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All tax-qualified annuities, regardless of classification, offer income tax deferral of earnings until the earnings are withdrawn. This tax-deferral feature of annuities has given rise to the saying that annuities enjoy “triple compounding” — interest on the principal, interest on the interest left in the annuity, and interest on the money that ordinarily would have been withdrawn to pay taxes. The only exception to this tax deferral is an annuity that is owned by an entity that is not an individual, or in trust whose beneficiaries are non-individuals. Such entities are allowed to own annuities; however, there is no tax deferral generally available.

Withdrawals

Withdrawals from an annuity are currently subjected to taxation on a last-in, first-out basis, unless they are annuitized over a finite period of time or for life. Parenthetically, some older annuities may still qualify for the first-in, first-out tax treatment. The tax-deferral feature of an annuity is rooted in the original purpose of the annuity, i.e., to pay an income to the owner in retirement. While annuities are now owned for reasons other than retirement or to fund a stream of future income payments, the tax-deferral feature of the annuity has endured as insurance companies have lobbied effectively to retain this benefit.

Asset protection

This same “retirement purpose” of an annuity has sheltered them from creditors in many states. As the use of annuities has changed, so has the attitudes of the various law-making bodies of the states and at this time there is great variability among states regarding creditors. Accordingly, the reader is advised to confirm the “creditor exempt” status of annuities in the states in which they are used. Obviously, even in states that exempt annuities from creditor claims there are always extenuating circumstances that could negate their exempt status.

1035 exchanges

One annuity may be exchanged for another annuity in accordance with the Internal Revenue Code Section 1035(e). Such 1035 exchanges do not trigger a taxable event and may be affected at any time regardless of the age of the owner or annuitant. Furthermore, the cash value of a life insurance policy may also be exchanged for an annuity without tax consequences, but the reverse is not permitted without triggering a taxable event. It should be noted, however, that many insurance companies will not honor “partial transfers” or the transfer of one annuity into multiple annuities. Nonetheless, the Revenue Service has ruled that partial exchanges may occur and that one annuity may be exchanged for two or more like annuities without taxable consequences. The exchanges in accordance with Section 1035 must conform to the exact procedures to avoid taxation; therefore, the reader is advised to consult with a knowledgeable professional when doing a tax-free exchange under Section 1035 of the IRS Code.

Investment protection

All annuities are also protected by the various state guaranty funds. These are reserve funds maintained by the various states to safeguard the cash value of policies, up to a certain limit, in the event an issuing insurance company is unable to meet it obligations under the contracts. A state’s guaranty fund is maintained by assessing all legal reserve insurance companies selling life insurance and annuity contracts in the state, and by having back-up access to the state’s general funds in certain situations. The amounts covered are generally at least $100,000 but some states have substantially higher limits.

To be continued.

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