A PROFESSIONAL S GUIDE TO INCOME OPPORTUNITIES USING ANNUITIES

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1 A PROFESSIONAL S GUIDE TO INCOME OPPORTUNITIES USING ANNUITIES CPAs Attorneys Enrolled Agents Tax Professionals Professional Education Network TM

2 CONTENTS 1 Introduction 2 Withdrawal Guidance in Retirement 3 Inherent Annuity Income Options 4 Income Annuities 8 Living Benefit Riders 10 Guaranteed Income from Annuities 12 Conclusion 12 How Edward Jones Can Help Introduction With the elimination of company pension plans, the uncertainty of Social Security and increasing life expectancies, more and more people are searching for ways to produce retirement income. A client s retirement income strategy generally needs to address three main purposes: 1. Provide for current spending needs 2. Grow with inflation to provide for future spending needs 3. Last throughout retirement Retirement income strategies will likely include income from outside sources, such as Social Security and perhaps in increasingly rare situations, a pension. However, most people will need to depend upon their retirement savings and investments to cover any gap between expected spending and the income generated by these outside sources. This brochure discusses the different ways annuities can help provide another source of guaranteed income and provide a sustainable foundation for income in retirement. 1

3 Withdrawal Guidance in Retirement In general, Edward Jones recommends an initial withdrawal rate of 4% for clients who are in their early 60s. This assumes that withdrawals increase annually for inflation, which is estimated at 3% per year. For example, if in the first year, a 4% withdrawal of a portfolio totals $40,000, and the next year the client increases that amount by 3% for inflation, the client takes out $41,200 in year two, $42,436 in year three, and so on. Thus, assuming a 3% annual inflation rate, the amount the client withdraws in the 25th year is more than twice the first year s withdrawal. The same withdrawal rate will not work for everyone. Four percent may be a great rule of thumb for one 65-year-old retiree, but depending upon factors such as age, asset allocation, spending flexibility and risk tolerance, the appropriate rate may be different for another. The Role of Income Insurance Although clients can plan for the expected and employ a sustainable withdrawal approach, some unexpected risks can still derail a retirement strategy. These include: Living much longer than expected A dramatic market decline, especially early in retirement Inflation Given their ability to provide some protection against these risks, annuities can play an important role in building a sustainable retirement income strategy. Predictable annuity payments, along with Social Security, could be used to cover a larger portion of a client s necessary expenses, e.g., food, shelter, clothing and health care, although some tradeoffs exist with this strategy, including insurance expenses, the possibility of lower account value growth due to investment restrictions and less flexibility than with more traditional investment strategies using mutual funds. Annuities may not be appropriate in every situation, and allocation within a portfolio should be based upon each individual client s needs. Phases of Annuity Contracts By definition, every annuity contract has two phases: accumulation and distribution. In the accumulation phase, money grows tax deferred, and the owner may often make additional contributions over the years prior to needing income. In the distribution phase, the annuity value is paid out to the owner over his or her lifetime or for a set period of time. Three ways to take income from an annuity contract are as follows: Annuitization Guaranteed lifetime withdrawals through a living benefit rider Non-guaranteed lifetime withdrawals 2

4 Inherent Annuity Income Options Annuitization and withdrawals are two income options inherent in every annuity contract. The following table outlines the basic differences between these two options. Annuitization Withdrawals Description The process of converting a deferred annuity contract into a series of income payments that can last for a specified period of time or for life Allow the owner to access the account value while the remaining funds continue to accumulate tax deferred Features Fixed annuitization provides income payments of a set amount that do not change over time Variable annuitization provides income payments that fluctuate based upon the performance of underlying equity investments called subaccounts Lump sum usually a one-time occurrence Systematic withdrawals set up on a monthly, quarterly, semiannual or annual basis Flexibility The owner can choose how long the payments will last. Payments can be made on a monthly, quarterly, semiannual or annual basis. The owner can choose how much to withdraw (percentage or dollar amount). The owner can decide when to start or stop withdrawals. Risk Once elected, annuitization income payments are normally irrevocable. Generally, the owner does not have access to the account value once payments begin. During a down market, withdrawals may invade principal and result in depleting account value sooner than expected or intended. Withdrawals may be subject to a surrender penalty. Taxation Qualified dollars the full amount of each payment is taxed at the owner s ordinary income tax rate. Nonqualified dollars each payment is considered part return of principal and part earnings; only the earnings portion is taxable. Earnings are taxed at the owner s ordinary income tax rate. Prior to age 59½ payments may be subject to a 10% federal tax penalty. Clients should consult a CPA or tax professional for specifics. Qualified dollars the full amount of each withdrawal is taxed at the owner s ordinary income tax rate. Nonqualified dollars all earnings are withdrawn first (before principal) and taxed at the owner s ordinary income tax rate. Prior to age 59½ withdrawals may be subject to a 10% federal tax penalty. Clients should consult a CPA or tax professional for specifics. Fees The type of annuitization program chosen (fixed or variable) determines the cost of the annuity contract. Fixed annuitization all fees associated with the contract are captured before the income payment is quoted to the client. Variable annuitization fees are the same as those applicable to a deferred variable annuity (as described at right). Variable annuities carry two types of annual asset-based expenses: M&E&A charges and investment management fees. Mortality and expense and administration (M&E&A) charges are the costs of the insurance benefits contained in the annuity contract. Investment management fees are the costs associated with managing the investment portfolio of the subaccounts. 3

5 Annuitization of deferred annuities can be one of the most efficient methods for converting assets into income because a client can often generate more income with fewer assets and generate a paycheck for life. Income Annuities For marketing purposes, annuitization and income annuities are similar. Both accomplish the goal of converting a sum of money into an income stream. The primary difference is that annuitization takes place from a deferred annuity, where the money has already been accumulating tax deferred, while the premium paid for an income annuity can come from many different sources. Income annuities can be classified as follows: Immediate Fixed Annuities Immediate Variable Annuities Deferred Income Annuities Immediate Fixed Annuities Immediate fixed annuities provide payments of equal value over a client s lifetime (joint lifetime between spouses) or for a set period of time. The payments remain the same (fixed) and are guaranteed by the issuing insurance company. However, immediate fixed annuity payments may not keep pace with inflation. When purchasing an immediate fixed annuity, a client does not pay a sales charge, but the insurance company still has expenses and an income stream to guarantee. The contract s expenses are reflected in the income payment quoted to the client. Immediate fixed annuities may be best used to close the gap between the client s necessary expenses in retirement and other predictable lifetime income sources such as Social Security and pensions. Immediate Variable Annuities Immediate variable annuities can also provide payments over a client s lifetime (joint lifetime between spouses) or for a set period of time. Unlike fixed annuitization, immediate variable annuity (or variable annuitization) payments fluctuate depending upon the performance of the underlying subaccounts. Some modern variable annuitization programs provide for minimum income amounts, even in a down market, but these benefits come with an additional cost. When purchasing an immediate variable annuity, a client may be subject to the same expenses as a deferred variable annuity contract. This includes the M&E&A charges and investment management fees described previously. Immediate variable annuities should be considered to help address inflation and the rising cost of necessary expenses, as well as to provide additional income to meet discretionary, i.e., nonessential but important, retirement expenses. The remaining assets within the portfolio may then be used to meet other planned needs, such as continued investment growth, leaving a legacy, etc. Programs for systematic withdrawals from the portfolio can be pursued with more confidence once a base of predictable cash flow for life has been created. 4

6 Deferred Income Annuities Similar to an immediate fixed annuity, a deferred income annuity is usually funded with a single payment and can provide a stream of lifetime payments. Because these payments typically begin two to 10 years after the initial investment (not immediately), payments are higher than those typically available from an immediate fixed annuity, assuming the same initial investment. The longer the start date is deferred, the higher the payment. Factors Affecting Income Annuity Payments A number of factors determine the initial payment and subsequent payments from income annuities. These same factors may also affect annuitization payments: Purchase amount Age and gender of annuitant at the time of purchase When payments are scheduled to begin and how long they will last Current market interest rates (applicable to immediate fixed and deferred income annuities) Purchase Amount The lump-sum amount of money used to generate income payments is the purchase amount. The larger the lump sum, the greater the payments. Age and Gender of Annuitant at the Time of Purchase The age and gender of the annuitant are used to determine the life expectancy for the payments. Older-age clients generate higher payments than younger-age clients, and male clients tend to be subject to higher payments than female clients due to shorter life expectancies in both cases. When Payments Are Scheduled to Begin and How Long They Will Last The annuity owner chooses how long payments will last by selecting the relevant payment option. The following chart outlines the different available payment options. Clients can also choose the frequency of payments: monthly, quarterly, semiannually or annually. The insurance company s costs Assumed interest rate (AIR) (applicable to immediate variable annuities only) 5

7 Payment Option Information Generally Recommended for Life Only Single Life Provides the highest payment amount per dollar of premium of any lifetime payment option because payments continue only as long as the annuitant is alive. Payments stop at death. Generally, there is no death benefit after 30 days, even if payments have not yet begun. There is no death benefit once payments have begun. This varies according to insurance company. Clients who want to maximize their income payments and are not concerned with preserving any portion of the premium or income payments for their beneficiaries. Life Only Joint Life Provides payments as long as one of two spouses is alive. Payments stop at the second death. Because the payments are contingent upon two lives, income payments are lower than a life only (single life) annuity for the same amount of premium. Generally, there is no death benefit after 30 days, even if payments have not yet begun. There is no death benefit once payments have begun. This varies according to insurance company. Clients who need a guaranteed payment for life, but who desire to preserve a portion of the premium or income payments for their beneficiaries. Life with Installment Refund Single Life or Joint Life Provides lifetime income with a guarantee that payments will continue for the client s life (or both clients lives in the case of a joint policy) or a specified period whichever is longer. This option ensures that payments will be made for at least a specified period of time to the client or the beneficiary. The specified periods typically range from five to 30 years. Because payments are guaranteed for a fixed period of time, they are lower than payments from a life only annuity for the same amount of premium. Clients who need a guaranteed payment for life and want to ensure that at least the original premium is returned in the form of payments to themselves, their beneficiaries or a combination thereof. Life with Cash Refund Single Life or Joint Life Provides lifetime income with a return of premium guarantee that payments will be made at least until the initial premium has been returned to the client or the beneficiary. Premium is returned to the client in the form of payments. A lump-sum payment to the beneficiary, if any, equals the premium minus the payments received. Payments are lower than payments from a life only annuity, but may be more or less than payments from a life with period certain annuity for the same amount of premium. Because of the lump-sum payment option for beneficiaries, a cash refund annuity generally has lower payments than an installment refund annuity. Clients who need a guaranteed payment for life and want to ensure that at least the original premium is returned in the form of payments to themselves, their beneficiaries or a combination thereof. Period Certain No Lifetime Guarantee Provides payments for a set number of years (usually between five and 30) and then stops. This option ensures that in the event of the client s death, payments continue to the beneficiaries until the end of the specified period. This payment option does not provide guaranteed lifetime income. Clients who need a guaranteed income for a specific period of time without the need for a guaranteed income for life. All of these guaranteed-payment options are contingent upon the claims-paying ability of the issuing insurance companies. 6

8 Assumed Interest Rate (AIR) With immediate variable annuities or variable annuitization, the insurance company calculates the first payment using an AIR, which can range from 3% to 6%. The AIR serves as the bogey for subaccount performance. To calculate subsequent payments, the performance of the subaccounts is compared to the AIR, and payments are adjusted to either a higher or lower amount than the initial payment. The client chooses the AIR at the time of purchase or annuitization. The percentage is locked in for the duration of the contract and cannot be changed at a later date. The higher the initial AIR chosen, the higher the initial variable income payment will be. However, that also means that the subaccounts must exceed a higher bogey in order for the payments to stay the same or increase. For most variable annuitization programs, the client has the option to choose how often the payments are adjusted to reflect subaccount performance monthly, quarterly, semiannually or annually. Taxation As referenced previously, taxation of annuitization payments depends upon the source of funds. This is also true for income annuity payments. Qualified Income Annuities A qualified income annuity is purchased with pretax funds, such as 401(k) or Individual Retirement Account (IRA) assets. The full amount of each payment is taxed at the owner s ordinary income tax rate. Once qualified assets have been annuitized, they are not subject to the required minimum distribution (RMD) rules of the Internal Revenue Code because the insurance company is deemed to have already made the appropriate calculation for lifetime distribution of the underlying assets. Nonqualified Income Annuities A nonqualified income annuity is purchased with after-tax money. A portion of each payment from a nonqualified annuity is nontaxable based upon an exclusion ratio. The exclusion ratio is the percentage of the annuity payment that represents return of principal and is excluded from taxable income. The exclusion ratio is determined by the insurance company and is based upon a formula, established by IRS regulations, that takes into account the client s life expectancy and/or guarantee period. Once a client has received his or her original premium back in the form of payments, subsequent annuity payments are fully taxable. Prior to Age 59½ Determining whether the 10% federal tax penalty applies to annuitized payments received prior to age 59½ depends upon the source of the funds used to purchase the annuity. When an income annuity is purchased with nonqualified money or money that has never been tax-deferred, payments are generally penalty-free, regardless of the payment option chosen. When an annuity is purchased with qualified money or as part of an exchange from a deferred annuity contract, payments are not penalty-free unless the payment option chosen has a life contingency: single or joint life only, life with period certain, life with installment or life with cash refund. Thus, a period-certain-only payment option would not satisfy this requirement. 7

9 Living Benefit Riders Living benefit riders can be added to deferred variable annuities at an additional cost to provide guarantees on the inherent ways to take income from a contract withdrawals and annuitization. The fees associated with living benefit riders are in addition to the other expenses of an annuity, including the M&E&A charges and the investment management fees. Types of Living Benefit Riders The two most common types of living benefit riders are as follows: Guaranteed lifetime withdrawal benefit Guaranteed minimum income benefit Guaranteed Lifetime Withdrawal Benefit (Lifetime GLWB) A lifetime GLWB guarantees that a fixed percentage typically 4% to 6% of the amount initially invested in the annuity (the premiums) can be withdrawn annually for as long as the client (or, for joint annuities, the client or spouse) lives. These payments continue even after the initial investment amount has been paid out, regardless of the actual account value. Example Juanita purchases a $100,000 variable annuity, with a lifetime GLWB of 5%. She will receive $5,000 a year for as long as she lives, even beyond the 20 years it takes to recoup the amount she initially invested and even if the account value falls to zero. The guarantees provided by living benefit riders are contingent upon the claims-paying ability of the issuing insurance companies. However, guaranteed withdrawals do not come into play until the account value of the annuity contract reaches zero due to withdrawals and subaccount performance. While account value is available, the client is actually withdrawing his or her own money. In cases where an annuity contract performs favorably, a client who pays extra for the benefit of a withdrawal guarantee may never actually use it. Withdrawing a percentage higher than the rider allows can have a negative impact upon the underlying guarantees. Withdrawals under GLWB riders are taxed just like those from a variable annuity contract without a rider. If a variable annuity is funded with qualified dollars, the full amount of each withdrawal will be taxed at the owner s ordinary income tax rate. Some riders allow a client to withdraw a higher percentage than allowed for RMD purposes without negating the underlying guarantees. The client may have to meet certain withdrawal guidelines in order to receive this favorable treatment for the rider. 8

10 If an annuity is funded with nonqualified dollars, all earnings are withdrawn first (before principal) and taxed at the owner s ordinary income tax rate. Withdrawals taken prior to age 59½ may be subject to a 10% federal tax penalty. Guaranteed Minimum Income Benefit (GMIB) A GMIB guarantees that a fixed percentage generally 5% of the amount initially invested in the annuity (the premiums) can be withdrawn annually as long as there is account value. If the contract value grows, withdrawals may be higher, but never lower than the initial withdrawal amount. If the contract value reaches zero, the initial investment amount will be annuitized to provide lifetime income. The client may also elect annuitization at any point after 10 years. These income payments are based upon one of the following, whichever will provide the most income: the contract value, highest anniversary value or a minimum payment base typically equal to the amount invested compounded at 5% annually. The fixed lifetime income can last as long as the client (and client s spouse for joint annuities) lives but does not have the potential to increase. The annuitization rates used to determine the fixed lifetime income payment under a GMIB may be lower than the rates applied to the account value. The guarantees provided by GMIBs are contingent upon the claims-paying ability of the issuing insurance companies. If the contract is never annuitized or the higher account value is used to determine the income payments, the client will have paid extra for a rider that was not needed. Income payments under a GMIB rider are taxed just like payments from annuitization without a rider. If a variable annuity is funded with qualified dollars, the full amount of each payment is taxed at the owner s ordinary income tax rate. If a variable annuity is funded with nonqualified dollars, each payment is considered part return of principal and part earnings. Only the earnings portion is taxable at the owner s ordinary income tax rate. Example Aaron invests $100,000 in a variable annuity and selects a GMIB, guaranteeing a 5% annual growth on the payout base. He makes no withdrawals or transfers. At year 12, regardless of the value of his contract, Aaron has at least $179,585 to annuitize at the guaranteed rates. If the current contract value is higher than $179,585, he can annuitize the higher amount at the current annuitization rates, which provides a greater amount of income. 9

11 Living Benefit Rider Fees In most cases, the contract owner elects a living benefit rider at the time of purchase, although some riders can be added to an existing contract. Not all riders are revocable, so once a rider has been added, it and the related cost may apply for the life of the contract. Fees vary among living benefits and impact long-term performance. Fees are typically a percentage assessed annually on either the account value or the benefit amount. Living Benefit Type Fee Range Lifetime GLWB 0.60% 1.55% GMIB 0.50% 1.00% Guaranteed Income from Annuities When a client decides that an annuity may be appropriate for providing him or her guaranteed income, the next question becomes, Which type of annuity may be most appropriate? Deciding which type of annuity one should select is not an either/or decision. The types can be used together in concert with systematic withdrawals to help meet a client s retirement income needs. Immediate Fixed Annuity A client s goal is to maximize the initial annuity payments and have stable payment amounts that do not fluctuate. This client does not highly value having access to his or her principal or leaving a legacy. The client plans to take income now or within 12 months from the date of purchase. Immediate Variable Annuity The client is willing to accept lower initial payments relative to immediate fixed annuities in exchange for the potential of increased payments over time (due to exposure to the markets). This client does not highly value having access to principal or leaving a legacy. The client plans to take income now or within 12 months from the date of purchase. Deferred Income Annuity The client s goal is to maximize income and receive fixed payments that begin within two to 10 years after purchase. This client does not highly value having access to his or her principal. 10

12 Living Benefit Riders The client is willing to accept lower initial payments relative to income annuities in exchange for 1) the potential for increased payments over time (due to exposure to the markets), 2) flexibility and limited access to his or her principal and 3) a potential death benefit. The following graph shows the trade-offs to be considered when one is deciding which type of annuity income to utilize. Living benefit riders tend to offer lower guaranteed income but provide greater flexibility. Immediate annuities tend to offer higher guaranteed payments but have less flexibility. Accumulation Withdrawals Distribution Annuitization High Deferred income Annuity Immediate Variable Annuity Immediate Fixed Annuity Guaranted Income GMIB Lifetime GMWB Graphical representations are not drawn to scale. High Low Flexibility All guarantees are based on the claims-paying ability of the issuing insurance company. 11

13 Conclusion With the elimination of company pension plans and the uncertainty of Social Security benefits, the responsibility for providing retirement income is falling upon individual investors. Annuities provide another choice for those investors seeking additional guaranteed income in retirement. How Edward Jones Can Help Edward Jones offers a variety of investments and services that can help clients plan and save for retirement. These include a lineup of income annuities, fixed and variable annuities and variable annuities with lifetime GMLBs. Using the specialized tools available to them, Edward Jones financial advisors can work with mutual clients tax and legal professionals to design retirement income strategies that help fulfill retirement needs, taking into consideration investment objectives, risk tolerance and time horizon. Building a Team of Professionals to Help Provide Solutions for Our Clients At Edward Jones, we believe that when it comes to financial matters, the value of professional advice cannot be overestimated. In fact, in most situations we recommend that clients assemble a team of professionals to provide guidance regarding their financial affairs: an attorney, a tax professional and a financial advisor. The legal, accounting and financial services industries are governed by constantly changing complex laws and regulations; by working together as a team, driven by similar philosophies and guiding principles, professionals in a variety of financial fields can use complementary knowledge and skills to assist mutual clients in planning for today s financial and tax challenges. This publication is for educational and informational purposes only; it is not intended, and should not be construed, as a specific recommendation or legal, tax or investment advice. The information provided is for tax and legal professionals; it is not for use with the general public. Edward Jones, its financial advisors and its employees cannot provide tax or legal advice; before acting upon any information herein, individuals should consult a qualified tax advisor or attorney regarding their circumstances Edward Jones. All rights reserved. 12 CPA-2532C-A EXP 30 MAR 2016

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