Sunday, September 30, 2007

Variable Annuities

The term annuity derives from a Latin term meaning annual and generally refers to any circumstance where principal and interest are liquidated through a series of regular payments made over a period of time. A deferred annuity is an annuity in which both the income, and any taxes due on growth inside the contract, are pushed into the future, until they are actually received by the owner.

A commercial, tax-deferred annuity is a contract between an insurance company and a contract owner. In a typical situation, the contract owner contributes funds to the annuity. The money put into the contract is then allowed to grow for a period of time. At some future date, the contract owner has the choice to: 1) Annuitize the accumulated funds paid out, generally through periodic payments made over a specified period of time, the life of an individual, or the joint lives of a couple. 2) Continue to let the money grow or 3) Take withdrawals of amounts he would like.

A variable annuity is a type of annuity in which the contract owner directs the overall investment strategy for the funds placed in the contract.

Two primary annuity types are fixed and variable annuities. Although these annuities have many features in common, the key differences between them arise from the means used to grow the funds contributed by the contract owner.

Fixed annuities: Fixed annuities are characterized by a minimum interest rate guaranteed by the issuing insurance company. Typically, a minimum annuity benefit is also guaranteed. The funds contributed to the contract by the annuity owner are placed in the insurance companys general account, and the investment risk involved rests entirely on the insurance company. With a fixed annuity, the focus is on safety of principal and stable investments returns. Variable annuities: In contrast, a variable annuity contract generally has no guarantees as to investment return or annuity benefits. The funds contributed by the contract owner are placed in special, variable annuity subaccounts. Within these subaccounts, the annuity owner may choose to invest the funds in a wide variety of investment options. Annuity benefits depend upon the investment results achieved, and the investment risk rests entirely on the contract owner. With a variable annuity, the goal is to provide benefits that keep pace with inflation.

During the accumulation phase, the contract owner contributes funds to the contract through either a single lump sum, or a series of payments. Any increase or decrease in the market price of the underlying investments is always reflected in the value of each accumulation unit.

If a contract owner decides to annuitize the contract, the accumulation units are exchanged for annuity units. The number of annuity units received will depend on the price per unit, and certain insurance company assumptions regarding income, mortality and expenses. Once determined, the number of annuity units remains constant. The amount of periodic income payable is determined by multiplying the current value of each annuity unit by the number of units. As the value of each annuity unit increases or decreases, so does the periodic income.

There are a number of key contract provisions that a buyer of a variable annuity contract should be aware of. Among these are: Guaranteed death benefit: The contract will pay the named beneficiary the greater of the investment in the contract (less any withdrawals) or the contract value on the date of death. Enhanced death benefit: Some variable annuities offer an enhanced death benefit option. This feature provides that upon the death of the annuitant, the beneficiary will receive the greater of the accounts value on the date of death, or the highest contract value ever reached during the accumulation years. The ultimate death benefit is subject to the claims paying ability of the insurer. Prospectus: Variable annuities are considered by the Securities and Exchange Commission (SEC) to be a security. The SEC requires that the purchase of a variable annuity be given a prospectus, which provides detailed information on how the annuity contract works, and the subaccounts available. The SEC also requires individuals selling variable annuities to be licensed to sell securities. Contract fees and charges: A contract may include charges for investment management, administrative and mortality risk charges to cover the insurers basic expenses, as well as the cost of the guaranteed death benefit provision.

The tax treatment of payments made from an annuity will vary, depending on where in the life cycle of the annuity the payments are made. In general, the following rules apply:

Withdrawals: Funds withdrawn from an annuity contract prior to annuitization are considered to be made first from interest or other growth. These earnings are taxable as ordinary income. If the annuity owner is under age 591/2 at the time a withdrawal is made, the earnings are also generally subject to a 10% IRS penalty. If earnings are completely withdrawn, and payments are then made from the owners initial investment, the withdrawal is treated as a tax-free recovery of capital.

Annuitization: Regular annuity payments are treated as being composed of part earnings, and part return of capital. The earnings portion is taxable as ordinary income. Once the owner has completely recovered his or her investment in the contract, all remaining payments are fully taxable as ordinary income.

Estate taxes: Any amount payable to a beneficiary under an annuity contract by reason of an owners death is includable in the owners gross estate. If an annuitant/owner receiving payments under Lie Only annuity contract dies, no further payments are due, and nothing is includable in his or her estate.

Tax-deferred annuities are primarily intended to be long-term investments. Because of this, and because of the complexity of many annuity contracts, an individual considering the purchase of a tax-deferred annuity should carefully consider all aspects before entering into the contract. The advise and counsel of appropriate tax, legal, and other advisors is highly recommended.

Mark K. Lund, CRFA, has spent almost a decade as a Wealth Manager, serving the retirement planning needs for clients in Salt Lake City, Utah. Mark is one of a very small number of retirement planners across the country trained in retirement tax strategies. Most financial professionals typically take only one aspect of your personal finances and attempt to make it grow in a very linear, single-dimensional fashion. Thats why they dont bother to correlate other items or tax issues in your total financial picture! Mark looks at all four phases of wealth accumulation to plan the most effective way to manage your wealth. To learn more about Mark, please visit http://www.stonecreekwealthadvisors.com