Annuities and IRAs

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Annuities and IRAs

• Lecture 18

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Annuities

• Annuity a periodic payment that continues for a
  fixed period or for the duration of a designated
  life or lives
• Purpose to provide lifetime income that cannot
  be outlived
• Advantage Investment income accumulates on
  tax-deferred basis taxed when paid out

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Tax-deferred Compounding Builds Wealth Faster
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Annuities

• Types
• Fixed Annuity
• Variable Annuity
• Equity Indexed

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Fixed Annuity

• Pays periodic income payments that are guaranteed
  and fixed in amount
• Two rates
• Guaranteed rate minimum rate credited
• Current rate based on market conditions
• Accumulation period
• Liquidation Period

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Illustration of the Accumulation Period and the
Liquidation Period
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Fixed Annuity, cont.

• Immediate annuity first payment begins one
  interval from date of purchase
• Deferred annuity income payments begin at
  future date
• Annuitant dies death benefit paid out typically
  equal to sum of premiums or cash value, whichever
  is higher
• Single-premium deferred annuity
• Flexible premium annuity

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Annuity Settlement Options

• Cash option lump sum or in installments
• Life annuity (no refund) provides life income
  while annuitant alive payments end at death
• Highest periodic income
• Suitable for income needs w/ no dependents
• Life annuity w/ guaranteed payments
• Usually 5, 10, 15 or 20 years

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Annuity Settlement Options

• Installment refund pays life income to
  annuitant
• If annuitant dies, payments continue to a
  designated beneficiary until they equal the
  purchase price
• Joint and survivor pays benefits based on the
  lives of two or more annuitants
• Income paid until last survivor dies

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Variable Annuity

• Pays lifetime income, but income payments vary
  depending on stock prices
• Considered an inflation hedge
• Premiums invested in portfolio of stocks and
  other investments
• Premiums purchase accumulation units
• More or less units depending on price

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Variable Annuity

• At retirement, accumulation units converted into
  annuity units
• Number of annuity units remains constant, but the
  value of each unit changes with stock prices
• Ex 10,000 accumulation units converted into 100
  annuity units (monthly)
• If value of unit 10, receive 1,000 if value
  falls to 9.90, receive 990

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Variable Annuities, cont.

• Typically provide a guaranteed death benefit
• Paid higher of
• Amount invested in contract
• Cash value of account
• Some pay enhanced benefits rising floor or
  stepped up benefits

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Variable Annuities, cont.

• Fees and expenses
• Investment management charge
• Administrative charge
• Management and expense risk (ME) charge
  mortality risk associated with guaranteed death
  benefit
• Surrender charge
• Front and/or back-end loads
• Can easily exceed 2 of assets

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Five Low-Cost Variable Annuities
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Annuity Funds Performance and Fees
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Equity-Indexed Annuity

• Fixed, deferred annuity that
• Allows participation in growth of stock market
• Provides downside protection against loss of
  principal if held to term
• Participation rate percentage of growth in
  stock index credited to account (25 to 90)
• Maximum percentage of gain
• Guaranteed minimum value (usually 90 of premium
  accumulated at 3)

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Taxation of Annuities

• Do not qualify for retirement plan benefits
• Premiums not tax-deductible and are paid with
  after-tax dollars
• Taxable portion taxed as ordinary income
• 10 penalty for distribution prior to 59 ½
• Exclusion ratio investment in contract/
  expected return (expected total payments)
• Net cost is recovered using exclusion ratio
  income tax free

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Individual Retirement Accounts

• Traditional IRAs
• Roth IRAs
• Education IRAs

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Traditional IRA

• Can deduct part or all of contribution
• Investment income accumulates income-tax free on
  tax-deferred basis
• Distributions taxed as ordinary income
• Nonworking spouse can increase contribution to
  4,000 (spousal IRA)

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Traditional IRA - eligibility

• Must have taxable compensation
• Must be under age 70 ½
• Contribution limits 2,000, or 100 of taxable
  income, whichever is less
• Contributions deductible if
• Not a participant in employee sponsored plan
• Is a participant, but modified AGI below certain
  thresholds also, spouse can make deductible
  contrib.
• Can still contribute in non-deductible way (Roth)

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2001 Tax act

• Contribution limits changed
• 2001 2,000
• 2002 2004 3,000
• 2005 2007 4,000
• 2008 after 5,000
• Catch-up IRA contributions
• Age 50 and older
• Increases from 2000 to 6000 in 2008

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Withdrawal

• Withdrawals prior to age 59 ½ are premature
  distributions 10 tax penalty
• Exceptions
• Death or disability
• Annuitized
• Return of non-deductible contributions
• Certain medical expenses or medical insurance
• Qualified higher education expenses
• Qualified expenses for 1st time home-buyer (to
  10,000)

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Taxation of traditional IRA

• Distributions are taxed as ordinary income
• Except nondeductible contributions, which are
  income-tax free
• 10 penalty for early withdrawal
• IRA rollover tax-free distribution from one
  retirement plan directly into another (note if
  you receive funds, 20 is withheld for federal
  income taxes)

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How Long Will Your Retirement Assets Last?
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Roth IRA

• Maximum contribution 2,000 (see 2001 tax act
  slide however)
• Contributions are NOT tax deductible
• Income accumulates income-tax free
• Distributions are not taxable if certain
  requirements are met

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Roth IRA

• Qualified distributions made after a five year
  period after first contribution and
• Age 59 ½ or older
• Disabled
• Paid to beneficiary or estate after death
• First-time homebuyer (max of 10,000)
• Contributions can be made after 70 ½, and no
  minimum distribution rules
• Conversion should do calculation

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Education IRA

• Non-deductible contributions of 500 annually for
  qualified higher education expenses
• Investment income accumulates income-tax free
• Distributions not taxable if for qualified higher
  education expenses (tuition, room, board, books,
  fees, supplies)
• AGI limits apply

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2001 Tax Act

• Now includes elementary and secondary school
  expenses, including
• Tuition at private schools
• Computer expenses
• Contribution limits expanded increases to 2000
  in 2002
• Income eligibility limits raised
• Phaseout 190,000 220,000 married couples
• 95,000 to 110,000 single

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Comparison of IRA Accounts
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Comparison of IRA Accounts