A primer on annuities.

• Author: Minker, Marc J.

For most CPAs, the basics of annuities are learned in their first accounting class. Essentially, an annuity is a series of fixed payments, usually made monthly over a certain period of time. Simple examples of annuities would be rental payments to a landlord or lease payments for autos or other equipment. In the financial planning arena, annuities can be more complicated. In this context, they are considered a financial "product" and can serve a variety of functions, such as providing a constant income stream to a retiree, as a device to accumulate money on a tax-deferred basis, or to provide pension benefits to retirees. There are different types of annuities available, which are especially useful in fulfilling many of the financial needs of older adults. A general understanding of the concept and workings of an annuity contract is critical for the personal financial planner and tax practitioner.

Annuity Classification

There are a number of factors that an adviser needs to be aware of when helping clients with annuities. Annuities can be categorized in a variety of ways.

Immediate vs. deferred: An immediate annuity provides payment of benefits immediately on funding. Deferred annuities, however, are invested in for a period (accumulation phase), after which periodic payments are made to the annuitant (distribution phase). Deferred annuities allow partial withdrawals during the accumulation phase and, thus, have no distribution requirement. This is important to an analysis of the taxation of annuity benefits (discussed later).

Fixed vs. variable: Annuities can also be classified as either fixed or variable. A fixed annuity earns a fixed and stated rate of return. A variable annuity has several options for allocating invested funds. Typically, there is a series of mutual-fund-type investment options (subaccounts), as well as one, or possibly more, fixed accounts. For example, a contract might have a six-month or a one-year fixed account, in addition to the variable subaccounts.

Variable annuity vs. mutual fund: In a variable contract, investors allocate their money among a variety of investment subaccounts. The subaccounts behave like mutual funds and are usually managed by mutual fund managers. Typically, the owner has a choice of subaccounts, ranging from extremely conservative to extremely aggressive options, and assumes the risk of such investments. Because the contract owner assumes the risk, variable annuities are not suitable for everyone. However, for the long-term investor for whom a variable contract is suitable, variable annuities have many desirable features. Often, an investor will choose between investing money in a variable annuity and purchasing mutual funds. A major advantage of a variable annuity is tax deferral. Mutual fund dividends are immediately taxable, while variable annuity dividends paid by the funds in the subaccounts are not.

Most variable annuity contracts offer portfolio reallocation at defined intervals. For example, suppose an individual wants to invest 50% in domestic equities and 25% in international equities, with the balance in government bonds. Over time, the composition of the annuity contract will vary based on market performance. On a periodic basis (e.g., quarterly or annually), subaccount shares will be bought and sold to maintain this allocation. As long as the reallocation is done within the annuity contract, it should not trigger current taxable capital gain or loss.

Many variable annuity contracts offer performance and income guarantees that cannot be provided by mutual fired portfolios. For example, a...