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FOCUSING ON:
"UNDERSTANDING ROLLOVERS:
IRA Rollover, 401K Rollover"

TYPES OF IRA'S
In 1974, Congress developed the IRA, or Individual Retirement Account, that allowed individual citizens to save money for their retirement. The Employee Retirement Income Security Act, as it was called, has been modified several times since its inception, in some ways offering more benefits and in some ways creating more restrictions. No matter whether you choose to set up your own IRA with new contributions, you inherit one from a family member, rollover a retirement plan, or are offered one by an employer, it is easy to get started saving for your own retirement savings.

Contributory IRA
With a contributory IRA, you simply contribute out of your income. During 2008, you can invest up to $5,000 and if you are over 50, you can also contribute up to $1,000 more to supplement your account. You may even be able get a tax deduction for your contributions if you aren't covered by a retirement plan through your employer. Even if you are covered, you still may qualify for a deduction, depending on your income. Keep in mind that each year, the contribution levels do change and may become a bit more tricky if you are married and only one spouse has a workplace retirement plan. For questions about whether or not your contribution qualifies as a tax deduction, make sure to ask your tax advisor.

Rollover IRA
Rollover IRAs are created when you create a new IRA by transferring assets from an employer-sponsored plan or another type of IRA. You can transfer these assets by making an institutional transfer from it's current holder to the new institution that you have chosen for your rollover IRA. If you prefer, you can also take your funds out of the original IRA and deposit them into the new IRA as long as the transfer takes place within 60 days. Once in your rollover IRA, you have control over how you want those assets to be managed and all assets therein are tax deferred.

Roth IRA
Roth IRAs are different than traditional IRAs as their contributions are not tax deductible upon deposit, but once in the IRA, assets are tax free. Which means that as funds are taken out during retirement, there are no taxes on these distributions. There are different rules that apply to Roth IRAs vs. regular IRAs and most information on this site pertains to traditional IRAs.

To open a Roth IRA, you will first have to check to be sure that you qualify based on income thresholds that are set and adjusted from year to year. If you qualify, simply deposit after-tax contributions to your account.

If you already have a traditional IRA and want to transfer those assets into a Roth IRA, you simply have to pay taxes on the assets at the time of the conversion. Once transferred over, you will no longer have to worry about any taxes on those assets. Conversions to Roth IRAs from traditional IRAs are prohibited if your income is over $100,000 during the year you convert to a Roth IRA.

Inherited IRA
Inherited IRAs are subject to changes in rules once they are inherited and differ depending on the situation of the inheritance. For example, once an IRA is transferred to its beneficiary, it no longer has the same characteristics it had as a traditional IRA. For spouses, the IRA can become their own and is then considered a rollover IRA which allows that spouse to contribute to it each year. For non-spouses, the IRA becomes an inherited IRA and at that point, no additional contributions can be made.

Workplace IRA
If your employer offers a retirement plan, be sure to ask if they offer incorporate SEP and SIMPLE IRAs into your benefit package. They will have to give you specific details for their plan.

HOW TO ROLLOVER YOUR IRA

Problems you could encounter with a 60-day rollover: * Check could be lost in the mail. * You could miss the 60 day deadline. *

The check could be lost or destroyed in your own home. Retirement Plan: Retirement plans call for a little different process during the 60-day rollover. When you take assets out of your retirement fund, 20% of the assets will be withheld for taxes. These funds can be reclaimed when you file taxes, but only if you deposit the full amount in your new IRA (including the 20% that was withheld). This means that if you were planning to rollover $10,000 from your IRA, you would only be given a check for $8,000, since $2,000 (20%) would be held for tax purposes. Now, in order to recover the $2,000 that was withheld, you will have to deposit the full amount of $10,000 into your new rollover IRA within 60 days of receipt of your distribution check. When you file for taxes, you will get the additional $2,000 that was withheld back. If you would rather simply transfer the full $10,000, or whatever amount you choose, from your retirement fund to your IRA rollover, you can opt for a direct trustee-to-trustee transfer. Ask your pension administrator to set that up for you. Finally, in order to keep people from continually "borrowing" their IRA money, only one 60-day rollover (with the same assets) is allowed during the course of one year. However, if you have assets in both a pension and an IRA, as long as they are different assets, there is no rule stating that they can't both be rolled over during the same year.

Beneficiaries
IRAs can be a great option for passing along assets without causing your beneficiaries to go through the hassles of court or paying probate fees. With many custodians requiring a yearly update on all beneficiary forms, IRAs are often the most up to date record for assets and supercede an outdated will. For example, if your will states that all your assets should be left to your two children, but your IRA beneficiary form states that the assets should be given to your first grandchild, that's who will inherit your assets in the event of your death.

If you leave your IRAs to someone other than a spouse, you will definitely need to pay special attention to rules governing the titling, transfer, and distributions. Whether it be your children, grandchildren, niece, or nephew, that inherits your IRA, be sure to leave them some instructions on how to handle their new assets in your absence. You may even want to suggest an advisor to help them follow the rules properly, because unlike many assets you may leave behind, IRAs can't simply be retitled. If they were to just retitle the account, that would be considered an immediate (and taxable) distribution. Thus, funds would no longer be tax-deffered. In addition, distributions require attention as well. If the proper amount isn't take at the proper time, your beneficiary could lose up to 50% of the required distribution!

While in the early phases of accumulating wealth, IRAs can be great tools for avoiding taxation and building wealth. However, once it comes time to consider estate-planning and beneficiary designations, you may want to consult a professional estate attorney. They may be able to give you the advice you need to set up your IRA to give you the best results now without costing your beneficiaries exorbitant amounts in taxes once you are gone.

INVESTMENT CHOICES FOR YOUR IRA

ABOUT ROLLOVERS

Established by the Tax Reform Act (TRA) of 1986, (Pub.L. 99-514, 100 Stat. 2085). A Traditional IRA is an individual retirement account (IRA) in the United States. The IRA is held at a custodian institution such as a bank or brokerage, and may be invested in anything that the custodian allows (for instance, a bank may allow certificates of deposit, and a brokerage may allow stocks and mutual funds). Unlike the Roth IRA, the only criterion for being eligible to contribute to a Traditional IRA is sufficient income to make the contribution. However, the best provision of a Traditional IRA — the tax-deductibility of contributions — has strict eligibility requirements based on income, filing status, and availability of other retirement plans (mandated by the Internal Revenue Service). Transactions in the account, including interest, dividends, and capital gains, are not subject to tax while still in the account, but upon withdrawal from the account, withdrawals are subject to federal income tax (see below for details). This is in contrast to a Roth IRA, in which contributions are never tax-deductible, but qualified withdrawals are tax free. The traditional IRA also has more restrictions on withdrawals than a Roth IRA. With both types of IRA, transactions inside the account (including capital gains, dividends, and interest) incur no tax liability. Here is a 401(k) IRA matrix that compares various types of IRAs with various types of 401(k)s.

Traditional IRA contributions are limited as follows:

Advantages

• The main advantage of a Traditional IRA, compared to a Roth IRA, is that contributions are often tax-deductible. For instance, if a taxpayer contributes $4,000 to a traditional IRA and is in the twenty-five percent marginal tax bracket, then a $1,000 benefit ($1,000 reduced tax liability) will be realized for the year. Because qualified distributions are taxed as ordinary income (the taxpayer's highest rate), the long-term benefits of the traditional IRA are only comparable to those of a Roth IRA (whose qualified distributions are tax free) if the current year tax benefit ($1,000 above) is reinvested.

• Also, if a taxpayer expects to be in a lower tax bracket in retirement than during the working years, then a traditional IRA offers an increased incentive over the Roth IRA.

• Another advantage of a Traditional IRA is that the taxpayer gets the tax benefit immediately.

• With the Roth IRA, there may be a risk that over the next several decades Congress will decide to tax Roth IRA distributions.

Disadvantages

• There are the eligibility requirements for the tax-deductibility. If one is eligible for a retirement plan at work, one's income must be below a specific threshold for your filing status.

• All withdrawals from a Traditional IRA are included in gross income and subject to federal income tax (with the exception of any nondeductible contributions; there is a formula for determining how much of a withdrawal is not subject to tax). If one's investment style is buy-and hold or dividend-seeking, then a Traditional IRA is at a disadvantage since holding stocks in an IRA means they lose their favorable tax treatment given to dividends and capital gains.

• If one has a lot of disposable income, a Roth IRA in effect shelters more assets from taxes on gains than a Traditional IRA does. Suppose someone with $4000 to invest is eligible to either contribute $4000 to a Roth IRA, or to contribute $4000 to a Traditional IRA and deduct it. If one chooses the Traditional IRA, then one receives an upfront tax deduction (worth, say, $1000 to someone in the 25% tax bracket). When the money is withdrawn from the Traditional IRA it will be taxed at marginal rates. On the other hand, if one chooses the Roth IRA, then there is no upfront tax deduction, but the money and the gains are all exempt from taxes upon retirement. So, someone must be in a lower tax bracket upon retirement than in their contribution year for a Traditional IRA to be tax preferential to a Roth IRA.

• Perhaps the greatest disadvantage of the Traditional IRA is its forced distributions based on age. Withdrawals must begin at age 70½ (more precisely, April 1 of the calendar year after age 70½ is reached) according to a complicated formula. If an investor fails to make the required withdrawal, half of the mandatory amount will be confiscated automatically by the IRS. The Roth is completely free of these mandates.

• In addition to the distribution being included as taxable income, the IRS will also assess a 10% early distribution penalty if the participant is under age 59½. The IRS will waive this penalty with some exceptions, including first time home purchase (up to $10,000), higher education expenses, death, disability, unreimbursed medical expenses, health insurance, annuity payments and payments of IRS levies, all of which must meet certain stipulations.

Income limits

All United States taxpayers can make IRA deposits and defer the taxation of earnings. However, as explained below, the deposits are not deductible from income under certain circumstances. Accordingly, traditional IRAs are sometimes referred to as either "deductible" or "non-deductible."

If a taxpayer's household is covered by one or more employer-sponsored retirement plans, then the deductibility of traditional IRA contributions are phased out as specified income levels are reached.

• Married Filing Jointly or Qualified Widow and Modified Adjusted Gross Income is between $83,000 and $103,000 in 2007. If you are not covered by an employee-sponsored retirement plan but your spouse is, the limits for 2007 (married filing jointly) are $156,000 and $166,000.

• Married Filing Separately (and you lived with your spouse at any time during the year) and modified AGI is between $0 and $10,000

• Single, Head of Household or Married Filing Separately (and you did not live with your spouse) and modified AGI is between $52,000 and $62,000

The lower number represents the point at which the taxpayer is still allowed to deduct the entire maximum yearly contribution. The upper number is the point as of which the taxpayer is no longer allowed to deduct at all. The deduction is reduced proportionally for taxpayers in the range. Note that people who are married and lived together, but who file separately, are only allowed to deduct a relatively small amount.

To be eligible, you must meet the earned income minimum requirement. In order to make a contribution, you must have taxable compensation (not taxable income from investments). If you make only $2000 in taxable compensation, your maximum IRA contribution is $2000.

Converting a Traditional IRA to a Roth IRA

Conversion of a Traditional IRA to a Roth IRA results in the converted funds becoming taxed in the year they are converted (with the exception of non-deductible assets).

Two circumstances prohibit a conversion to a Roth IRA: Modified Adjusted Gross Income exceeding $100,000 or the participant's tax filing status is Married Filing Separately. With recent legislation, as part of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), the modified AGI requirement of $100,000 and not be married filing separately criteria will be removed in 2010.

Transfers vs. Rollovers

Transfers and rollovers are two ways of moving IRA sheltered assets between financial institutions.

A transfer is normally initiated by the institution receiving the funds. A request is sent to the disbursing institution for a transfer and a check (made payable to the other institution) is sent in return. This transaction is not reported to the IRS

A rollover (sometimes referred to as a 60 day rollover) can also be used to move IRA money between institutions. A distribution is made from the institution disbursing the funds. A check would be made payable directly to the participant. The participant would then have to make a rollover contribution to the receiving financial institution within 60 days in order for the funds to retain their IRA status. This type of transaction can only be done once every 12 months with the same funds. Contrary to a transfer, a rollover is reported to the IRS. The participant who received the distribution will have that distribution reported to the IRS. Once the distribution is rolled into an IRA, the participant will be sent a Form 5498 to report on their taxes to nullify any tax consequence of the initial distribution.

"Borrowing Money" from an IRA

A loan from an IRA is prohibited. It is considered a prohibited transaction and the IRS may disqualify your plan and tax you on the assets. Some use the 60 day rollover as a way to temporarily take funds from an IRA. A participant will take a distribution and, in turn, all or some of the distribution that the participant takes may be rolled back into the same IRA plan within the allowed period to retain its tax deferred status. One 60 day rollover is allowed every rolling 12 months, per allocation of funds within the IRA. For instance, if you hold $100,000 in an IRA and withdraw $10,000, you have 60/Days to return it. After returning the 1st $10,000, you can then withdraw another $10,000 and repeat the process. Assuming each rollover is in $10,000 allotments from a $100,000 account, you can repeat this process 10 times within 1 year. If you instead rollover the entire $100,000 account in 60 days, you would have to wait another year before repeating the process.

WHAT IS ROTH IRA

The Roth 401(k) is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Code, section 402A, and represents a unique combination of features of the Roth IRA and a traditional 401(k) plan. As of January 1, 2006 U.S. employers have been free to amend their 401(k) plan document to allow employees to elect Roth IRA type tax treatment for a portion or all of their retirement plan contributions. The same change in law allowed Roth IRA type contributions to 403(b) retirement plans. The Roth retirement plan provision was enacted as a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001),

In the U.S. an annuity contract is created when an individual gives a life insurance company money which may grow on a tax-deferred basis and then can be distributed back to the owner in several ways. The defining characteristic of all annuity contracts is the option for a guaranteed distribution of income until the death of the person or persons named in the contract. Perhaps confusingly, the majority of modern annuity customers use annuities only to accumulate funds and to take lump-sum withdrawals without using the guaranteed-income-for-life feature.

General

Annuity contracts in the United States are defined by the Internal Revenue Code and regulated by the individual states. Variable annuities have features of both life insurance and investment products. In the U.S., annuity contracts may be issued only by life insurance companies, although private annuity contracts may be arranged between donors to non-profits to reduce taxes. Insurance companies are regulated by the states, so contracts or options that may be available in some states may not be available in others. Their federal tax treatment, however, is governed by the Internal Revenue Code. Variable annuities are regulated by the Securities and Exchange Commission and the sale of variable annuities is overseen by FINRA (the largest non-governmental regulator for all securities firms doing business in the United States).

There are two possible phases for an annuity, one phase in which the customer deposits and accumulates money into an account (the deferral phase), and another phase in which customers receive payments for some period of time (the annuity or income phase). During this latter phase, the insurance company makes income payments that may be set for a stated period of time, such as five years, or continue until the death of the customer(s) (the "annuitant(s)") named in the contract. Annuitization over a lifetime can have a death benefit guarantee over a certain period of time, such as ten years. Annuity contracts with a deferral phase always have an annuity phase and are called deferred annuities. An annuity contract may also be structured so that it has only the annuity phase; such a contract is called an immediate annuity.

Immediate annuity

The term "annuity," as used in financial theory, is most closely related to what is today called an immediate annuity. This is an insurance policy which, in exchange for a sum of money, guarantees that the issuer will make a series of payments. These payments may be either level or increasing periodic payments for a fixed term of years or until the ending of a life or two lives, or even whichever is longer. It is also possible to structure the payments under an immediate annuity so that they vary with the performance of a specified set of investments, usually bond and equity mutual funds. Such a contract is called a variable immediate annuity. See also life annuity, below.

The overarching characteristic of the immediate annuity is that it is a vehicle for distributing savings with a tax-deferred growth factor. A common use for an immediate annuity might be to provide a pension income. In the U.S., the tax treatment of an immediate annuity is that every payment is a combination of a return of principal (which part is not taxed) and income (which is taxed at ordinary income rates, not capital gain rates). When a deferred annuity is annuitized, it works like an immediate annuity from that point on, but with a lower cost basis and thus more of the payment is taxed.

Annuity with period certain

This type of immediate annuity pays the annuitant for a designated number of years (i.e., a period certain) and is used to fund a need that will end when the period is up (for example, it might be used to fund the premiums for a term life insurance policy). Thus this option is not necessarily suitable for an individual's retirement income, as the person may outlive the number of years the annuity will pay.

Life annuity

A life or lifetime immediate annuity is used to provide an income for the life of the annuitant similar to a defined benefit or pension plan.

A life annuity works somewhat like a loan that is made by the purchaser (contract owner) to the issuing (insurance) company, which pays back the original capital or principal (which isn't taxed) with interest and/or gains (which is taxed as ordinary income) to the annuitant on whose life the annuity is based. The assumed period of the loan is based on the life expectancy of the annuitant. In order to guarantee that the income continues for life, the insurance company relies on a concept called cross-subsidy or the "law of large numbers". Because an annuity population can be expected to have a distribution of lifespans around the population's mean (average) age, those dying earlier will give up income to support those living longer whose money would otherwise run out. Thus it is a form of longevity insurance (see also below).

A life annuity, ideally, can reduce the "problem" faced by a person that he/she doesn't know how long he/she will live, and so he/she doesn't know the optimal speed at which to spend his/her savings. Life annuities with payments indexed to the Consumer Price Index might be an acceptable solution to this problem, but there is only a thin market for them in North America.

Life annuity variants

For an additional expense (either by way of an increase in payments (premium) or a decrease in benefits), an annuity or benefit rider can be purchased on another life such as a spouse, family member or friend for the duration of whose life the annuity is wholly or partly guaranteed. For example, it is common to buy an annuity which will continue to pay out to the spouse of the annuitant after death, for so long as the spouse survives. The annuity paid to the spouse is called a reversionary annuity or survivorship annuity. However, if the annuitant is in good health, it may be more advantageous to select the higher payout option on his or her life only and purchase a life insurance policy that would pay income to the survivor.

The pure life annuity can have harsh consequences for the annuitant who dies before recovering his or her investment in the contract. Such a situation, called a forfeiture, can be mitigated by the addition of a period-certain feature under which the annuity issuer is required to make annuity payments for a least a certain number of years; if the annuitant outlives the specified period certain, annuity payments continue until the annuitant's death, and if the annuitant dies before the expiration of the period certain, the annuitant's estate or beneficiary is entitled to the remaining payments certain. The tradeoff between the pure life annuity and the life-with-period-certain annuity is that the annuity payment for the latter is smaller. A viable alternative to the life-with-period-certain annuity is to purchase a single-premium life policy that would cover the lost premium in the annuity.

Impaired-life annuities for smokers or those with a particular illness are also available from some insurance companies. Since the life expectancy is reduced, the annual payment to the purchaser is raised.

Life annuities are priced based on the probability of the annuitant surviving to receive the payments. Longevity insurance is a form of annuity that defers commencement of the payments until very late in life. A common longevity contract would be purchased at or before retirement but would not commence payments until 20 years after retirement. If the nominee dies before payments commence there is no payable benefit. This drastically reduces the cost of the annuity while still providing protection against outliving one's resources.

Deferred annuity

The second usage for the term annuity came into being during the 1970s. Such a contract is more properly referred to as a deferred annuity and is chiefly a vehicle for accumulating savings with a view to eventually distributing them either in the manner of an immediate annuity or as a lump-sum payment.

All varieties of deferred annuities owned by individuals have one thing in common: any increase in account values is not taxed until those gains are withdrawn. This is also known as tax-deferred growth.

A deferred annuity which grows by interest rate earnings alone is called a fixed deferred annuity (FA). A deferred annuity that permits allocations to stock or bond funds and for which the account value is not guaranteed to stay above the initial amount invested is called a variable annuity (VA).

A new category of deferred annuity, called the equity indexed annuity (EIA) emerged in 1995. Equity indexed annuities may have features of both fixed and variable deferred annuities. The insurance company typically guarantees a minimum return for EIA. An investor can still lose money if he or she cancels (or surrenders) the policy early, before a "break even" period. An oversimplified expression of a typical EIA's rate of return might be that it is equal to a stated "participation rate" multiplied by a target stock market index's performance excluding dividends. Interest rate caps or an administrative fee may be applicable.

Deferred annuities in the United States have the advantage that taxation of all capital gains and ordinary income is deferred until withdrawn. In theory, such tax-deferred compounding allows more money to be put to work while the savings are accumulating, leading to higher returns. A disadvantage, however, is that when amounts held under a deferred annuity are withdrawn or inherited, the interest/gains are immediately taxed as ordinary income.

Features

A variety of features and guarantees have been developed by insurance companies in order to make annuity products more attractive. These include death and living benefit options, extra credit options, account guarantees, spousal continuation benefits, reduced contingent deferred sales charges (or surrender charges), and various combinations thereof. Each feature or benefit added to a contract will typically be accompanied by an additional expense either directly (billed to client) or indirectly (inside product).

Deferred annuities are usually divided into two different kinds:

• Fixed annuities offer some sort of guaranteed rate of return over the life of the contract. In general such contracts are often positioned to be somewhat like bank CDs and offer a rate of return competitive with those of CDs of similar time frames. Many fixed annuities, however, do not have a fixed rate of return over the life of the contract, offering instead a guaranteed minimum rate and a first year introductory rate. The rate after the first year is often an amount that may be set at the insurance company's discretion subject, however, to the minimum amount (typically 3%). There are usually some provisions in the contract to allow a percentage of the interest and/or principal to be withdrawn early and without penalty (usually the interest earned in a 12-month period or 10%), unlike most CDs. Fixed annuities normally become fully liquid depending on the surrender schedule or upon the owner's death. Most equity index annuities are properly categorized as fixed annuities and their performance is typically tied to a stock market index (usually the S&P 500 or the Dow Jones Industrial Average). These products are guaranteed but are not as easy to understand as standard fixed annuities as there are usually caps, spreads, margins, and crediting methods that can reduce returns. These products also don't pay any of the participating market indices' dividends; the trade-off is that contract holder can never earn less than 0% in a negative year.

• Variable annuities allow money to be invested in insurance company "separate accounts" (which are sometimes referred to as "subaccounts" and in any case are functionally similar to mutual funds) in a tax-deferred manner. Their primary use is to allow an investor to engage in tax-deferred investing for retirement in amounts greater than permitted by individual retirement or 401(k) plans. In addition, many variable annuity contracts offer a guaranteed minimum rate of return (either for a future withdrawal and/or in the case of the owner's death), even if the underlying separate account investments perform poorly. This can be attractive to people uncomfortable investing in the equity markets without the guarantees. Of course, an investor will pay for each benefit provided by a variable annuity, since insurance companies must charge a premium to cover the insurance guarantees of such benefits. Variable annuities are regulated both by the individual states (as insurance products) and by the Securities and Exchange Commission (as securities under the federal securities laws). The SEC requires that all of the charges under variable annuities be described in great detail in the prospectus that is offered to each variable annuity customer. Of course, potential customers should review these charges carefully, just as one would in purchasing mutual fund shares. People who sell variable annuities are usually regulated by FINRA, whose rules of conduct require a careful analysis of the suitability of variable annuities (and other securities products) to those to whom they recommend such products. These products are often criticized as being sold to the wrong persons, who could have done better investing in a more suitable alternative, since the commissions paid under this product are often high relative to other investment products.

There are several types of performance guarantees, and one may often choose them a la carte, with higher risk charges for guarantees that are riskier for the insurance companies. The first type is comprised of guaranteed minimum death benefits (GMDBs), which can be received only if the owner of the annuity contract, or the covered annuitant, dies.

GMDBs come in various flavors, in order of increasing risk to the insurance company:

• Return of premium (a guarantee that you will not have a negative return)
• Roll-up of premium at a particular rate (a guarantee that you will achieve a minimum rate of return, greater than 0)
• Maximum anniversary value (looks back at account value on the anniversaries, and guarantees you will get at least as much as the highest values upon death)
• Greater of maximum anniversary value or particular roll-up

Insurance companies provide even greater insurance coverage on guaranteed living benefits, which tend to be elective. Unlike death benefits, which the contractholder generally can't time, living benefits pose significant risk for insurance companies as contractholders will likely exercise these benefits when they are worth the most. Annuities with guaranteed living benefits (GLBs) tend to have high fees commensurate with the additional risks underwritten by the issuing insurer.

Some GLB examples, in no particular order:

• Guaranteed minimum income benefit (a guarantee that one will get a minimum income stream upon annuitization at a particular point in the future)
• Guaranteed minimum accumulation benefit (a guarantee that the account value will be at a certain amount at a certain point in the future)
• Guaranteed minimum withdrawal benefit (a guarantee similar to the income benefit, but one that doesn't require annuitizing)
• Guaranteed-for-life income benefit (a guarantee similar to a withdrawal benefit, where withdrawals begin and continue until cash value becomes zero, withdrawals stop when cash value is zero and then annuitization occurs on the guaranteed benefit amount for a payment amount that is not determined until annuitization date.)

Criticisms of deferred annuities

Deferred annuities are generally sold by financial professionals, some of whom may work directly for an insurance company. Most financial professionals, however, are independent agents of the insurance company, not employees. The financial professional who sells an annuity collects a commission from the insurance company. This commission will be a percentage of the total premium paid by the investor. This percentage can be as little as 1% and as high as 12%; the average is 6%. Since these commissions appear high and there are deferred sales charges on annuities, many financial gurus have criticized annuity products.

The investor will, generally, not pay any of this commission directly to the financial professional; the commission is paid by the insurance company to the financial professional up front. The insurance company will recapture the commission paid to the financial professional through the fees charged to the customer (in a variable or equity indexed annuity) or the spread in the interest rate market (for a fixed annuity). There are also deferred back-end charges that will be applied if the investor closes out his or her contract before the agreed-upon time frame, usually 8 years. These charges can last for as little as 1 year or as many as 20 years, depending on the type of annuity and issuing company. These back-end charges concern many financial professionals and financial gurus.

Some annuities do not have any deferred surrender charges and do not pay the financial professional a commission, although the financial professional may charge a fee for his or her advice. These contracts are called "no-load" variable annuity products and are usually available from a fee-based financial planner or directly from a no-load mutual fund company. Of course various charges are still imposed on these contracts, but they are less than those sold by commissioned brokers. It is important that potential purchasers -- of annuities, mutual funds, tax-exempt municipal bonds, commodities futures, interest-rate swaps, in short, any financial instrument -- understand the fees on the product and the fees a financial planner may charge.

Variable annuities are controversial because many believe the extra fees (i.e., the fees above and beyond those charged for similar retail mutual funds that offer no principal protection or guarantees of any kind) may reduce the rate of return compared to what the investor could make by investing directly in similar investments outside of the variable annuity. A big selling point for variable annuities is the guarantees many have, such as the guarantee that the customer will not lose his or her principal. Critics say that these guarantees are not necessary because over the long term the market has always been positive, while others say that with the uncertainty of the financial markets many investors simply will not invest without guarantees. Past returns are no guarantee of future performance, of course, and different investors have different risk tolerances, different investment horizons, different family situations, and so on. The sale of any security product should involve a careful analysis of the suitability of the product for a given individual.

A controversial practice of insurance sales is the selling of insurance contracts within an IRA or 401(k) plan. Since these investment vehicles are already tax deferred, investors do not receive additional tax shelters from the annuities. The benefit of the annuity contract is the guaranteed lifetime income that all annuity contracts must have by state law. Approximately 90% of annuitants, however, have not taken the life annuity upon retirement. If an investor does not intend to take the life income option from an annuity contract at retirement he or she may want to consider a low-cost deferred annuity.

If an investor needs to take lifetime income at retirement, on the other hand, he or she may want to try to buy an annuity upon retirement or might consider selecting a 401(k) plan account with an option to buy the annuity just before retirement.

In the October 2003 edition of Wealth Manager, an article titled "Photo Finish" by W. McAfee, Jr. examined the effects of taxation on annuities relative to other investment vehicles. The author found that annuities are generally not effective as a tax-deferral vehicle and that there are significant flaws in the use of annuities for financial planning during the accumulation phase.

Taxation

In the U.S. Internal Revenue Code, the growth of the annuity value during the accumulation phase is tax-deferred, that is, not subject to current income tax, for annuities owned by individuals. The tax deferred status of deferred annuities has led to their common usage in the United States. Under the U.S. tax code, the benefits from annuity contracts do not always have to be taken in the form of a fixed stream of payments (annuitization), and many of annuity contracts are bought primarily for the tax benefits rather than to receive a fixed stream of income. If an annuity is used in a qualified pension plan or an IRA funding vehicle, then 100% of the annuity payment is taxable as current income upon distribution (because the taxpayer has no tax basis in any of the money in the annuity). If the annuity contract is purchased with after-tax dollars, then the contractholder upon annuitization recovers his basis pro-rata in the ratio of basis divided by the expected value, according to the tax regulation Section 1.72-5. (This is commonly referred to as the exclusion ratio.) After the taxpayer has recovered all of his basis, then 100% of the payments thereafter are subject to ordinary income tax.

Since the Jobs and Growth Tax Relief Reconciliation Act of 2003, the use of variable annuities as a tax shelter has greatly diminished, because the growth of mutual funds and now most of the dividends of the fund are taxed at long term capital gains rates. This taxation, contrasted with the taxation of all the growth of variable annuities at income rates, means that in most cases, variable annuities shouldn't be used for tax shelters unless very long holding periods apply (for example, more than 20 years).

Also, any withdrawals before an investor reaches the age of 59 ½ are generally subject to a 10% tax penalty in addition to any gain being taxed as ordinary income.

In the October 2003 edition of Wealth Manager, an article titled "Photo Finish" by W. McAfee, Jr. [4] examined the effects of taxation on annuities relative to other investment vehicles. The author found that annuities are generally not effective as a tax-deferral vehicle and that there are significant flaws in the use of annuities for financial planning during the accumulation phase.

Insurance company default risk and state guaranty associations

An investor should consider the financial strength of the insurance company that writes annuity contracts. Major insolvencies have occurred at least 62 times since the conspicuous collapse of the Executive Life Insurance Company in 1991.

Insurance company defaults are governed by state law. The laws are, however, broadly similar in most states. Annuity contracts are protected against insurance company insolvency up to a specific dollar limit, often $100,000, but as high as $500,000 in New York, New Jersey, and the state of Washington. This protection is not insurance and is not provided by a government agency. It is provided by an entity called the state Guaranty Association. When an insolvency occurs, the Guaranty Association steps in to protect annuity holders, and decides what to do on a case-by-case basis. Sometimes the contracts will be taken over and fulfilled by a solvent insurance company.

The state Guaranty Association is not a government agency, but states usually require insurance companies to belong to it as a condition of being licensed to do business. The Guaranty Associations of the fifty states are members of a national umbrella association, the National Organization of Life and Health Insurance Guaranty Associations (NOLHGA). The NOLHGA website provides a description of the organization, links to websites for the individual state organizations, and links to the actual text of the governing state laws.

A difference between guaranty association protection and the protection e.g. of bank accounts by FDIC, credit union accounts by NCUA, and brokerage accounts by SIPC, is that it is difficult for consumers to learn about this protection. Usually, state law prohibits insurance agents and companies from using the guaranty association in any advertising and agents are prohibited by statute from using this Web site or the existence of the guaranty association as an inducement to purchase insurance(e.g.). Presumably this is a response to concerns by stronger insurance companies about moral hazard.

Compensation for advisors or salespeople

Deferred annuities, including fixed, equity indexed and variable, typically pay the advisor or salesperson 1 percent to 4 percent of the amount invested as a commission, with possible trail options of 25 basis points to 1 percent. Sometimes the advisor can select his payout option, which might be either 7 percent up front, or 5 percent up front with a 25 basis point trail, or 1 percent to 3 percent up front with a 1 percent trail.

Some firms allow an investor to pick an annuity share class, which determines the salesperson's commission schedule. The main variables are the up-front commission and the trailing commission.

"No-load" variable annuities are available on a direct-to-consumer basis from several no-load mutual fund companies. "No-load" means the products have no sales commissions or surrender charges. Even these lower cost variable annuities often make sense only after an investor has exhausted all other forms of tax shelters, and only if being held for quite some time.

Fixed and Indexed Annuity commissions are paid by the insurance companies the licensed agent represents. Commissions are not paid out of the clients principal.