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Now's the time to learn the facts about annuities

By GREGORY G. GAY
© St. Petersburg Times
published May 28, 2002

Many times a person requesting an estate plan will own one or more commercial annuity contracts purchased from insurance companies. These annuities normally permit the owner to name a beneficiary to receive the unpaid annuity payments should the owner die before his entire investment is returned. If the owner of the annuity has named a beneficiary, these proceeds will be distributed at death directly to that person.

Therefore, the amount to be received by the beneficiaries of the annuities must be considered when determining who will be the beneficiaries of the other assets being distributed through the will or a revocable trust. An exception to this rule occurs when the owner has purchased an immediate annuity which is payable only during her lifetime.

An annuity is an agreement by the insurance company to disburse to a person either monthly, quarterly or annual payments during the term of the agreement. These payments include a return of a portion of the premium initially deposited with the insurance company, together with earnings on the amount deposited. The person designated to receive these payments is known as the annuitant.

A negative feature of annuities is that there is normally a penalty for early withdrawal or termination. This penalty normally begins at 7 percent of the deposit and decreases one percent each year over seven years. In addition, a person under age 59 1/2 may be subject to an additional penalty imposed by the Internal Revenue Service for early withdrawal, amounting to 10 percent of the amount withdrawn.

All commercial annuity contracts issued in Florida are required to have an unconditional refund period. This is frequently called the "free look period." The Florida statutes mandate a minimum period of at least 10 days for an unconditional refund, starting from the date of delivery of the annuity contract. Each annuity contract has the free look period shown in the contract, and it is usually on the first page of the contract. This free look period may last longer, depending on the insurance company.

A fixed annuity represents an agreement to pay a specified amount over the term of the contract. Such an agreement might be to pay $300 a month for life. By contrast, a variable annuity is an agreement that assures periodic payments. However, the amount of each payment will vary based on the performance of the investment fund in which the investor's deposit is placed.

Annuity payments can begin immediately, or they can be deferred until a future date. An immediate annuity will begin within one year after the initial premium is paid. With a deferred annuity, there will be a period of time during which the amount invested increases due to interest and capital gains earned on the premiums invested.

When the payments begin under a deferred annuity, they will include a portion of the amount invested together with interest and capital gains earned during the accumulation period. A major benefit of a deferred annuity is that the income tax owed on the earnings during the accumulation period is deferred until the payments are received by the annuitant.

Another advantage of a deferred variable annuity is that the owner can select the investments made with the premiums paid in. However, investment selection subjects the annuity to a market risk that might have an adverse impact on the payments the annuitant ultimately receives. Good investments will cause the payments to go up, and a bad investment experience will cause them to go down.

It is important to understand that the portion of an annuity payment attributable to earnings is taxed as ordinary income, even though a portion of the earnings may be capital gains. The undistributed value of an annuity on the owner's date of death, including the interest and capital gains, is used to determine the value of the owner's gross estate for federal estate tax purposes. However, unlike mutual funds and stocks, there is no stepup in the basis of a deferred variable annuity.

Here is an example of how an annuity performs during the lifetime of the recipient. A person purchases an annuity contract for $50,000; it provides he will receive monthly payments for life. The person's life expectancy is determined by mortality tables. The number of months the person is projected to live is then multiplied by the monthly benefit.

If this calculation determines that this person is expected to receive $62,500, over his or her life expectancy, the exclusion ratio for income tax purposes for this annuity will be $50,000/$62,500, or 80 percent. If the person purchasing the annuity receives $500 per month from this investment, $400 per month is excluded from gross income and $100 is taxable. Of the $6,000 payable each year, only $1,200 is included in gross income until the $62,500 is paid. Once this amount has been received, the annuitant will have received his or her $50,000 investment back, and the total payments received thereafter will be included as income.

Prior to Aug. 13, 1982, withdrawals from annuity contracts were treated by the Internal Revenue Service on a "first in-first out" basis. This means that partial withdrawals were considered to be first taken from the initial investment and then from accumulated income. Thus, amounts withdrawn up to the value of the initial investment are income tax free.

It is also important to understand that if a person initially purchased an annuity, before Aug. 13, 1982, and subsequently exchanged this annuity for another annuity under the tax-free exchange exception described in the following paragraph, the first in-first out provisions are grandfathered into the new annuity. Thus, the amounts equal to the initial investment can be withdrawn income tax free, as if the new annuity were purchased before Aug. 13, 1982, and the withdrawal is made before the annuity starting date.

* * *

The Internal Revenue Code permits a tax-free exchange of annuity contracts if the annuitant is the same under both contracts. If a person holds a deferred annuity with substantial accumulated interest and/or capital gains, she can purchase a new annuity by rolling over the value of the old annuity into the new annuity without paying income taxes on the accumulated income or capital gains.

The new annuity is funded with the full value of the old annuity, and no taxes are due. However, the seller receives a full commission for the new annuity, and the customer is subject to a new penalty period. Unless the customer holds the new annuity until the end of the new penalty, he may not be better off with the new annuity.

Another benefit of the deferred fixed annuity is that the premiums deposited and the accrued interest are not subject to attachment for creditor claims if the owner of the annuity is a Florida resident.

If the owner of an annuity dies before all of the deposit and the earnings have been distributed and the surviving spouse is the beneficiary of the annuity, the surviving spouse will be considered the contract holder. This will make it possible for the surviving spouse to continue the deferral of the income tax on the accrued and future income under the annuity contract until he requests payments.

If the owner of the annuity dies before the annuity starting date and the spouse is not named as the beneficiary or has predeceased the owner, the deceased owner's entire interest in the annuity must normally be distributed to the named beneficiary within five years of death.

If the owner of the annuity dies without a surviving spouse on or after the annuity starting date and before the entire interest in the contract has been distributed, the remaining balance must be distributed to the named beneficiary at least as rapidly as under the method being used at the date of death. However, if the owner of the annuity has named a designated beneficiary, the remaining proceeds may be distributed over a period not exceeding the life expectancy of the designated beneficiary, provided the distributions begin not later than one year after the date of the owner's death.

The estate and income tax effects of annuities are significant. A person intending to purchase an annuity should first seek the advice of a certified public accountant or a tax attorney.

Frank J. Rief of the Tampa law firm of Rief & Straske and A. Edward Bound of Clearwater assisted with this article.

Gregory G. Gay is a lawyer who specializes in elder law in Pasco and Hernando counties. Write him in care of Seniority, St. Petersburg Times, P.O. Box 1121, St. Petersburg, FL 33731.

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