In this video, we walk through 5 TCP practice questions teaching about annuities. These questions are from TCP content area 1 on the AICPA CPA exam blueprints: Tax Compliance and Planning for Individuals and Personal Financial Planning.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Annuities
An annuity is a financial product designed to provide a steady income stream, typically used as a retirement solution. It involves an individual making a lump sum payment or series of payments to an insurance company, which in return commits to making periodic payments back to the individual, starting either immediately or at a future date. This financial vehicle is popular among retirees looking to secure a stable income for their post-working years.
Types of Annuities
There are primarily two types of annuities: fixed and variable.
- Fixed Annuities: These provide a guaranteed payout, where the payment amount does not change through the duration of the annuity. The insurance company bears the risk of investment performance, ensuring a stable, predictable income regardless of market fluctuations. For example, if a retiree purchases a fixed annuity for $100,000 that promises a 5% annual return, they would receive $5,000 per year, typically broken into monthly payments of $416.67.
- Variable Annuities: Unlike fixed annuities, the payments from variable annuities can fluctuate based on the performance of the underlying investments chosen by the annuitant. This means the retiree bears some investment risk, but also has the potential for higher returns. For instance, if the selected fund performs well, the monthly payouts could increase; if the fund performs poorly, the payouts could decrease.
An important aspect of understanding annuities is recognizing that each payment typically consists of two parts: a return of principal (or capital) and earnings. This distinction is crucial for tax purposes, as the return of principal is not taxed, whereas the earnings component is.
Return of Principal in Annuities
When an individual invests in an annuity, the money they pay into the annuity is considered their principal or capital. During the payout phase, a portion of each payment represents a partial return of this initial investment, and therefore, this portion is not subject to income tax. The remainder of the payment, which constitutes earnings on the investment, is taxed as ordinary income.
Calculating the Return of Principal
The proportion of each payment that is considered a return of principal is calculated using the exclusion ratio. This ratio is determined by dividing the total principal paid into the annuity by the total expected return from the annuity. Here’s how to calculate it with an example:
Example:
Marie invests $120,000 in a fixed annuity that promises to pay her $1,000 per month for 15 years (180 months).
- Total Principal Paid: $120,000
- Total Expected Return: $1,000 per month × 180 months = $180,000
- Exclusion Ratio: Total Principal ($120,000) ÷ Total Expected Return ($180,000) = 2/3 or about 66.67%
This means that 66.67% of each payment received by Marie is a return of her principal and is not taxable. The remaining 33.33% is considered earnings and is subject to income tax.
Calculation for Each Payment:
- Total Monthly Payment: $1,000
- Return of Principal per Payment: $1,000 × 66.67% = $666.70
- Taxable Earnings per Payment: $1,000 – $666.70 = $333.30
Practical Implications
In practice, this means Marie will receive $666.70 of each monthly payment tax-free, while the remaining $333.30 will be added to her taxable income for the year. This calculation is crucial for retirees to understand how much of their annuity income will actually contribute to their taxable income each year.
Annuities in the Year of Death
In the event of the annuitant’s death, the treatment of the remaining annuity depends on the type of annuity and its specific terms. For nonqualified annuities, any amount of the original investment in the contract that has not yet been distributed as income is deductible on the final tax return of the deceased, reducing the taxable estate.
Employer Sponsored and Individual Annuities
- Employer-Sponsored Annuities: These are often part of a qualified retirement plan like a 401(k) or 403(b). They can be funded with pre-tax dollars through payroll deductions and may include matching contributions from the employer. The annuity benefits are typically tied to the employment and offer tax advantages similar to other qualified retirement plans.
- Individual Retirement Annuities: These are purchased directly from an insurance company by an individual. They can be funded with after-tax dollars, and the growth is tax-deferred. Unlike employer-sponsored plans, there is no potential for matching contributions, but individuals have more flexibility in choosing providers and annuity options.
Example
Let’s consider two retirees: Alice opts for a fixed annuity within her 401(k) plan, contributing $200,000 that grows tax-deferred and begins receiving fixed payments when she retires at 65. Bob, on the other hand, purchases a variable annuity with $200,000 in after-tax dollars. He selects a mix of stocks and bonds as the underlying investments, hoping for a higher return, understanding that his income could vary each year.
Conclusion
Annuities can be a valuable tool for managing longevity risk and ensuring a steady income stream during retirement. However, they are complex products involving various fees, tax implications, and terms that must be carefully considered. Whether a fixed or variable annuity is appropriate will depend on an individual’s financial situation, risk tolerance, and retirement goals.
