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Annuity 101

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If you're looking to secure your future beyond your working years, the government wants to help. You have many options for saving and investing your money, but when it comes to long-term planning, the IRS has special rules that let you save on a tax-deferred basis. Combine tax deferral with the long-term growth possibilities inherent in stock and bond investments and you have an ideal retirement planning vehicle . . . you have a variable annuity. Available to anyone seeking a retirement savings plan, variable annuities have many advantages:

  • Tax deferral: You pay no tax on earnings until withdrawal.
  • Potential for long-term growth of your money: You're able to invest in professionally managed securities portfolios.
  • Income for life: You can be guaranteed a retirement income you can't outlive.
  • Taxes are due upon withdrawal or distribution: A 10% federal tax penalty may apply to withdrawals before age 59-1/2.

The questions and answers in this presentation should help you understand more about the important role variable annuities can play in your retirement planning.

What is a variable annuity?

It is a contract between you (the annuity owner) and a life insurance company. In return for your payment, the insurance company agrees to provide either a regular stream of income or a lump sum payout at some future time (generally, once you retire or pass age 59 1/2). Your premiums are invested in one or more securities portfolios and fixed interest accounts, where they earn interest and/or capital appreciation. No taxes are due until these earnings are paid out. (If you make a withdrawal before age 59 1/2, you could incur a 10% tax penalty.)

How does it work?

A variable annuity has two stages: the accumulation period and the payout period. The accumulation period begins as soon as you invest. You invest with one large payment if you select a single premium annuity. Or you may make one or more payments of various amounts to a flexible premium annuity. Once you make a payment, your money begins to accumulate tax-deferred earnings. Later, your principal and interest can be paid out to you in the form of a regular income or as a lump sum.

What do I purchase with my premium?

Your premium usually purchases "accumulation units" in the insurance company's separate account, which is maintained separately from the company's regular portfolio of investments. This separate account in turn purchases shares in professionally managed securities portfolios. Each unit's value or "price" is determined by the value of the portfolio, divided by the number of units outstanding. Each unit represents a share of the total worth of the portfolio. For example, assume a $10 million portfolio has one million accumulation units: Each unit has a current value of $10. If the portfolio appreciates to $12 million, the unit value rises to $12 each. Divide your premium by the unit value at the time you invest to approximate the number of units you'll purchase.

What happens once I've purchased accumulation units?

The underlying securities have the potential to earn interest, dividends and/or capital gains, which may be reinvested to earn still more of the same. (Of course, the underlying securities can also lose value.) Tax-deferred compounding - not paying taxes until later - can allow the value of your annuity to grow considerably faster than a comparable taxable investment.

What is the difference in taxation for taxable and tax-deferred investments?

When you invest in a taxable investment such as mutual funds, stocks or some bonds, any dividends or interest you earn during the year are considered taxable income. Also, if you sell the investment or the mutual fund money manager sells an investment and gives you a distribution, you'll owe capital gains taxes. When you invest in the underlying securities of a variable annuity, growth is credited to your account but is not taxed in that year. You pay taxes only on money withdrawn. When you make a withdrawal, you'll owe income taxes at your current rate on any portion of the withdrawal that is considered growth. For tax purposes, withdrawals are always considered interest first, so unless you begin to exhaust principal, you'll owe taxes on the full amount of your withdrawal. In addition, because the IRS set up tax deferral rules in order to encourage Americans to save for retirement, if you make a withdrawal before age 59 1/2, you're likely to owe a 10% federal tax penalty on the amount withdrawn. (Only under certain IRS defined situations, such as disability, will you be exempt from this penalty.) If you purchase your annuity in a qualified plan such as an individual retirement account or Keogh account, different tax rules apply. The full amount of any withdrawal, even an amount attributed to principal, is taxable. This is because in a qualified plan, the contributions to the annuity are made on a pretax basis.

What types of securities do the portfolios contain?

The majority of variable annuities let you choose among portfolios of stocks, bonds and money market instruments. You allocate your money to purchase accumulation units in different portfolios, depending upon how aggressive or conservative you wish to be.

Who decides exactly what to invest in?

You choose the portfolios in which you will invest from among those offered. The insurance company backing the annuity develops a relationship with a professional money manager, whose experts decide which specific stocks and bonds will be a part of each portfolio. In some newer variable annuities, you can take advantage of the acumen of more than one expert money manager, allowing you even more flexibility in structuring your investment.

Why is it called a "variable" annuity?

"Variable" refers to the fact that the market value and/or income generated by the underlying securities is not fixed; your return may vary due to prevailing interest rates and other market factors. What are the important features of a variable annuity? Separate accounts: The variable portfolios in your annuity are part of a separate account, established and maintained apart from the company's general investment portfolio. The performance of your investment does not depend on the insurance company's portfolio. Only the performance of the variable portfolios you have chosen will affect your results. Diversification: Even if you invest in a single portfolio, your risk is spread among many securities, reducing the possibility of losing a substantial amount due to any one security. Switching privileges: Most variable annuities permit you to reallocate your money among the portfolios, usually without charge as long as you don't move the money too often.

What guarantees do I have?

Guaranteed death benefit: The insurance company generally guarantees that in the event of death before annuitization, your beneficiary will receive the greater of a) the entire amount of your premiums, less withdrawals, charges and fees; or b) the current contract value. Some annuities provide more generous options. Fixed interest options: Most annuities also let you allocate funds to one or more "fixed account" options in which the insurance company guarantees your interest rate. Special programs: Some annuities go even further in protecting against loss. They may provide a special program in which the insurance company guarantees a return of your premium when you place an appropriate portion of that premium in a fixed interest option. Meanwhile, the other part of your premium can be invested in variable portfolios that have the potential to provide higher returns.

Can I have access to my money before I'm 59-1/2?

Yes. Most variable annuities provide for withdrawal of a specified amount free of charge. Withdrawals in excess of the amount specified are possible but, in the early years of the contract, may trigger surrender charges. As discussed previously, if you are younger than age 59 1/2, the IRS may impose a 10% penalty tax. You may also encounter a "market value adjustment" (MVA) if you withdraw money from fixed interest options before the end of the interest rate guarantee period. An MVA ensures that you receive the market value of assets withdrawn before their maturity date and may increase or decrease the value of your account. Finally, be aware that some annuities allow you to make systematic withdrawals from your account on a regularly scheduled basis, which can help in providing you with a steady income. Systematic withdrawals are subject to the same tax rules as other withdrawals.

What does 'annuitize' mean?

Choosing to receive payments at regular intervals over time is "annuitizing". Most companies offer several annuity options, based primarily on how long you want the income to last. How is the amount of my payment/withdrawal determined if I annuitize? First, the insurance company converts your accumulation units to "annuity units", which entitle you to payouts that are partly a tax-free return of principal and partly taxable earnings. Meanwhile, the undistributed portion of your investment continues to compound, tax-deferred. The amount of each payment will depend on the annuity option selected, your age, the number of annuity units and the performance of the securities in the portfolio(s) you have selected.

Am I taxed differently on annuity payouts than on withdrawals?

Yes. Once you have annuitized, each payment is structured as a partial return of principal and part interest. Only the interest portion of the payment is taxable. In addition, you can annuitize over your lifetime before age 59-1/2 and your regular payments will not be subject to a tax penalty. You should consult your financial advisor before deciding to annuitize.

What happens if the money is paid out to my beneficiary?

A variable annuity provides a death benefit that avoids probate and is paid directly to your beneficiary, thereby avoiding costs and delays. The guaranteed minimum death benefit is generally the greater of either the total amount of your premiums, less withdrawals, or the current value of your investments. Some companies are more generous in their contracts, allowing for a guaranteed increase in the premium amount or a step-up in the guaranteed death benefit value at certain contract years. Read the literature and contract language for the variable annuity you choose to find out exactly what type of death benefit the company offers.

How do variable annuities compare to IRAs?

Annuities and IRAs both provide tax-deferred growth, but there are differences. Anyone can invest in an annuity, in an unlimited amount. With an IRA, only those with earned income can invest, and contributions are limited. Also, an annuity can guarantee you an income for life; most IRAs cannot. In addition, the IRS says you must begin taking distributions from your IRA at age 70 1/2; most annuities do not require you to begin taking regular payments before age 85. For information on the tax deductibility aspects of IRAs, consult your tax advisor. If you qualify for an IRA deduction, consider funding your IRA with a variable annuity, which will provide the benefits of both. If the annuity funds an IRA, IRA rules apply.

What should I consider when selecting a variable annuity?

The historical performance of the underlying portfolios, while not a guarantee of future results, should tell how well the annuity's investment manager has done in both positive and adverse markets. This is more important to the growth potential of your investment than any short-term figures. Fees and charges should be carefully reviewed. Some annuities have a surrender charge that declines over a number of years. Others maintain a high charge for a stated period of time. Be sure to look at annual administration fees and asset charges, and find out if the insurance company charges for transfers among the portfolios. It's important that you understand the fees before you purchase your annuity. The soundness of the insurance company is important. Find out whether the company is rated "Excellent" (A) or higher by independent industry analyst A.M. Best Company.

How can I find out whether an annuity is right for me?

You can give us a call toll free at 800-944-7730 or send us Email at We are here to review your circumstances and help you determine what annuity is best for you. Then consider the annuity's unique advantages - no maximum investment, retirement income you cannot outlive, death benefit, professional management and diversification.

To contact us:
Tactical Wealth Advisors, LLP
8226 Village Harbor Drive
Cornelius, NC 28031
Phone: 800-944-7730


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