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Annuities can be an ideal vehicle for someone who suddenly receives a large sum of money — an inheritance, a lottery win, damages from a lawsuit, proceeds from selling a business, or a lump-sum distribution from a qualified pension plan. In these situations, a person may use a single premium immediate annuity to convert that lump sum into a stream of periodic income.
Because annuities are a popular vehicle for retirement income, they are frequently used to fund qualified retirement plans — plans that meet IRS guidelines and therefore receive favorable tax treatment.
A qualified plan conforms to federal tax law requirements, and the IRS treats an employer's contributions to the plan as tax-deductible business expenses. Contributions grow without being taxed during the accumulation period, and the employee is not taxed on the employer's contribution until benefits are actually received. Qualified plans must also avoid discriminating in coverage, contributions, or benefits in favor of highly compensated employees, shareholders, or company officers.
A nonqualified plan is one where contributions are not exempt from taxation. Even so, any increase in the funds during the accumulation period remains untaxed until it is actually received.
A Guaranteed Minimum Withdrawal Benefit (GMWB) is an optional feature some retirement annuities offer, allowing the annuitant to withdraw a maximum percentage of their investment each year until the original investment has been fully recovered. This feature protects the annuitant against investment losses.
Qualified retirement annuities can be individual — such as an individual retirement account (IRA) — or group, such as a tax-sheltered annuity (TSA) or a profit-sharing pension plan.
Anyone with earned income is eligible to establish an IRA (Individual Retirement Annuity or Account). An individual may contribute up to 100% of earned income, up to a specified annual limit. A married couple may together contribute double the individual limit, even if only one spouse has earned income — but each spouse must maintain a separate account, and neither account may exceed the individual contribution limit. Excess contributions to a traditional IRA are subject to a 6% penalty until the excess is withdrawn.
Earned income refers to salary, wages, and commissions — it does not include income from investments, unemployment benefits, or trust distributions.
Contributions to a traditional IRA are generally tax deductible in the year they are made. Anyone not participating in another qualified retirement plan may deduct the full contribution amount, up to the applicable limit. Someone who does participate in another qualified plan is subject to income limitation tests that determine how much, if any, of their IRA contribution is deductible. Individuals not covered by an employer-sponsored plan may deduct the full amount of their IRA contribution regardless of income level.
Whether or not the contribution itself was deductible, IRA assets always grow on a tax-deferred basis.
A 403(b) plan, or tax-sheltered annuity (TSA), is a qualified plan available to employees of certain nonprofit organizations under Section 501(c)(3) of the Internal Revenue Code, as well as to employees of public school systems.
Contributions may be made by the employer or by the employee through salary reduction, and are excluded from the employee's current taxable income. As with other qualified plans, 403(b) contributions are capped at a maximum amount that changes annually to adjust for inflation, and the same catch-up contribution provisions apply.
403(b) plans are available to employees of nonprofit organizations and public-school systems.
Beyond retirement income and estate liquidation, annuities can also be used to accumulate funds for a child's college education, providing tax-deferred savings toward future education expenses.
Under the Pension Protection Act of 2006, annuity owners are permitted to transfer funds from an annuity to pay long-term care insurance premiums on a tax-free basis. Previously, distributions from a nonqualified annuity used for this purpose were taxable; now, such distributions can be used to pay long-term care premiums and, in many cases, avoid taxation on the annuity's gains altogether. As a result, many insurers now offer hybrid annuity products with a built-in long-term care feature, providing income, long-term care coverage, or both.
While a business may use an annuity purely as an investment vehicle, annuities are more commonly used by businesses to fund employee retirement plans, whether established by a single employer or jointly with other employers or a labor union. Such a plan may cover the employees of one particular business, or it may be a multiemployer plan serving workers from a number of related or unrelated firms. These plans supplement Social Security retirement benefits once an employee retires, and the employer benefits from offering the plan through improved employee retention.
The principal use of an annuity is to provide retirement income, though it may also be used for any accumulation of cash or simply to liquidate an estate. Because annuities can serve so many different purposes, agents must always evaluate how well a recommended product fits the applicant's particular needs and resources — this is known as the suitability of a product.
The main use of annuities is to provide retirement income.
It is a producer's responsibility to ensure that annuity transactions address a consumer's needs and financial objectives. To satisfy suitability requirements, producers must make a reasonable effort to obtain relevant information from the consumer and evaluate the following factors:
Insurers are required to establish standards, procedures, and a system to supervise recommendations to consumers that result in annuity transactions. In the case of an exchange or replacement of an annuity, the exchange or replacement must be suitable, and the consumer must be informed of relevant features of the annuity, such as the potential surrender period and surrender charges, tax penalties, mortality and expense fees, potential charges for riders, and market risks.
Suitability requirements do not apply to the following transactions: