ASSET OF THE MONTH August Annuities

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1 ASSET OF THE MONTH August 2011 Annuities What is an annuity? An annuity is a contract between the investor and an issuer where the investor agrees to give the issuer principal and in return the issuer guarantees the investor fixed or variable payments over time. Annuities are not insurance policies; however, they are issued by insurance companies. An annuity is similar to a retirement plan in that it can be funded in a lump sum or a little at a time, and all capital in an annuity grows tax-deferred until you begin making withdrawals. Unlike retirement plans, there is no limit as to how much you can invest in annuities. The amount you receive is wholly dependent on the amount of money you put in to an annuity. Three choices to make when purchasing an annuity: Timing of payout -- immediate or deferred: In an immediate annuity, the investor begins to receive payments immediately upon investing. This is for investors who need immediate income from their annuity. In a deferred annuity, the investor receives payments starting at some later date, usually at retirement, while deferring taxes. There are usually surrender charges and annual fees plus management charges of the underlying investment. The most common type of deferred annuity is the variable annuity which lets you choose from several mutual fundlike accounts. The value of your accounts rises and falls with the performance of those funds. You don t owe taxes until you begin making withdrawals. Unlike an IRA or company sponsored plan, there are virtually no limits on contributions to a deferred annuity. There are two phases to a deferred annuity. The first is the "accumulation phase" during which your assets grow tax deferred. If you withdraw money from your annuity during the "accumulation phase" of the contract the insurance company may assess a withdrawal charge. You may also incur tax penalties as a result of withdrawals prior to age 59 ½. The second is the "payout phase" which begins when you are ready to receive income from your annuity. At that time, there are a number of options from which you can choose, according to your needs. You can withdraw your money in a lump sum, through systematic withdrawals or in a regular stream of income payments guaranteed to last as long as you live.

2 Investment type -- fixed or variable: Fixed annuities are mainly invested in government securities and corporate bonds. They offer a guaranteed rate, typically over a period of one to fifteen years. Basically, an annuity is a contract with an insurance company that makes payments at regular intervals for a set period of time. A classic fixed-annuity provides people a set payment for however long they live from a few months to decades. An insurance company s actuaries take their best guess on your life expectancy and you hope to outwit them and collect a check into your 90s. Few annuities are structured this way anymore. One reason is people have realized that a set payout is not great because it does not account for inflation: $1,000 a month today will probably not buy as much in 10 or 20 years. To make annuities more appealing and to bring in more money insurance companies created more sophisticated types of variable annuities. Variable annuities allow you to invest in various accounts, such as securities portfolios, fixed interest accounts, and money market securities. These accounts are tied to market performance. Withdrawal options Most annuities allow you to withdraw either your interest earnings or up to 15% per year without a penalty. Any withdrawal from an annuity may be subject to taxes and a 10% federal penalty if taken prior to age 59. Most annuities have a surrender charge. This is a penalty for making an early withdrawal above the free withdrawal amount. Typically this surrender charge decreases over a seven-year period. Some annuities with surrender charges offer a bonus : the insurance company usually adds 3% to 5% to the amount of your principal. I.e. if you invest $10,000 in a bonus annuity the insurance company will add $300 to $500 to your annuity immediately. The trade-off is that with a bonus annuity the surrender period is usually longer. For investors who may need spur of the moment access to their money, there are also annuities without any surrender. They may also charge a higher fee than the standard annuity, in exchange for 100% access to the money. Some insurance companies charge higher fees for their no-surrender charge products. Most companies now offer nosurrender annuities. However, if you are asking a local broker or agent for their recommendation they may not share with you the no-surrender annuity, as these annuities pay the broker a much lower fee. Death Benefit Another important feature of annuities is the death benefit provision, a feature included in most annuities in one form or another. The annuity issuer guarantees at a minimum that upon your death your total premiums are paid to your beneficiaries. Many annuities

3 step-up on the anniversary of the date the annuity was purchased, to the highest value at any prior anniversary. For example, you invest $10,000 in a variable annuity with an annual step-up in death benefit. Then several years later, on the investment anniversary, your variable annuity has grown to $40,000. Then the market drops and the value of your variable annuity shrinks to $25,000. Then you die. In this case, your surviving beneficiaries would receive the highest value on the anniversary of the purchase, or $40,000. Death Benefits apply mainly to variable annuities and usually come at an additional cost. Miscellaneous You probably should not consider the purchase of an annuity unless you have fully funded or intend to fully fund your IRA, 401(k), or 403(b) for the year. These investments occur before income tax. If you have fully funded those retirement plans and have additional funds, you could invest an unlimited amount of money in an annuity without paying any current taxes until you start to take money out. There is no qualifying of any kind with an annuity, and as long as you are not receiving payments, there is no IRS reporting (no 1099 or tax bill). An additional benefit of an annuity is that they are not attachable by most creditors and they avoid probate in all 50 states. Investors need to be careful to understand the annuity they are considering purchasing. First, investors must consider the rating of the insurance company issuing the annuity. Second, it is important to understand the level of fees paid to the brokers that market the annuities. Many agents, brokers, financial planners, and others who market annuities have overstated annuity advantages, and sometimes recommend annuities based on the fee the broker will receive, rather than whether an annuity is right for the investor. The benefit of putting a chunk of your retirement nest egg into annuities is the guaranteed payment. Whether the economy is good or bad, an annuity pays a minimum amount of income every month. You may have to put a large part of your nest egg into the annuity to receive the amount you need to live on, but you know it will be there. However, there are things to watch for: - Expense: A fixed annuity typically pays out no more than 5 percent of the principal each year. That means you would have to put $100,000 into a fixed annuity to receive an annual payout of $5,000, and it is extremely difficult to live on $400 a month. - Fees: The more features attached to an annuity, the higher the cost. These costs, as with mutual funds, are hidden in the annuity payouts. They do not come in an upfront fee. - Expectations: People who bought annuities with payments that grew as the underlying securities grew could be in trouble. Those payouts will not go up when the stock market loses 40 percent of its value in one year. Lastly, the government taxes distributions from annuities as ordinary income, with rates that run up to 35 percent.

4 The following table illustrates how eligibility for various public assistance programs is affected by ownership of an annuity. Program Rule Citation Food Share Counted Unearned Count unearned income as income in the month that it is received, except when: Foodshare It isn't available to the Food Share group. 2. You're told otherwise by specific instructions in the Food Share. Note: Annually paid annuities should be averaged over 12 months. Do not count the entire amount in the month received. Assets: There is no asset limit for households with gross income less than or equal to 200% FPL FSH Fuel Assistance Senior Care For pension or annuities paid on a monthly basis enter the amount paid each month. For those paid on a quarterly or other basis, enter the average monthly amount. Often 1099 forms can be used for verification. Assets: Disregarded (No asset test) The energy program does not have a vehicle or asset limit test for eligibility. Annuities are not on the list of SeniorCare disregarded income. Count annuity payouts as income The SC applicant must report the estimated gross amount of all interest and dividends that s/he expects to receive in the next 12 months, beginning with the month of application. Sources of interest and dividends include annuities. WHEAP Manual Chapter WHEAP Manual Chapter

5 Payments do not need to be directly received. If they are rolled back into the asset, they still must be reported. SSI Assets: Disregarded No asset test There is no asset test for SeniorCare Annuities are unearned income. Unearned income is counted as income in the earliest month it is: received by the individual; credited to the individual's account; or set aside for the individual's use. Resources: Resources are cash and any other personal property, as well as any real property, that an individual (or spouse, if any): owns; has the right, authority, or power to convert to cash (if not already cash); and is not legally restricted from using for his/her support and maintenance. Factors such as state law (ie. ) and irrevocability determine whether an annuity is a countable resource POMS SI POMS SI POMS SI POMS SI Wisconsin / Medicare Savings Programs Payments from an annuity that is considered to be unavailable must be counted as income. Assets: For Annuities purchased after March 1, 2004 : 1) Can the annuity be surrendered (ie. is its cash value available for withdrawal)? If yes, then annuity is available asset Value of annuity that can be surrendered: Total deposits made to the annuity PLUS

6 Earnings on the deposits not previously paid out MINUS Withdrawals and surrender costs charged for withdrawal. Equals Annuity s value 2) If annuity cannot be surrendered, can it be sold? If it can be sold per the contract, then it is an available asset unless reasonable attempts have been made to obtain fair market price by offering annuity for sale to companies active in annuity market ) If annuity cannot be sold, does it have a value? Verify by having the annuity contract reviewed by a company active in the annuities market for an opinion of its value to the company. If the company documents an amount at which it values the annuity, that amount will be considered an available asset. 4) If the company states that it places no value on the annuity, then it is an unavailable asset. Document the company s statement. If annuity an unavailable asset, evaluate for possible divestment Annuities Purchased before March 1, 2004 Annuities that can be surrendered (In the accumulation phase) are available assets because the annuitant can cash the annuity in for its cash value. Cash (or surrender ) value equals: Total deposits made to the annuity. PLUS Earnings on the deposits not previously paid out MINUS Withdrawals and surrender costs charged for withdrawal. In determining the cash value, do not deduct income tax withheld or tax penalties for early withdrawal. Annuities in the Pay-Out Phase (cannot be surrendered)

7 The pay-out (annuitization) phase begins at the time payments start going to the annuitant in accordance with the settlement option. The settlement option specifies the way the funds from the annuity will be paid out. An annuity becomes an unavailable asset on the date the settlement option is made final, even if the payment starts months later.