Qualified and Unqualified Annuities

For all fixed annuities, the growth of the money invested is tax deferred, but annuities can be purchased with pretax income and be tax deferred, or they may be purchased with money that has already been taxed. The type of income (pretax or after-tax) with which an annuity is purchased determines whether it qualifies for tax-deferred status.

Those annuities purchased with pretax income qualify for tax-deferred status because the money invested in them has never been taxed. Qualified annuities are purchased at retirement with funds that have been invested in a qualified retirement plan, such as a 401(k), and have grown tax free.

Qualified annuities can also be bought periodically over the working life of the annuitant with money that is not yet taxed.

Annuities that are purchased with money that has already been taxed at the income source do not qualify for tax-deferred status. These are usually purchased at retirement or during the working life of the annuitant.

The advantage of a qualified annuity is tax-free growth on invested money, and tax is deferred until the money is paid out. The advantage of an unqualified annuity is tax-deferred growth on the income made from taxed money invested in the annuity.

In the case of either qualified or unqualified annuities, when the annuitant passes away, the beneficiary will owe very high taxes on the investment income. Beneficiaries do not enjoy tax-free status on annuities they inherit. When annuitants are doing their estate planning, it is important to consult with a specialist or do careful research to ensure that their loved ones are not being left with a tremendous tax burden.

The Bottom Line

Fixed annuities are a powerful vehicle for saving for retirement and guaranteeing regular streams of income during it. They are often used for tax deferral and savings. At the same time, annuities can be very tricky to manage for maximum returns, as the cost of insurance features can eat into the return you get on your initial investment.

Annuity contracts are complicated, and those who don’t understand them may end up paying a a great deal of money for an instrument that doesn’t serve its intended purpose. To reap the benefits of reduced taxes, stabilized returns and the invaluable peace of mind that fixed annuities can offer, investors need to thoroughly research and consider these instruments against other retirement income, such as pension payouts, 401(k)s and IRAs.

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Different Types of Life Annuities

There are several kinds of life annuities, and they differ by the insurance components they offer. That is, certain types of life annuities may alter the future payment structure in the event of something negative happening to the annuitant, such as sickness or early death. More specifically, the more insurance components there are, the longer the payments may last over time once the annuitization phase begins (we look at how this works below), and the longer the payments are to last, the smaller they will be. The amount of the monthly payments also depends on the life expectancy of the annuitant; the lower the life expectancy, the higher the payment because more of the annuity investment must be paid out over a shorter period.

Also, the prices of life annuities are composed of the money invested in the annuity but also the premium paid for these insurance components. Therefore, the more insurance components you have, the more expensive your annuity will be. Each type of life annuity has its own advantages and disadvantages, depending on the nature of the annuitant. Let’s look at the various types of life annuities more closely.

Straight Life Annuities

These are the simplest form of life annuities – the insurance component is based on nothing but providing income until death. Once the annuitization phase begins, this annuity pays a set amount per period until the annuitant dies. Because there is no other type of insurance component to this type of annuity, it is less expensive.

Also, straight life annuities offer no form of payout to surviving beneficiaries after the annuitant’s death. Those wishing to leave an estate to their survivors would be well advised to keep other investments if they are inclined to purchase a straight life annuity.

Substandard Health Annuities

These are straight life annuities that may be purchased by someone with a serious health problem. They are priced according to the chances of the annuitant dying in the near term. The lower the life expectancy, the more expensive the annuity because there is less of a chance for the insurance company to make a return on the money the annuitant invests.

For this reason the annuitant of a substandard health annuity also receives a lower percentage of his or her original investment in the annuity. However, because life expectancy is lower, the payouts per period are substantially increased compared with the payments made to any annuitant who is expected to live for many years. Other insurance components are generally not offered with these vehicles

.

Life Annuities with a Guaranteed Term

Life annuities with a guaranteed term offer more of an insurance component than straight life annuities by allowing the annuitant to designate a beneficiary. If the annuitant dies before a period of time (the term) has passed, the beneficiary will receive the sum of the money not paid out. In the event of an earlier-than-expected death, however, annuitants do not forfeit their savings to an insurance company. Of course, this advantage comes at an additional cost.

Another thing to remember with life annuities with a guaranteed term is that in the event of unexpected death, beneficiaries receive one lump-sum payment from the insurance company. The likely result of such a payout is a spike in the annual income of the beneficiaries and an increase in income taxes in the year in which they receive the payment. These tax implications can result in the annuitant leaving less to his or her designated beneficiaries than intended.

Joint Life with Survivor Annuity

These continue payments to the annuitant’s spouse after his or her death. The payments are passed on no matter what (that is, they don’t depend on whether the annuitant dies before a certain term). These annuities also provide the annuitant the chance to designate additional beneficiaries to receive payments in the event of the spouse’s sooner-than-expected death. Annuitants may state that beneficiaries are to receive lower payments.

The advantages of a joint life with last survivor annuity is that the annuitant’s spouse has the security of continued income after the annuitant’s passing. But because the payments are periodic rather than lump sum, the spouse will not be left with unnecessary tax burdens. The disadvantage here is cost. As these contain more of an added insurance component, the costs to annuitants are substantially higher.

Term Certain Annuities

These annuities are a very different product than life annuities. Term certain annuities pay a given amount per period up to a specified date, no matter what happens to the annuitant over the course of the term. However, if the annuitant dies before the specified date, the insurance company keeps the remainder of the annuity’s value

These contain no added insurance components; that is, unlike the life annuities discussed above, term certain annuities do not account for the annuitant’s condition, life expectancy or beneficiary. Further, in the event of failing health and increased medical costs, the income of a term certain annuity will not increase to accommodate the annuitant’s increased expenses. Because these annuities offer fewer insurance options and therefore pose no risk to the insurer or financial-services provider, they are substantially less expensive than life annuities.

The disadvantage of these income vehicles is that once the term ends, income from the annuity is finished. Term certain annuities are often sold to people who want stable income for their retirement but are not interested in buying any sort of insurance component or cannot afford one

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Explaining Types of Fixed Annuities

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Fixed annuities help to stabilize income from investments and are most commonly used

 by people who are not fully participating in the workforce, are about to retire or are

 retired. Fixed annuities are insurance contracts that offer the annuitant – the person

 who owns the annuity – a set amount of income paid at regular intervals until a 

specified period has ended or an event has occurred. There are advantages and

 disadvantages to purchasing a fixed annuity, and there are many types of options that,

 for a fee, can be added to a basic fixed annuity.

How Do Fixed Annuities Work?

Fixed annuities can be bought from insurance companies or financial institutions with

 a lump-sum payment (usually most of the annuitant’s cash and cash-equivalent

 savings), or they can be paid for on a periodic basis while the annuitant is working. 

The money that is invested in the annuity is guaranteed to earn a fixed rate of return

 throughout the accumulation phase of the annuity (when money is being put into it).

During the annuitization phase (when money is being paid out), the balance invested,

 minus payouts, will continue to grow at this fixed rate. In some cases, however,

 annuitants don’t live long enough to claim the full amount of their annuities. When this 

happens, they end up passing the remainder of their annuity savings to the company

 that sold it to them. But whether the annuitant chooses to try to avoid this depends on 

the kind of policy purchased.

When you are considering purchasing a fixed annuity, it is important to remember that

 you can often negotiate the price of these products. Also, the amount of money that an 

annuity will pay out varies (sometimes greatly) among the financial intermediaries 

selling these products, so it’s best to shop around and avoid making quick decisions.

The two main types of fixed annuities are life annuities and term certain annuities. Life 

annuities pay a predetermined amount each period until the death of the annuitant, 

while term certain annuities pay a predetermined amount each period (usually monthly)

 until the annuity product expires, which may very well be before the death of the

 annuitant.

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Types of Fixed Annuities

Fixed annuities help to stabilize income from investments and are most commonly

 used by people who are not fully participating in the workforce, are about to retire or

 are retired. Fixed annuities are insurance contracts that offer the annuitant – the 

person who owns the annuity – a set amount of income paid at regular intervals until 

a specified period has ended or an event has occurred. There are advantages and disadvantages to purchasing a fixed annuity, and there are many types of options that

, for a fee, can be added to a basic fixed annuity.

How Do Fixed Annuities Work?

Fixed annuities can be bought from insurance companies or financial institutions with

 a lump-sum payment (usually most of the annuitant’s cash and cash-equivalent

 savings, or they can be paid for on a periodic basis while the annuitant is working. 

The money that is invested in the annuity is guaranteed to earn a fixed rate of return throughout the accumulation phase of the annuity (when money is being put into it).

During the annuitization phase (when money is being paid out), the balance invested,

 minus payouts, will continue to grow at this fixed rate. In some cases, however,

 annuitants don’t live long enough to claim the full amount of their annuities. When

 this happens, they end up passing the remainder of their annuity savings to the 

company that sold it to them. But whether the annuitant chooses to try to avoid this 

depends on the kind of policy purchased.

When you are considering purchasing a fixed annuity, it is important to remember that

 you can often negotiate the price of these products. Also, the amount of money that

 an annuity will pay out varies (sometimes greatly) among the financial intermediaries

 selling these products, so it’s best to shop around and avoid making quick decisions.

The two main types of fixed annuities are life annuities and term certain annuities. Life

 annuities pay a predetermined amount each period until the death of the annuitant, 

while term certain annuities pay a predetermined amount each period usually monthly

 until the annuity product expires, which may very well be before the death of the

 annuitant.

Read more: Explaining Types Of Fixed 

Income Annuity

 

What is an 'Income Annuity'

An income annuity is an annuity contract that is designed to start paying income as soon as the policy is initiated. Once funded, an income annuity is annuitized immediately, although the underlying income units may be in either fixed or variable investments. As such, the income payments may fluctuate over time. An income annuity, also known as an "immediate annuity," a "single-premium immediate annuity (SPIA)," or an "immediate payment annuity," is typically purchased with a lump sum payment (premium), often by individuals who are retired or are close to retirement

Breaking Down 'Income Annuity'

Investors seeking income annuities should have clear picture of how much income will be received and for how long. Most annuities pay out until the death of the annuitant and some pay out until the death of spouse. Although the insurance product may be annuitized immediately, variable investments can allow for some principal protection by participating in equity markets. Even if all income units are in fixed investments, there may be a provision allowing for a higher return if a specific benchmark index performs extremely well.

The return an annuity buyer gets from their income annuity is based on how long they live — greater longevity equals more payments and a better return. Payments may begin as soon as a month after a contract is signed and a premium payment is made. Income annuity payments may be monthly, quarterly, semi-annually or annually. Many income annuities offer a death benefit. If a cash refund option is chosen, the designated beneficiary of an annuitant who dies before receiving enough payments to equal their initial premium will receive the balance. As such, an annuitant's age, life expectancy and health are relevant to deciding whether such an annuity is suitable.

Income annuities may be purchased for a little as a few thousand dollars. Bigger income annuities may require special vetting, however. Some income annuities may be deferred to build income for use later in life.

Income Annuity: Who is it For?

The strategy behind an income annuity is to create a steady stream of income for a retiree that cannot be outlived. In effect, an immediate annuity may act as longevity insurance. A good rule of thumb is that payments backed by an income annuity should replace a retiree's wage payments until they pass away. Another strategy utilizing an income annuity is using them to provide income to pay a retiree's expenses, such as rent or mortgage, food and energy, assisted living facility fees, insurance premiums or provide the cash for any other recurring payment needs.

One disadvantage of income annuities is that once they are initiated they cannot be rolled back or stopped. Also, payments for such annuity may be fixed and not indexed to inflation, and will therefore stay the same. As such, the purchasing power of each payment will decrease over time as inflation takes its toll.

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Financial Accounting vs. "Other" Accounting

Financial accounting represents just one sector in the field of business accounting. Another 

sector, managerial accounting, is so named because it provides financial information to a 

company's management. This information is generally internal (not distributed outside of the 

company) and is primarily used by management to make decisions. Other sectors of the 

accounting field include cost accounting, tax accounting, and auditing.

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Financial Reporting

Financial reporting is a broader concept than financial statements. In addition to the financial 

statements, financial reporting includes the company's annual report to stockholders, its annual 

report to the Securities and Exchange Commission (Form 10-K), its proxy statement, and other 

financial information reported by the company.

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Financial Statements

Financial accounting generates the following general-purpose, external, financial statements:

1. Income statement (sometimes referred to as "results of operations" or "earnings statement" or "profit and loss [P&L] statement")
2. Balance sheet (sometimes referred to as "statement of financial position")
3. Statement of cash flows (sometimes referred to as "cash flow statement")
4. Statement of stockholders' equity

Income Statement

The income statement reports a company's profitability during a specified period of time. The period of time could be one year, one month, three months, 13 weeks, or any other time interval chosen by the company.

The main components of the income statement are revenues, expenses, gains, and losses. Revenues include such things as sales, service revenues, and interest revenue. Expenses include the cost of goods sold, operating expenses (such as salaries, rent, utilities, advertising), and nonoperating expenses (such as interest expense). If a corporation's stock is publicly traded, the earnings per share of its common stock are reported on the income statement.

Balance Sheet

The balance sheet is organized into three parts: (1) assets, (2) liabilities, and (3) stockholders' equity at a specified date (typically, this date is the last day of an accounting period).

The first section of the balance sheet reports the company's assets and includes such things as cash, accounts receivable, inventory, prepaid insurance, buildings, and equipment. The next section reports the company's liabilities; these are obligations that are due at the date of the balance sheet and often include the word "payable" in their title (Notes Payable, Accounts Payable, Wages Payable, and Interest Payable). The final section is stockholders' equity, defined as the difference between the amount of assets and the amount of liabilities.

Statement of Cash Flows

The statement of cash flows explains the change in a company's cash (and cash equivalents) during the time interval indicated in the heading of the statement. The change is divided into three parts: (1) operating activities, (2) investing activities, and (3) financing activities.

The operating activities section explains how a company's cash (and cash equivalents) have changed due to operations. Investing activities refer to amounts spent or received in transactions involving long-term assets. The financing activities section reports such things as cash received through the issuance of long-term debt, the issuance of stock, or money spent to retire long-term liabilities. 

Statement of Stockholders' Equity

The statement of stockholders' (or shareholders') equity lists the changes in stockholders' equity for the same period as the income statement and the cash flow statement. The changes will include items such as net income, other comprehensive income, dividends, the repurchase of common stock, and the exercise of stock options.

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Accounting Principles

If financial accounting is going to be useful, a company's reports need to be credible, easy to understand, and comparable to those of other companies. To this end, financial accounting follows a set of common rules known as accounting standards or generally accepted accounting principles (GAAP, pronounced "gap").

GAAP is based on some basic underlying principles and concepts such as the cost principle, matching principle, full disclosure, going concern, economic entity, conservatism, relevance, and reliability.

GAAP, however, is not static. It includes some very complex standards that were issued in response to some very complicated business transactions. GAAP also addresses accounting practices that may be unique to particular industries, such as utility, banking, and insurance. Often these practices are a response to changes in government regulations of the industry.

GAAP includes many specific pronouncements as issued by the Financial Accounting Standards Board (FASB, pronounced "fas-bee"). The FASB is a non-government group that researches current needs and develops accounting rules to meet those needs

In addition to following the provisions of GAAP, any corporation whose stock is publicly traded is also subject to the reporting requirements of the Securities and Exchange Commission (SEC), an agency of the U.S. government. These requirements mandate an annual report to stockholders as well as an annual report to the SEC. The annual report to the SEC requires that independent certified public accountants audit a company's financial statements, thus giving assurance that the company has followed GAAP.

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Double Entry and the Accrual Basis of Accounting

At the heart of financial accounting is the system known as double entry bookkeeping (or "double entry accounting"). Each financial transaction that a company makes is recorded by using this system.

The term "double entry" means that every transaction affects at least two accounts. For example, if a company borrows $50,000 from its bank, the company's Cash account increases, and the company's Notes Payableaccount increases. Double entry also means that one of the accounts must have an amount entered as a debit, and one of the accounts must have an amount entered as a credit. For any given transaction, the debit amount must equal the credit amount.

The advantage of double entry accounting is this: at any given time, the balance of a company's asset accounts will equal the balance of its liability and stockholders' (or owner's) equity accounts.

Financial accounting is required to follow the accrual basis of accounting (as opposed to the "cash basis" of accounting). Under the accrual basis, revenues are reported when they are earned, not when the money is received. Similarly, expenses are reported when they are incurred, not when they are paid. For example, although a magazine publisher receives a $24 check from a customer for an annual subscription, the publisher reports as revenue a monthly amount of $2 (one-twelfth of the annual subscription amount). In the same way, it reports its property tax expense each month as one-twelfth of the annual property tax bill.

By following the accrual basis of accounting, a company's profitability, assets, liabilities and other financial information is more in line with economic reality., 

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