimes mentioned as a poor financial planning product? According to Richard Everett, president of Everett Financial Group Inc. in Northhaven, Conn., it has to do with a misperception of fees.

Every once in awhile, something is published that says that annuities are bad for seniors or bad for young people. “When a headline says that all annuities have high fees,” Everett notes, “that’s just not accurate. Variable annuities do, but fixed annuities have no fees – you can’t group all the class together. That’s like saying all stocks are volatile – that’s just not fair.”

In fact, it is increasingly the case among senior clients that while annuities may have been initially funded to guarantee a given monthly payout during retirement, they actually become very effective as a tool to pass down wealth.

According to Barry Humphrey, LUTCF, advance market director with PinnacleUSA in Quincy, Mass., what may have been purchased for one reason turns out to work quite nicely for another.

“I think, quite frankly, most people don’t annuitize their product anyway,” Humphrey says, “because of a nest egg [that they may have] or they want to pass it along to their heirs.”

The tax man cometh
So you know that tax day is coming, but what does the taxman take away as it relates to annuities? As mentioned above, all non-qualified annuities grow tax-deferred. When those funds are accessed, they are taxed based on the scenario of the withdrawal.

If a client pulls all of his funds out in a lump sum, he will be required to pay tax on the gain at the current, ordinary rate. Should he choose to annuitize it, where the client gives up control of his money to the insurance company, and the insurance company, in turn, gives him X amount of dollars for X amount of years, tax advantages exist.

Here, payouts from annuities are subject to the exclusion ratio, an IRS regulation that, in effect, lowers the amount of tax that will come due. To quote JD Edwards’ resources on annuities: A portion of your payment will be considered a return of premium and will not be subject to ordinary income tax. The amount that is taxable will be determined at the time you elect to annuitize the policy. A calculation will be made by the insurance company to determine the “exclusion ratio,” which will determine the percentage of each payment that will be excluded from income tax.

How does it play out? Generally speaking, approximately 25 percent of the income streaming out is taxable and the rest is a return of principal. So if a client had, for example, a $100,000 contract and annuitized it at $1,000 per month, he’d only be taxed on $250 of that sum, and that at his ordinary rate.

Another innovative use of annuities is in the qualified market to store proceeds from any IRA products where (because of age limits) clients have to take distributions. In the typical IRA scenario, a client will be taxed when he has to take out funds. If, however, he transfers funds directly to an annuity and doesn’t touch any of the money, an exclusion will come in to play that allows the client to mitigate his tax burden.

No matter what tax scenario you can imagine, bear in mind that, as Everett puts it, “All annuities – from a tax point of view – are seen the same; they all structurally work the same way.” Whatever you don’t know should be run by a tax advisor or lawyer before presenting any scenarios to a client.

Death in the family
So what are the tax consequences to survivors of a decedent with an active annuity? Assuming we’re taking about non-qualified annuity, the heirs would have choices on how they take the benefits. First, they would have it re-titled to their name. Second, they could then opt to have it grow on a tax-deferred basis, have it annuitized or they could take a lump sum (in which case the taxes on the gain are due at that time at their ordinary rate).

According to Debie Knowles, vice president of marketing operations with Standard Life and Accident Insurance Co. in League City, Texas (south of Houston), having to pay that tax at an ordinary rate (for an heir) is bad estate planning. “[That heir] can lose up to half or even 70 percent of that money. If you haven’t planned, you can lose quite a bit of it.”

There are strategies to avoid that taxation, including the parents paying taxes on the annuity during their lifetime or other scenarios involving transfers to other products.

“Somebody is going to have to pay on it at some point,” Knowles says, but strategies can be employed that net the biggest bang for the buck.

For example, the parents could pay the taxes on it and move that money from an annuity into a life insurance policy and then the death benefit from that policy would go to the children. Such solutions get at a bigger benefit at the time of death and seek to avoid the big one-time tax hit.

On the flip side, if the annuity is qualified (i.e., is an IRA), and the beneficiary designation is done properly, you can stretch it out over the lifetime of the beneficiary: A spouse can continue a qualified IRA as an IRA with all the same rules and can simply step into those shoes. Once she registers that product in her name, it becomes hers and, if she’s listed as a beneficiary, she may be able to take it without paying a penalty on it. There are lots of nuances and subtleties and it’s best to consult with a specialist to work out the best possible scenario.

Risks (and rewards)
No matter what a client sets forth as a retirement objective, it’s important to keep annuities in your tool kit as something that can perform a vital role. Despite different types of annuities (fixed, indexed or variable), they all function fundamentally the same way and the type selected will ultimately be contingent on a client’s risk level.

Bear in mind that with annuities – as with any financial product – your recommendation has to be suitable for the client and, as Humphrey emphasizes, “That does not mean putting 100 percent of their funds into an annuity; there are suitability issues” that have to be considered.

“Most agents know what an annuity is,” Humphrey continues. “But many don’t know that other products exist – some are good and some are not. And, when you come to the annuitization phase, your carrier may not be the best on the market.

“The annuity is usually purchased for tax reasons,” he concludes. “You have to look at the total financial picture to see what is or what is not needed and the carrier, in particular, should be responsible to look at the suitability” of a certain product as it aligns with an investor’s objectives.