1 Chapter 19 Retirement Products: Annuities and Individual Retirement Accounts Overview Thus far we have examined life insurance in great detail. Life insurance companies also market a product that addresses another important personal risk. That personal risk is the risk of outliving the income and assets that you have accumulated. The product that addresses this personal risk is called a life annuity. Life annuities provide periodic income to an individual for as long as he or she is living. These products help many retirees to achieve economic security. In addition to annuities, individuals have another retirement savings vehicle available to them. An individual may establish a tax-advantaged savings plan called an individual retirement account (IRA). In this chapter we will examine the characteristics of individual annuities and IRAs (traditional and Roth). Group retirement plans and retirement plans for the self-employed are discussed in Chapter 22. Learning Objectives After studying this chapter, you should be able to: Show how an annuity differs from life insurance. Describe the basic characteristics of a fixed annuity and a variable annuity. Explain the major characteristics of an equity-indexed annuity. Describe the basic characteristics of a traditional tax-deductible individual retirement account (IRA). Explain the basic characteristics of a Roth IRA. Explain the income tax treatment of a traditional IRA and a Roth IRA. Define the following: Accumulation period Accumulation unit Annuitant Annuity Annuity settlement options Annuity unit Cash refund annuity Deferred annuity Equity-indexed annuity Exclusion ratio Fixed annuity Flexible-premium annuity Immediate annuity Individual retirement account (IRA) Inflation-indexed annuity option Installment refund annuity IRA rollover account Joint-and-survivor annuity option Life annuity (no refund) Life annuity with guaranteed payments Liquidation period Nondeductible IRA Roth IRA Single-premium deferred annuity Spousal IRA Traditional IRA Variable annuity 2011 Pearson Education, Inc.
2 Outline I. Individual Annuities II. Types of Annuities A. Fixed Annuity 1. Payment of Benefits 2. Annuity Settlement Options B. Variable Annuity 1. Basic Characteristics 2. Guaranteed Death Benefit 3. Fees and Expenses C. Equity-Indexed Annuity 1. Participation Rate 2. Maximum Cap Rate or Cap 3. Indexing Method 4. Guaranteed Minimum Value III. Taxation of Individual Annuities IV. Individual Retirement Accounts A. Traditional IRA 1. Eligibility Requirements 2. Annual Contribution Limits 3. Income Tax Deduction of Traditional IRA Contributions 4. Spousal IRA 5. Tax Penalty for Early Withdrawal 6. Taxation of Distributions 7. Establishing a Traditional IRA 8. IRA Investments 9. IRA Rollover Account B. Roth IRA 1. Income Limits 2. Conversion to a Roth IRA V. Adequacy of IRA Funds
3 Chapter 19 Retirement Products: Annuities and Individual Retirement Accounts 443 Short Answer Questions 1. Explain the annuity principle. Why is it said that annuities are the opposite of life insurance? 2. Explain the elements that comprise life annuity payments. 3. Differentiate between the accumulation period and the liquidation period of a fixed annuity.
4 444 Rejda Principles of Risk Management and Insurance, Eleventh Edition 4. Explain the life annuity (no refund), life annuity with guaranteed payments, and installment refund settlement options. 5. Discuss the mechanics of a variable annuity. 6. Explain why an equity-indexed annuity is said to have characteristics of both a fixed annuity and a variable annuity.
5 Chapter 19 Retirement Products: Annuities and Individual Retirement Accounts Explain the tax treatment of the periodic annuity payments that a retiree receives from an individual annuity. 8. Are traditional IRA contributions fully income-tax deductible, partially deductible, or not deductible? Explain your answer. 9. Under what circumstances can withdrawals be made from a traditional IRA before age 59.5 without incurring the early withdrawal penalty tax?
6 446 Rejda Principles of Risk Management and Insurance, Eleventh Edition 10. How does a Roth IRA differ from a traditional IRA with respect to (a) tax deductibility of contributions? (b) tax treatment of qualified distribution? Multiple Choice Questions Circle the letter that corresponds to the BEST answer. 1. Which of the following statements is (are) true with respect to annuities? I. Annuities pool the risk of premature death. II. Life annuities provide an income that the annuitant cannot outlive. (a) I only (b) II only (c) both I and II (d) neither I nor II 2. Income paid to an annuitant under a life annuity is comprised of all of the following EXCEPT: (a) interest earnings (b) insurer expenses (c) premiums paid (d) unliquidated funds from those who die early
7 Chapter 19 Retirement Products: Annuities and Individual Retirement Accounts Agnes, age 62, purchased an immediate annuity. The annuity will provide monthly payments to Agnes for as long as she lives. If Agnes dies before receiving payments for 10 years, the balance of these payments will go to a beneficiary. Agnes purchased a(n) (a) life annuity (no refund) (b) life annuity with guaranteed payments (c) installment refund annuity (d) joint-and-survivor annuity 4. Which of the following statements is (are) true with respect to a joint and survivor annuity? I. Payments begin upon the death of the first annuitant. II. Payments end upon the death of the last annuitant. (a) I only (b) II only (c) both I and II (d) neither I nor II 5. Thomas wants to participate in the growth of the stock market through a deferred annuity; however he wants downside protection against the loss of principal and prior investment earnings if the annuity is held to term. Thomas should purchase a(n) (a) equity-indexed annuity (b) variable annuity (c) fixed annuity (d) life income (no refund) annuity 6. Rochelle is preparing to do her taxes. To determine what percentage of her individual annuity income was taxable and not taxable, Rochelle divided her investment in the annuity by the total of the expected payments that she will receive through the annuity. This quotient is called the (a) percentage participation (b) break-even point (c) coinsurance percentage (d) exclusion ratio 7. All of the following statements about traditional IRAs are true EXCEPT: (a) No traditional IRA contributions are allowed for the tax year in which the participant attains age 70.5 (seventy and one-half) or for any later year. (b) If pre-tax contributions fund the IRA, the entire distribution is taxable. (c) Everyone is eligible to establish a traditional IRA and make fully tax-deductible contributions. (d) IRA funds can be invested in stocks, bonds, mutual funds, and certificates of deposit. 8. Which of the following statements is true regarding a traditional IRA? I. Contributions may be fully deductible, partially deductible, or not deductible. II. In certain circumstances, withdrawals are permitted before age 59.5 without triggering the early withdrawal penalty tax. (a) I only (b) II only (c) both I and II (d) neither I nor II
8 448 Rejda Principles of Risk Management and Insurance, Eleventh Edition 9. Kathy would like to save for retirement. She selected a plan through which she can make a limited contribution each year. Her contribution is not tax deductible, however the investment income accumulates income tax free, and qualified distributions from the plan are not taxed. Kathy is funding a(n) (a) variable annuity (b) Roth IRA (c) traditional IRA (d) equity-indexed annuity 10. Some employers make a lump-sum distribution of pension assets to workers who are terminating employment. To avoid receiving the account assets directly and having to pay taxes on the distribution, the funds may be deposited tax-free into a special account. Such an account is called a(n) (a) spousal IRA account (b) Roth IRA account (c) Section 401(k) account (d) IRA rollover account True/False Circle the T if the statement is true, the F if the statement is false. Explain to yourself why a statement is false. T F 1. The fundamental purpose of a life annuity is to provide an income that cannot be outlived. T F 2. It is impossible for an insurer to make a profit by selling a refund annuity. T F 3. Annuities can be funded through a single premium or through multiple premiums. T F 4. During the funding period, a variable annuity purchaser is credited with annuity units. T F 5. A key advantage of variable annuities is that insurers marketing these products do not charge any fees. T F 6. Equity-indexed annuities provide downside protection against the loss of investment income if the annuity is held to term. T F 7. Income from individual annuities is received tax-free by the annuitant at retirement. T F 8. Roth IRA contributions are tax deductible regardless of a person s income and whether or not he or she is covered by an employer-sponsored retirement account. T F 9. Most spouses who do not work outside of the home can make a fully deductible contribution to a traditional IRA even through their spouse is covered under a retirement plan at work. T F 10. Qualified distributions from traditional IRAs are received income tax-free after age T F 11. Qualified distributions from Roth IRAs are received income tax-free after age T F 12. In come cases, qualified distributions from Roth IRAs can be made before age 59.5.
9 Chapter 19 Retirement Products: Annuities and Individual Retirement Accounts 449 Case Applications Case 1 Andrea is considering the purchase of an annuity. She was surprised to learn about all of the annuity options that are available. She is also wondering how annuity income will be taxed upon her retirement. a. Differentiate between: (1) Immediate and deferred annuities: (2) Single-premium annuities and flexible-premium annuities: (3) The life annuity no refund, life annuity with guaranteed payments, and installment refund annuity settlement options:
10 450 Rejda Principles of Risk Management and Insurance, Eleventh Edition b. Assume that Andrea invests $120,000 in a life annuity. At the time she begins to receive monthly distributions of $1000, her life expectancy is 20 years. What is Andrea s exclusion ratio for this annuity? Case 2 Which IRA (traditional or Roth) would you recommend in the two scenarios described below? a. Charlene is single and will earn $40,000 this year. She is not eligible to participate in her employer s pension plan until next year. b. Vern is concerned that all of his retirement distributions will be taxable once he starts to receive the money. Vern earns $90,000 per year and is covered under his employer s qualified retirement plan.
11 Chapter 19 Retirement Products: Annuities and Individual Retirement Accounts 451 Solutions to Chapter 19 Short Answer Questions 1. Annuities pool the risk of excessive longevity in order to provide an income that cannot be outlived. By pooling the risk of excessive longevity, insurers offering life annuities are able to continue payments to those who live far beyond life expectancy. Some individuals in the pool will die early, freeing-up the unliquidated portion of their premiums to assist the insurer in continuing to make payments to those who live far beyond life expectancy. Life insurance and life annuities can be viewed as opposites as one provides protection against the adverse financial consequences of premature death while the other provides protection against the adverse financial consequences of excessive longevity. Life insurance creates an immediate pool of funds while life annuities are a means through which a pool of funds is systematically liquidated. 2. Life annuity payments are comprised of three elements. First, there is a return of premiums that were paid for the annuity. Second, there is interest income that was earned on the funds invested by the insurer. Finally, some life annuitants die before receiving back from the insurer what they paid for the annuity. This third component is the unliquidated principal of annuitants who die early. 3. The accumulation period of an annuity is the time when premiums are being paid and/or interest is being earned on the premiums paid to the insurer. This period is the time before the insurer begins to make payments to the annuitant. During the liquidation (payout) period, the insurer is making periodic payments back to the annuitant. 4. There are a number of settlement options for life annuities: The life annuity (no refund) provides the highest periodic income payment to the annuitant. This annuity provides no guarantees. Payments are made until the annuitant dies, and upon the death of the annuitant, payments end. The life annuity with guaranteed payments is a life annuity that promises that at least a specified number of payments will be made. For example, under a life income with 10 years for certain annuity, the insurer promises that payments will be made for at least 10 years. If the annuitant dies before receiving the minimum number of guaranteed payments, a beneficiary will receive the balance of the guaranteed payments. After the guaranteed period, the annuity is just like any other life annuity the insurer continues to make payments until the annuitant dies. The installment refund option is a life annuity that promises the insurer will pay out at least the total of the premiums paid for the annuity. Under this type of annuity, if the annuitant dies before receiving from the insurer at least what was paid in premiums, annuity payments continue to a beneficiary until at least what was paid for the annuity has been paid out by the insurer. After the insurer has paid out an amount equal to the premiums paid for the annuity, the annuity is just like any other life annuity. 5. Variable annuities can be funded through a lump sum contribution or through periodic installment premiums. During the funding period, the purchaser is credited with accumulation units. The value of accumulation units fluctuates with the performance of the securities in the portfolio supporting the annuity. During the funding period, the purchaser continues to buy accumulation units. At retirement, the accumulation units are converted to annuity units. The purchaser will have a fixed number of annuity units throughout retirement, however the value of the units, and hence the periodic income distribution, will fluctuate with the value of the investment portfolio supporting the annuity.
12 452 Rejda Principles of Risk Management and Insurance, Eleventh Edition 6. An equity-indexed annuity provides the possibility of earning a higher, variable rate of return with downside risk protection as the return can never drop below a specified fixed interest rate. The annuity value is linked to the performance of a stock market index. If the stock market rises, the annuity is credited with a portion of the investment gain (e.g. 80 percent of the return, up to a specified cap). If the stock market declines, the annuity earns at least a minimum return, which typically is 3 percent on 90 percent of the principal invested. So while the annuity can profit from superior investment performance like a variable annuity, it also provides a minimum guaranteed interest rate, like a fixed annuity, when investment performance is unfavorable. 7. Premiums for individual annuities are not income-tax deductible and are paid with after-tax dollars. The investment income, however, is tax-deferred and accumulates free of taxes until the funds are distributed. The portion of an annuity distribution that is investment income is taxed as ordinary income. The portion of the payment that is a return of premiums is received tax-free. To determine the portion received tax-free and the taxable portion, it is necessary to calculate an exclusion ratio. The formula for the exclusion ratio is total annuity premiums paid divided by the expected payments to be received. This value is determined by multiplying the periodic income by life expectancy. If the exclusion ratio is multiplied by the periodic income payment, the resulting value is the nontaxable amount. The balance of the payment is taxable. Once the total investment in the annuity has been recouped, the entire annuity distribution is taxable. 8. Traditional IRA contributions may be fully tax deductible, partially tax deductible, or not tax deductible: To be fully tax-deductible, the worker must not be an active participant in an employer-sponsored retirement plan. Such a worker can make a fully deductible IRA contribution. Even if the worker is covered by an employer-sponsored plan, a deduction is permitted if the worker s modified adjusted gross income is below a specified amount. If the modified adjusted gross income is within a threshold band, a partially tax deductible IRA traditional IRA contribution can be made. No deduction is permitted for taxpayers who have a modified adjusted gross income in excess of the phase-out deduction limit. Such taxpayers, however, should consider making a contribution to a Roth IRA if they are eligible. 9. The early withdrawal penalty does not apply in the following cases: distributions used to pay for unreimbursed medical expenses exceeding 7.5 percent of adjusted gross income (AGI), distributions not exceeding the cost of medical insurance if you lost your job and received unemployment compensation for 12 consecutive weeks, disability of the IRA owner, distributions to the beneficiary of a deceased IRA owner, distributions that are part of substantially equal payments paid over the life expectancy of the individual, distributions that are not more than qualified higher education expenses, qualified acquisition costs for a first-time home buyer (maximum of $10,000), distributions due to an IRS levy on the qualified plan, and qualified reservist distributions. 10. (a) As discussed in question #8, traditional IRA contributions may be fully deductible, partially deductible, or not deductible. The contributions made to a Roth IRA are never tax deductible. (b) Distributions from traditional IRAs are taxed as ordinary income except for any nondeductible IRA contributions, which are received income-tax free. Under a Roth IRA, after-tax contributions are made and investment income accumulates tax-free. If certain requirements are met, the entire distribution is received free of taxes.
13 Chapter 19 Retirement Products: Annuities and Individual Retirement Accounts 453 Multiple Choice Questions 1. (b) Only the second statement is true. Annuities do not pool the risk of premature death. Annuities pool the risk of excessive longevity. Life annuities continue to make payments for as long as the annuitant is alive. 2. (b) Insurer expenses are not part of life annuity payments. Annuity payments are comprised of a return of premiums paid, interest, and unliquidated funds from annuitants who die early. 3. (b) Agnes purchased a life annuity with guaranteed payments. In this case, the insurer has promised to make at least 120 payments (10 years 12 months). 4. (b) Only the second statement is true. Payments do not begin upon the death of the first annuitant. Payments are made jointly to the annuitants and continue until the last annuitant has died. 5. (a) An equity-indexed annuity will accomplish the goals that Thomas has set forth. He has the downside protection of a guaranteed minimum rate of return, while he still has the potential of earning higher equity returns. 6. (d) Rochelle calculated the exclusion ratio. The ratio tells her what percentage of the individual annuity distribution she can exclude from taxation as it represents a return of premiums paid for the annuity. The balance (the amount not excluded) is fully taxable. 7. (c) There are eligibility rules for establishing a traditional IRA. Contributions may be fully, partially, or not tax deductible, depending on an individual s income and whether he or she is covered under an employer s retirement plan. 8. (c) Both statements are true. Depending on the eligibility status of the contributor and his or her income level, the contribution may be fully tax deductible, partially tax deductible, or not tax deductible. There are a number of situations in which distributions may be taken from traditional IRAs before age 59.5 without triggering the 10 percent penalty tax. 9. (b) Kathy is funding a Roth IRA. After-tax contributions are used, but qualified distributions from Roth IRAs after age 59.5 are received tax-free. 10. (d) Distributions made to an IRA rollover account do not result in current taxation. True/False 1. T 2. F While it is true that the insurer will pay out an amount that is at least equal to the premiums paid for the annuity, the issue is timing. The repayment of all of the money paid for the annuity may take many years. At the same time, however, the insurer will be investing the funds and earning investment income on the premiums. 3. T 4. F During the funding period, the variable annuity purchaser is credited with accumulation units, not annuity units.
14 454 Rejda Principles of Risk Management and Insurance, Eleventh Edition 5. F Insurers marketing variable annuities charge a variety of fees and expenses, including management fees, administrative fees, surrender charges, and expense charges. 6. T 7. F A portion of the distribution, the amount which is attributable to a return of premiums paid, is received tax-free. The balance, which is investment income, is fully taxable. After the basis in the annuity has been recovered, the entire distribution becomes taxable income. 8. F Roth IRA contributions are never tax deductible. Roth IRA contributions are made with after-tax dollars, but the distributions at retirement are received tax-free. 9. T 10. F It pre-tax dollars are used to fund traditional IRAs, distributions from traditional IRAs at retirement are fully taxable. If any after-tax contributions were used to fund the traditional IRA, the portion of the distribution attributable to the after-tax contribution is received tax-free. 11. T 12. T Case Applications Case 1 a. (1) Immediate annuities begin to make payments to the annuitant in the period after the annuity is purchased. For example, a retiree may give a life insurance company $50,000 in exchange for an immediate annuity and begin to receive payments from the life insurer in the following month. A deferred annuity begins more than one period after the premium was paid. For example, an annuity purchaser age 30 may pay premiums over 20 years, then stop paying premiums, and begin to receive payments from the insurer at age 65. (2) Single premium annuities are funded through one, lump-sum, premium. Flexible premium annuities are funded through premiums paid over a number of years. Often level installment premiums are used to fund an annuity. (3) A life annuity, no refund annuity has no special guarantees for the annuitant. Payments are made until the annuitant dies. If the annuitant dies after receiving only one or two payments, there are no refunds or guaranteed payments. A life annuity with guaranteed payments promises to make at least a specified number of payments. For example, life income with 10 years for certain promises to make at least 120 monthly payments. If the annuitant dies before receiving all 120 payments, the balance of the promised payments is paid to a beneficiary. An installment refund option promises that the amount paid by the insurer will be at least the sum of the premiums paid for the annuity. So if the annuitant has received payments totaling $100,000 when he or she dies, and $120,000 was paid for the annuity, payments will continue to a beneficiary until the additional $20,000 has been paid-out by the insurer. b. Andrea s exclusion ratio is 50 percent as shown below: $120,000 in premiums = 50% exclusion ratio $240,000 in expected payments
15 Chapter 19 Retirement Products: Annuities and Individual Retirement Accounts 455 Case 2 The $240,000 in the denominator was obtained by multiplying $1000 per month by 12 months and 20 years ($ = $240,000). So Andrea can exclude 50 percent of the annual annuity income from taxation because it represents a return of premiums. Once the return of premiums equals $120,000, then the entire annual annuity distribution becomes fully taxable. a. A traditional IRA makes sense for Charlene. Given that Charlene is not covered under her employer s retirement plan and her income does not exceed the limit, she can make a fully-deductible traditional IRA contribution. The contribution will reduce her current taxable income and accumulate on a taxdeferred basis. b. Vern does not qualify for a tax-advantaged traditional IRA contribution his income is too high and he is covered under a qualified retirement plan through his employer. Vern can, however, make a contribution to a Roth IRA using after-tax dollars. Although the contribution is made with after-tax dollars, the IRA accumulates on a tax-deferred basis. If certain rules are satisfied, Vern s entire distribution from the Roth IRA will be received tax-free when he retires.