Tax deferred annuity
Annuities are basically insurance contracts wrapped up in a tax-deferred package. There are two common types, the fixed annuity and the variable annuity. The fixed annuity pays a fixed rate of return for a specified period of time. It is like a certificate of deposit. The variable annuity pays a variable rate of return depending on the fund investment. It is like a mutual fund. Many variable annuities permit the owner to allocate assets among different portfolio funds, such as a bond fund, a stock growth fund, and a money market fund. The owner may switch money among the portfolios within the annuity.
Unlike an IRA, there are no limits on the amount that a person can invest in an annuity. Contributions to an annuity are not tax-deductible.
The investment portion of the variable annuity is wrapped up in an insurance policy. The insurance element typically guarantees that if the owner dies, the death beneficiaries will receive back at least the owners initial investment. Thus, if a person invested $500,000 in a variable annuity and then died after the stock market crashed, the beneficiaries would receive at least $500,000. Because of the insurance wrapper, the investment earnings in the account are not taxed until the money is withdrawn.
Most insurance companies charge an annual fee of from 1 to 2 percent per year of the account value to cover the mortality charges and the insurance company expenses. These charges reduce the overall return under a variable annuity or the fixed amount payable under a fixed annuity. Normally, there are no up-front sales fees or commissions. But there are surrender fees or early withdrawal fees. The fees typically range from 6 to 7 percent in the first year, declining one percentage points per year thereafter. Some companies market annuity contracts without the early surrender fee. The trade-off is that the annuity pays a lower rate of return or has other features that offset the advantage of no surrender fee. One such feature is a deferred sales charge, such as 7.5 percent, which is recovered over a period of years regardless of when the annuity is paid.
Some insurance companies offer bonus yields or enhanced rates. These are above-market interest rates that are guaranteed for a limited period of time, such as the first year. The insurance company makes up the shortfall by paying lower yields after the guaranteed period, restricting how the money can be withdrawn upon retirement, or charging early surrender fees and other fees that offset the advantage of the bonus yields.
After the Taxpayer Relief Act of 1987, variable annuities are no longer an attractive investment. Gains from investments in variable annuities are taxed at the ordinary income tax rates upon distribution, plus there is an additional 10 percent penalty for distributions prior to age 59%.On the other hand, investments in a stock index fund or any stock mutual fund with a relatively low portfolio turnover allow capital gains to build up inside the fund on a tax-deferred basis. Unrealized capital gains are then taxed at a maximum 20 percent rate upon distribution if the investments have been held for at least one year. The large difference between the 20 percent capital gains tax rate and the maximum 39.6 ordinary income tax rate makes it difficult to justify variable annuities for wealthy tax payers. In addition, the stock index funds often carry a low annual expense charge. The variable annuities normally have high annual insurance charges.
Variable annuities are still marketed for the death benefit protection. That annuity feature ensures that the holders original investment will pass on to heirs. However, death benefits are rarely paid. The holder must die within a short period of time after a stock market crash before the death benefits are triggered. The death benefits normally expire at older ages.
There is no tax prior to distribution on interest, dividends, and other earnings received under the annuity contract. A tax payer can shift from one investment to another within the annuity plan without taxation on the capital gains or other investment earnings. However, there is immediate tax on earnings if the annuity contract is owned by a corporation or other non-natural person.
State and loan government plans must be funded, with all amounts set aside in a trust, custodial account, or annuity contract. The assets in the trust may not be subject to the claims of the employers creditors. The trust provides that all deferred amounts are held for the exclusive benefits of participants and their beneficiaries.
All deferred compensation must be transferred to the trust within an administratively feasible time period. To comply with this requirement, the employer may transfer the deferred compensation to the trust, or a subaccount maintained by the plan trustee in the name of the participant, no later than 15 business days after the end of the month when the compensation would otherwise have been paid to the participant.
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