ANNUITIES AND INDIVIDUAL RETIREMENT ACCOUNTS LEARNING OBJECTIVES After studying this chapter, you should be able to Show how an annuity differs from life insurance. # Describe the basic characteristics of a fixed annuity and a variable annuity. indexed annuity, + Explain the major characteristics of an equi '@ Describe the basic characteristics of a traditional tax-deductible individual retirement account (IRA). '@ Explain the basic characteristics of a Roth IRA. '@ Explain the income-tax treatment of a traditional IRA and a Roth IRA. sk Management and Insurance, Twelfth Edition. George E. Rejda, Michael J. MeNamara. 3c. All rights reserved. ‘From Chapter 14 of Principles of Ris! Copyright © 2014 by Pearson Education, In230 NT ACCOUNTS ANNUITIES AND INDIVIDUAL RETIREME lical iversity of Nebraska Medical ifer, age 26, recently graduated from the Universi unit jennifer, age 26, recently re natal nurse (RN) at a community Center. She accepted a posit rancial goals, which include paying hospital in Dallas, Texas. Sh hos a number of financial gle, WAT NEW Po off her student loans and starting a saving renee Be tit ote must be The head ofthe human resources department explinad to lenis’ Het 0s St ‘employed at the hospital for one year before she is eligible to Sea Ml eo Roc, 401(k) plan. However, the official recommended that adennifer 3 Y a a. individual retirement account (Roth IRA) during the interim period. ai saving money immediately for retirement; the investment income would a i income-tax free; and the retirement distributions would also be income-tax Like Jennifer, millions of workers dream of achieving financial independence anc a. comfortable retirement. Planning for a comfortable retirement should receive high priority in a personal risk management program. Yet current research studies show that the majority of workers are not financially prepared for retirement, and that the ‘amounts that many workers are saving for retirement are relatively small. In this chapter, we discuss the timely topic of retirement planning and how ‘annuities and IRAs can help ensure a comfortable retirement. Two major areas are emphasized. The first part discusses the annuity concept and the different types of annuities sold today. The second part discusses the characteristics of IRAs, including the traditional tax-deductible IRA and the Roth IRA. INDIVIDUAL ANNUITIES. The vast majority of American workers who retire today receive Social Security retirement benefi Many workers also receive benefits from their employers’ retirement plans. Individual annui ties can also be purchased to provide additional retirement income. An annuity is a tax-deferred product. Although the premiums are paid with after-tax dollars, the investment income accumu lates income-tax free and is not taxed until benefits are paid to the annuitant, The investment returns of tax-deferred compounding over long periods can be impressive. Annuity Principle Anannuity can be defined as a periodic payment that continues for a fixed period or for the duration of a designated life or lives. The person who receives the periodic payments or whose life governs the duration of payment is known as the annuitant, An annuity is the opposite of life insurance, Lit insurance creates an immediate estate and provides Protection against dying too soon before sufficiit financial assets can be accumulated. In ‘contrast, an annuity provides protection against living too long and exhausting one’s savings while the individual siill alive. Thus, the fundamental purpose of an ari isto provide alifetime income that cannot be outlived. Protects against the loss of income because of excessive longevity and the exhaustion of savings. __ Annuities are possible because the risk of exccs sive longevity is pooled by the group. Individuals acting alone cannot be certain that their savings will be sufficient during retirement. Some will die carly before exhausting their savings, whereas ot crs will stil be alive after exhausting their princips. Although the insurance company cannot predict how ae sve ti ia Member of the group will live, imine the approximate number of ant! ants who) willbe alive at the end of each succes" pie Thus, the company can calculate the a0" What cach Person must contribute to the pool. InteANNUIT| les a NO INDIVIDUAL RETIREMENT ACC em OUNTS d on the funds befo puitants. Also, some anmaganrs Paid out ind their unliquidated principatoss Nill die _The liquidation period (also called the payout an fa yi Period) follows the accumulation period and refers to the period in which the funds are being paid de additional paymesve ond their ie expectancy, uti" Who 10 the annuitant. During the liquid Mes ite cx tants who co the annuitant. During the liquidation peti: consi re accumulated cash can he anmuitized oF pai J{APreniam pay. to the annuitant in ee ; ime income, However, the periodic payments are Ye longevity, insurers car ot fixed in amount and generally do not change. As 2 Shnuitants thy ceaeetpcA8 Pay alifctime result fixed anmats provide litle or no peotesion bitants fend to be healthy individuals who “et avon Bi ioegec tan aides who Wie fanger han most persons. Because of Payment of Benefits A. fixed annuity can be Serres Cf anmutans actuaries we purchased so that the income payments start premiums. immediately. This type of fixed annuity is called an immediate annuity. Am immediate annuity is one where the first payment is due one payntent interval OF AN NUITIES from the date of purchase. For example, ifthe income Hla wide variety of individual annuities is paid monthly the Oo Peace a mony ake of convenicnce sud cadence: from the purchase date, or one yeas from the pur Gpannuitice cold today con be cesar chase dace ifthe income i paid anual. Immediate annuities are typically purchased in a lump sum by ple near retirement. An immediate annuity has the major advantage of a guaranteed lifetime income that cannot be outlived. There are other advantages as well (see Insight 1). ‘A fixed annuity can also be purchased that defers the income payments until some later date. ‘A deferred annuity provides income payments at pays periodic income payments that some future date. This type of annuity is essentially d and fixed in amount. During the lating a sum of money prior to period prior to retirement, premiums are retirement on a tax-deferred basis. If the annuitant Peerest There are typically two interest dies during the accumulation period prior to retits inter imum interest rate and a cur- ment, a death benefit is typically paid equal to the ate The guaranteed rate isthe minimum sum of the gross premiums paid of the cash value Thar will be credited to the fixed annuity, if higher. At the maturity date of the contract, the percent to 3 percent. The current rate is annuitant can secehe the funds in a lump sum or have them paid out under one of the settlement fis hased on current marker conditions such hem a ‘current rate is uaranteed only for a options (discusse later). teat 7 ‘\ fixed annuity that defers the income payments a plan for accumy ically one to five years: Re sen: Me purchase the annuity, until a farure date ean be purchased with a lump arses anraites, which silly sum» of the eoniae’ An permit flexible premium wiced ro the payments A defered annuity purchased with lwp ‘led a single-premium deferred annuity. amount of interest cr c “Testor who deposits sum is cal d f ‘ ee In contrast, a flexible-premium annuity allows sam ich a 3 percent bonus 2 : fo an annuity OF interest the the annuity owner (oT the premium payments; an additional $3000 of Tri free here is no requirement that the cr deposit 0 sue “Thus, the annuity wer, there ism ied amount each year ther rewal a specified 8 . Thu onus is paid for by reduced rereor owner has considerable lei fa the payment eed to the annuity ae nse fees.232 TIRE ANNUITIES AND INDIVIDUAL RE MENT ACCOUNTS P d Workers jiate Annuity to Retire Advantages of an Immediate oo assets and are not subject to the fluctuation: nancial markets. SD) Nosaledotedeminstetive charges fer initio! purchor ‘There are many advantages that an immediate annuity can Provide to retired workers. Here is a lst of just a few: © Security. An immediate annuity provides stable lifetime lncome, which can never be outlived or which may be uaranteed for a specified period, ‘Simplicity. The annuitant does not have to manage his ‘or her investments, analyze markets, or report interest cr dividends, ‘igh Returns. The interest rates used by insurance com- Panies to caleulate immediate annuity income are gener- ally higher than Certificate of Deposit (CD) or Treasury fates, and because part of the principal is returned with each payment, the income received is substantially Breater than would be provided by interest alone. AS a result, cash flow s substantially increased. Preferred Tax Treatment. If the money used to purchase the annuity comes from a taxable account, such asa sav- ings account, part of the income payments is received free of income taxes. A large part of each payment Includes a return of principal, which is not taxable when ‘received since it has already been taxed. Only the portion attributable to interest is taxable income, ‘Annuity Settlement Options The annuity owner has a choice of annuity settlement options. Cash can be withdrawn in a lump sum or in installments, or the funds can be annuitized and paid out as life income, As practical matter, most annuities are not annuitized, The following settlement options are typically available: = Cash option. The funds can be withdrawn in a lump sum or in installments. The taxable portion of the distribution (discussed later) is subject to federal and state income taxes. The cash option also leads to adverse selection against the insurer because those in poor health will take cash rather than annuitize the funds. ® Life annuity (no refund). A life annuity (no refund) option provides a life income to the annuitant only while the annuitant is alive, No additional payments are made after the annuitant dies. This type of settlement option pays the highest amount of periodic income payments in contrast, mutual funds that provide retiren income have an annual loading for investmen administrative expenses. i jiate annuities (SPIAs) are p: le premium immediate ; suitable forthe following situations: 1. Retirement from Employment 42, Terminal Funding or Pension Terminations (includ deferred commencements) Retired Life Buyouts 4, Structured Settlements for Personal Injury, & Divorce Cases Professional Sports Contracts Credit Enhancement and Loan Guarantee Transactio state o, SouncE: Adapted from Lessons in Annuities, immed Reprinted with permission of lmmediateAnmuies.com because it has no refund features. It is suitable f someone who needs maximum lifetime incom: and has no dependents or has provided for then through other means. However, because of the Hisk of forfeiting the unpaid principal if iesth Sreurs early, telatively few annuity owners elect this option, muitant dies before receiving the pa ynmeeamumberof payments, the remainin’ Payments are paid to a designated beneficiary fete canbe used by someone who needs waaime income but who alee eines ce sco Mids MWA So the hencficia,y + the event of an early death, Because ‘of the guaranteed pay ments, the periodic income payments arc lessing total income pay- fe purchase price of the armnc, mntinue to the beneficiary unit Purchase price. A cash refund let version of this option, If the before receiving total payments urchase price of the annuity, the lin a lump sum to the beneficiary and-survivor annuity. A joint-and-surviver lity option pays benefits based on the lives of ‘OF More annuitants, such as a husband and fe or a brother and sister. The annuity income until the last annuitant dies. Some con. § Pay the full amount of the original income ayments until the last survivor dies. Other plans ly two-thirds or one-half of the original after the first annuitant dies, tion-indexed annuity option. Many insurers ‘a fixed-annuity option that provides pro- n against inflation. An inflation-indexed ‘option provides periodic payments that adjusted for inflation. However, because of flation protection, the initial monthly pay- is less than the payment from a traditional d annuity. For example, based on the rates of a 67-year-old male in Nebraska who ised a $250,000 immediate fixed annuity d) in May 2012 would receive lifetime ‘of $1515 monthly. If indexed for infla- ed on the Consumer Price Index (Urban), er, the initial monthly payment would be 7 ot about 26 percent less. ant dies to the ibit 1 provides examples of monthly income ‘2 $250,000 immediate annuity issued Pp nuity is a variable annui sepa fete income, but the income depending on common stock prices. ‘purpose of a variable annuity i £0 iflation hedge by maintaining the rea power of the periodic payments during Exmioiry Examples of Monthly income Annuity Payments from an Immediate Annuity, $250,000 Purchase Price, Male, Age 67 Estimated _Annuity Settlement Option Monthly Income fe income with no refund 1523 Life income with s years uaranteed payments s7 Life income with 10 years guaranteed payments ust Life income with 15 years ‘uaranteed payments 1356 fe income with 20 years guaranteed payments 1296 Joint and survivor option® 1236 Joint and survivor option with 20 years guaranteed 1362 Joint and survivor option with installment refund paid to beneficiaries 1263 {Bah arate ge The snr ees oo pcr fe ony SoUsct:Inmedsteannten com. Dt sown ae etimaes or Nebras of May 2012 Reprod wth permason of mmeateknntis cm retirement. It is based on the assumption of a positive correlation between the cost of living and common stock prices over the long run. Basic Characteristics of @ Variable Annuity Premiums are invested ina portfolio of common stocks or other investments that presumably will increase in value during a period of inflation. The premiums are ‘used to purchase accumulation units during the period prior to retirement, and the value of each accumula- tion unit varies depending on common stock prices. For example, assume that the accumulation unit is initially valued at $1, and the annuitant makes a monthly premium payment of $100. During the first month, 100 accumulation units are purchased.! If common stock prices increase during the second month, and the accumulation unit rises to $1.10, about 91 accu- ‘mulation units can be purchased. If the stock market declines during the third month, and the accumula- tion unit declines to $0.90, 111 accumulation units can be purchased. Thus, accumulation units are pur- ‘chased over a long period of time in both rising and falling markets.234 COUNTS ANNUITIES AND INDIVIDUAL RETIREMENT A\ At retirement, the accumulation units are converted into annuity units. The number of annuity units remains constant during the liquidation period, bur the value of each unit will change each month oF year depending on the level of common stock prices. For example, at retirement, assume that the annuitant has 10,000 accumulation units. Assume that the accumulation units are converted into 100 annu- ity units As stated earlier, the number of annuity units remains constant, but the value of each unit will change over time. Assume that the annuity unit is intially valued at $10 when the annuitant retires. A monthly income of $1000 will be paid. During the second month, if the annuity unit increases in value to $10.10, the monthly income also increases to $1010. During the third month, if the annuity units decline in value to $9.90 because of a stock market decline, the monthly income is reduced to $990, ‘Thus, the monthly income depends on the level of common stock prices, Guaranteed Death Benefit Variable annuities typically provide a guaranteed death benefit that Protects the principal against loss due to market declines. If the annuitant dies during the accumulation period, the amount paid to the beneficiary will be the higher of two amounts: the account value of the annuity or the amount of total premiums paid adjusted for any withdrawals.Thus, if the annuitant dies during a market decline, the beneficiary receives ‘an amount at least equal to the (less any withdrawals), In addition, many variable annuities go one step further and provide enhanced death benefits by the payment of an additional premium. Enhanced ben- efits either (1) guarantee the Principal (contributions made) plus interest or (2) periodically adjust the value of the account to lock in investment gains. For example, the annuity may contain a rising-floor death benefit by which the death benefit is periodically reset. Thus, a 5 percent rising-floor benefit may be Periodically reset so that the beneficiary will receive the principal plus 5 percent interest. AA second example isthe stepped-up benefit by which thie contract periodically locks in investment gains, such as every five years. For example, assume that $10,000 is invested in year 1, and the account is now worth $15,000 in year 5. The new death total premiums paid snefit is $15,000, even though the ann, f invested only $10,000. Finally, an enhanced earning benefit is. , of death benefit that pays an additional anox, income taxes when the annuitant dies. ‘The a1. paid covers the income tax that heirs must accumulated earnings in the annuity. For e\,,,, assume that $100,000 invested in a variable ay, grows to $200,000, and the annuitant dies. T},. ignated beneficiary must pay an income tax ¢ $100,000 gain. The enhanced death benefit y..,, pay an additional amount, such as 40 perce, $40,000, to help pay the income tax on the ‘Many insurers also make available a numiy. additional guaranteed benefits to make variable » ties more appealing to consumers. Insight 2 additional guaranteed benefits that can be ade. variable annuity by paying an additional premium, RY ow, discuss. Fees and Expenses Variable annuity owners a number of fees and expenses. Some fees con. of investment management and administrative fc. other fees are insurance charges that pay for «i. Suarantees and other services provided. In addii., ‘most variable annuities have surrender charges Specifically, variable annuities typically cont the following fees and expenses: = Investment management charge. This c 4 payment to the investment manager and asc Management company for the brokerage services and investment advice Provided in the manag: ‘ment of the investment portfolio. Administrative charge, This charge covers the Paperwork, record keeping, and periodic reports to the annuity owner, = Mortality and expense risk charge. This fee ‘alled the “M8CE” fee, pays for (1) the mortal Hisk associated with the guaranteed death ben efit and excessive lon, ipevity; (2) a guarantee that annual €xpenses will not exceed a certain per centage of assets after the Contract is issued; and (3) an allowance for profit. SSE TMMCOAPAEMOs: annuities have 3 surrender charge if the Annuity is surrendered duringitheleatly years of the connec chatee helps t0 pay agents and brokers wh sell variable Annuities. Tt is usually a perce age of the account Value and declines over timBRE rininun dees Sassi ort ing to consumers. They include the following: ee ecount is now worth only $80,000 because ofa bear a. Ifthe specified percentage is 5 percent, he could '$5000 each year until the entire $100,000 is ifm wihdrol benef (LW Ure Se ati bene gure aryurber Beto cven youn ies Beitr gers ital beret e yet Bee ays investment in val sro Phencosus ree touch riverine nts are exhausted. You are not required to annu- pica mam inco en (MI Fst Mioamatian hs beet gues «rin le, if the surrender charge is 7 percent ‘account value for the first year, it would ‘one percentage point for each year until ero for the eighth and later years. Most “annuities permit partial withdrawals ‘of.as much as 10 percent of the account hout imposition of a surrender charge. have an annual d there may bea fon, the annuity may such as $25 or $505 an fare transferred from one subaccoun E In the aggregate, total annual fees and ncluding the cost of riders are relatively it to 4 percent range from 3 percent Shs a result, long-run total Dy be significantly reduced i high-cost stles of Variable Anni payment regardless ofthe value of your account also Pre ‘ides protection against losses in your investment account For esample, the guarantee may stat that if you annulizs, the minimum payment wil be based on the higher of out account value oa specfied percentage ofthe GMIB bereft base, which i equal to the amount invested compounded ata spected interest rate such 255 percent The higher of the two bases is used to determine your minimum income benefit The benefit has no value for annuity owners who do sccumulation benefit (CMA ofthe contract wll unt ater a certain ‘even though the not anuitze ‘¢ Guaranteed minimum a This benefit guarantees that the value be equal to a specified minimum amot number of years, such as 10 years, investment portfolio has declined in valve. “The guaranteed benefits are not fee; additional premiums are required depending on the guarantee selected. For eample, the additional annal cost of the GLWS typically ranges from 50 to 6o basis points # ures Ad uy and 28. sandy Myers “Customiing Your Anni New Fst ‘oubiy” Te Wa Se uel November 4 2027 Si eae tember, The Cost of VaribleAmaty Garon, irvesopei Sita Equity-Indexed Annuity ‘An equity-indexed annuity offers the guarantees of ced participation in stock a fixed annuity and Limite sarket gains. An equity-indexed annuity isa fixed, deferred annuity that allows the annuity owner to participate in the growth of the stock market and rico provides downside protection against the loss of principal and prio interest earnings ifthe annuity je held to term. Term periods typically range from one to 15 years. The annuity value is linked to the performance of a stock market index, typically Beandard and Poor's 500 Composite Stock Index. If the stock market rises, the annuity is eredited with part of the gain inthe index, which does not include ine reinvestment of dividends. If the stock mar- Ket declines, the annuity earns at least a minimum236 ReTI ANNUITIES AND INDIVIDUAL return, which typically is 3 percent on 90 percent of the principal invested Fi semen of ange eee are (1) the participation rate, (2) the maximum aj Tar (3 the indecey aod woes tat anteed minimum value. Participation Rate The participation rate is the percent of increase inthe stock index credited to the contract. The insurer periodically determines the participation rate, which is subject to change. Participation rates typically range from 25 percent to 90 percent of the gain in the stock index. Investors may receive only part of the increase im the stock index (excluding the reinvestment of dividends). For example, if the participation rate is 70 percent and the stock index rises 9 percent dur- ing the measuring period, the index-linked interest rate credited to your annuity will be 6.3 percent (9% X 70% = 6.3%). Instead of a participation rate, some insurers use a spread or asset fee by which a percentage is subtracted from any gain in the index. For exam- ple, if the index increased 8 percent and the spread is 3 percent, the gain credited to the annuity is only 5 percent. Maximum Cap Rate or Cap Some annuities have a maximum cap rate or upper limit on the index-linked interest rate credited to your annuity. The maximum. ‘cap rate is the maximum rate of interest the annuity will carn. In the earlier example, if the annuity has a maxi- ‘mum cap rate of 6 percent, the interest rate credited to the annuity would be only 6 percent, not 6.3 percent, Not all annuities have a maximum cap rate, Indexing Method The indexing method refers to the method for crediting excess interest to the annuity. Insurers use several indexing methods for crediting interest, only one of which is discussed here. Under the annual reset method (also known as the ratchet method), interest earnings are eal. culated based on the annual change in the stock index; the index value starting point is also reset annually. Thus, if the stock index decreases dur, ing any contract year, the decrease does not have to be recovered before any additional growth in the index will be credited to the contract. REMENT ACCOUNTS Guaranteed Minimum Value Eauity-ing ies with terms longer than one year hy ae ym value that provides dow, wuaranteed mini ois « Stotection against the loss of principal if the an, Ay is held to term. A typical minimum guaran 3 percent compounded on 90 percent of your in, deposit. The result is a guaranteed minimun at the end of the index period. Fot example, ij deposit $100,000 in an equity-indexed ann, 90 percent of that amount ($90,000) will « ‘guaranteed rate of 3 percent compounded ann.) regardless of how the index performs. Thus you keep the annuity in force until the end index period, say seven years, you are guarant. $110,689 in your account. However, becaus ‘minimum guarantee applies to only 90 percent the single premium, an investor who surrenders contract during the first three or four policy may experience a loss of principal. If it is hel term, the principal is guaranteed against los LONGEVITY INSURANCE Because of increased life expectancy, more peop are surviving until age 90 or even beyond, Ther always the risk that you will run out of money at advanced age and are still alive. To deal with the rs ‘of exhausting your financial assets age, some insurers haye designed longevity insuranc Products. Longevity insurance is a generic 4@ single-premium deferred annuity that begins p benefits only at an advanced age, typically ace $1 HurPose is to provide protection against the risk depleting your financial assets at an advanced ase For example, based on the rates of on Premium for a joint-and- y for a mar Pelcouple bothiage'Gs, which provides.» mor conute of $1500 beginning at age 85, is $49. Mediate annuity that Be? : ginning at age 65 would Tea Mele Premium in execs, «$300,000. Decne gees Products are low-cost annuities the policy. Ifthe noct8h values or death bencis 2 Period before nay umuitant dies during the defer the purchase se begin, he or she will forte lOWevVer, some insurers offer optional . Mees hat provide death Lesefnc ot at an advanced survivor annuiify insurance has both advantages and nthly benefits kick in at an advance. ther financial asses ec tyes to a traditional immediate an insurance is a relatively low cost annuity the policies generally do not provide cash not provide cas fr death benefits during the deferral cot gevity products can be purchased with an on hedge, which preserves the purchasing of the benefits that will be paid in the at future. downside, however, longevity insurance ng disadvantage: rs will lose money if you die durin, because, as stated earlier, fity products generally do not provide efits. sed, your funds are locked up, and not have access to the funds in the event cy. sk of possible forfeiture of the purchase death occurs during the deferral period, ly after payments begin, may make the ‘unappealing to risks-adverse individuals. annuity purchased from a commer- is a nonqualified annuity. A nonquali- by is an annuity that does not meet the rue Code requirements for employer such, it does not qualify for most “benefits that qualified employer retire TE ical yr individual am sible ‘and are paid with after-tax "the investment income. is (ax lceumulates free of current income fonds are actually distribured. nuities are not ANNUITIE HES AND INoIy NOIVIDUAL RETIREMENT ACCOUNTS The taxable portion of any distribution is tax- able as ordinary income. In addition, the taxable portion of a premature distribution before age 59% is subject to a 10 percent penalty tax, with certain exceptions. The periodic annuity payments from an indi- vidual annuity generally are taxed according to the General Rule. Under this rule, the net cost of the annuity payments is recovered incometax free over he payment period. The amount of each payment that exceeds the net cost portion is taxable as ordi- nary income. ‘An exclusion ratio must be calculated to deter- mine the nontaxable and taxable portions of the annuity payments. The exelusion ratio is determined by dividing the investment in the contract by the expected return: Investment in the contract Expected reuum— Pousionratio The investment in the contract (basis) is the total cost of the annuity, which generally is the toral amount of premiums, contributions, or other amounts paid less certain adjustments.5 The expected return is the total amount that the annui- tant can expect to receive under the contract based ‘on life expectancy. Life expectancy is obtained from actuarial tables provided by the IRS. Example. Assume that Ben, age 65, purchased an immediate annuity for $108,000 that pays a lifetime monthly income of $1000. The annuity has no refund features. Investment in the contract is $108,000. Based on the IRS actuarial table, Ben has a life expectancy of 20 years. Expected return is $240,000 (20 x 12 x $1000). The exclusion ratio is 0.45 ($108,000 + $240,000), Each year, until the net cost is recovered, Ben receives $5400 tax free (45% x $12,000) and $6600, which is taxable. “After the net cost is recovered, the total payment would be taxable. ‘In summary, annuities can be attractive to investors who have made maximum contributions to other tax-advantaged plans and who wish to Save additional amounts on a tax-deferred basis. ‘Also, because of the surrender charge, the inves- tor should expect to remain invested for 10 or more years.238 7 ACCOUNTS ANNUITIES AND INDIVIDUAL RETIREMEN However, annuities are not for everyone, espe cially a variable annuity. You should not purchase @ variable annuity if you will need the funds before age 5944; the period of investing is less than 15 years; and. you have not made maximum annual contributions to other tax-advantaged plans, such as a Section 401(k) plan and an IRA. Other considerations are important as well (see Insight 3). Variable aries are a valuable retirenent tool fused propel. However, vaable annuities are not for everyone. Before you buy an annuity, you should answer the following questions: © What are the annual fees and expenses? As discussed in the text, most variable annuities have relatively high annual fees and expenses. Other investments, especially Novload index mutual funds, have significantly lower annual expense charges. Before you buy, you should shop for an annuity with relatively low annual expenses. Are you willing to be locked into the annuity for at east 15 years? Most annuities have back-end surrender ‘charges that extend overlong periods, typically seven to ten years. You will lose a substantial amount of money ifyou surrender the annuity during the early yeas. Also, the favorable income tax advantages ofa variable anmu ity require a long holding period of at least 15 years for the tax benefits to offset the high fees and expenses, ‘Have you mede maximum annual contributions to your ‘employer's 40%(k) plan or other qualified retirement ‘plan and to an individual retirement account? Most employers make a partial matching contribution to ‘qualified retirement plans, and you ae passing up “fee ‘money" if you don't contribute the maximum allowed, ‘Also, an IRA may have lower annual expense charges than a variable annuity ‘¢ Have you considered your tolerance for risk? The value ‘of your annuity depends on the investment experience ‘of the underlying subaccounts. If the premiums are invested in a stock account, the value of your annu- fy can decline substantially in a severe market decline, Depending on your tolerance for risk, your "comfort" level may be adversely affected. ‘© Are you willing to tolerate fluctuations in monthly income? Variable annuity retirement benefits also fluc- tuate with the investment experience of the undes)ying INDIVIDUAL RETIREMENT ACCOUNTS indivi frement account (IRA An individual ret 1 ace: workers with taxable compensation annual contributions to a retirement plan certain limits and receive favorable inc, treatment. ST Ten Questions to Answer Before You Buy a Variable Annuity subaccounts. Ifthe funds are invested in a stock m account, a substantial market decline can be Snr. painful. Common stocks are also sensitive to ine, rates, Finteret rates rise because of inflationary «., tations or a change in Federal Reserve mone: your variable annuity benefits may decline + Will you need the funds before age 59%? You « ‘ot buy a variable annuity if the funds will be before age 5924. Cash withdrawals before age ss). ‘erally ate subject to a 10 percent federal tax ‘on the taxable portion of the distribution. You v! have available cash to cover three to six mon living expenses, which reduces the need to withd funds from your annuity * Isyour combined federal and state income tax bracket ct east 28 percent? Ifyou are in a lower tax bracket b¢- ‘variable annuity fees and expenses can dilute tne advantages of defered annuity ‘Are you aware that capital gains are taxed os ordinary income when annuity distributions are made?” twable portion of variable annuity distribution is taxed 4s ordinaty income, which ean be as high as 35 percen for zor2. In contrast, at the time of writing, long: ‘Capital gsinsinataxableaccount are taxed at 3 mim capital gains rate 15 percent (2012). Ate you aware that if you should di faxed onthe variable annuity eanings just os you would? {piconttast mutual funds in a taxable account pass to You Invest your IRA contributions in a varisble annuity? As a general, Hille, the answer is no. IRAs alreac) receive favorable Income-tax treatment. investing | Cetitbilonsin avariable annuity results in an unnece* ‘sary duplication of fees ‘and expenses, a aepere are two basic types of IRA plans: IRA nal IRA is an IRA that all tax deduction for part or all of shee IR The investmene income secre free on a tax-deferred basis, and the da, are taxed as ordinary income. 4 Requirements There are two eligibility sments for establishing a traditional tax during the year. Taxable compensation ages and salaries, bonuses, commissions, nent income, and taxable alimony and maintenance payments. However, taxable does not include interest and dividend Contribution Limits Changes in the tax bbstantially increased the annual contri- ts to an IRA plan. Special catch-up rules W older workers to make additional con- ‘catch-up provisions are designed to crs who have saved little or nothing 012, the maximum annual contribution 100 percent of taxable compensation, sles. Older workers age 50 and over can mm additional $1000, or a maximurt o} annual IRA contribution limit is indexed iin increments of $500- Deduction of Traditional IRA Traditional IRA contributions may -tax deductible, (2) partly deduct- deductible at all. A full deduction is general situations. ANNUITiES ES AND 1 NO INDIVIDUAL RETIREMENT ACCOUNTS First, a worker who is not an active participant in an employer's retirement plan for any part of the year can make a fully deductible IRA contribution up to the annual maxinnan limit. As noted earlier, for 2012, the maximum tax-deductible IRA contribution is the lower of $5000 ($6000 if age 50 or older), or 100 percent of taxable compensation. Second, even ifthe worker is actively participating in the employer's retirement plan, the IRA contribution is fully or partly deductible if the worker's modified adjusted gross income is below certain threshold limits. Modified adjusted gross income (AGI) generally is the adjusted gross income figure shown on your tax return without taking into account the IRA deduction. and certain other items.° For 2012, a single person or head of household receives a full deduction if modi- fied AGI is less than $58,000. If modified AGI is between $58,000 and $68,000, a partial deduction is allowed. No deduction is allowed if modified AGI exceeds $68,000. For 2012, married couples filing jointly receive a full deduction if modified AGI is less than $92,000 and a partial deduction if modified [AGI is between $92,000 and $112,000. No dedue- tion is allowed if modified AGI exceeds $112,000. For example, a single worker with a modified AGI ess than $58,000 receives a full deduction up to the maximum, contribution limit. However, a single worker with a modified AGI of $63,000 could deduct only half of the contribution. The income limits are indexed for infla~ tion in increments of $500. ‘Taxpayers with incomes that exceed the phase~ out limits can contribute to a traditional IRA but cannot deduct their contributions. This type of IRA js called a nondeductible IRA. In such cases, a Roth IRA (discussed later) should be considered. Spousal IRA In many families, a married worker is an active participant in the employer's retirement plan, but the other spouse is not an active partici- pant. A spousal IRA allows a spouse who is not in the paid labor force to make a fully deductible contribution to a traditional IRA up t0 the annual dollar limit even though the other spouse is covered under a retirement plan at work. For 2012, the maximum IRA deduction for a nonworking spouse who is not an active participant is $5000 ($6000 if age 50 of older). The couple must file a joint return, and the working spouse must have suffi- cient earnings to cover the contribution. For 2012,ENT ACCOUNTS ITIES AND INDIVIDUAL RETIRE ANN full deduction is allowed if modified AGI is less than $173,000. The tax deduction is phased out for married couples with modified AGI between $173,000 and $183,000. No deduction is allowed if modified AGI is more than $183,000. Example. Josh, age 35, is covered under a Section 401(k) retirement plan at work. His wife, Ashley, age 32, is a full-time homemaker. For 2012, their modified AGI is $150,000. For 2012, Ashley can make a tax-deductible IRA contribu- tion of $5000 because she is not considered an active participant, and the couple's modified AGI is less than $173,000. However, Josh cannot make a tax-deductible contribution because his income exceeds the income threshold for active participants, ‘Tax Penalty for Early Withdrawal With certain ‘exceptions, distributions from a traditional IRA before age 59% are considered to be an early with- drawal. A 10 percent tax penalty must be paid on the amount of the distribution included in gross income. However, the penalty tax does not apply to distribu- tions that result from any of the following: «= Distributions used to Pay for unreimbursed med- ical expenses in excess of 73 Percent of adjusted Bross income (2012) ® Distributions that do not exceed the cost of your medical insurance and you lost your job and received unemployment compensation for 12 consecutive weeks because of the job loss = Disability of the IRA owner = Distributions to the beneficiary of a deceased TRA owner ® Distributions from a traditional IRA that are part of a series of substantially equal payments Paid over your lifetime (or your life expectancy), or over the lives of you and your beneficiary (or joint life expectancies) = Distributions that are not qualified higher education expenses = Distributions to buy, build, or rebuild a first home ($10,000 maximum) = Distribution due to an IRS levy on the qualified plan ® Qualified reservist distributions Distributions from a traditio start no later than April 1 of the the calendar year in which the in age 7044. The funds can be withdraw ¢ more than your nal IRA must year following idual attains min a lump or in installments. A minimum annual « tution requirement must be met. ‘The annual distribution payment is based on, expectancy of the individual or the joint life taney of the individual and his or her benesi, ‘The Internal Revenue Service (IRS) has dey-), life expectancy tables for purposes of determ,.! the minimum annual distribution. If the di.., tions are less than the amount required | a 50 percent excise tax is imposed on the accumulation. The purpose of this requirem, to force participants in traditional IRAs ;., | the funds paid out over a reasonable periad «,, the federal government can collect taxes «, tax-deferred amounts. Taxation of Distributions Distributions ; a traditional IRA are taxed as ordinary inc, except for any nondeductible IRA contrihws, which are received income-tax free. Part of sy. tribution is not taxable if nondeductible cons: tions are made. The other part is taxable and be included in the taxpayer's income. A com! formula and an IRS worksheet must be os. compute the nontaxable and taxable portions each distribution, In addition, as noted earlier, a 10 percent Penalty applies to premature distributions tal. before age 5944, Establishing a Traditi IRA can be established organizations. mutual fund, lonal IRA A traditional with a variety of financial You ean set up an IRA with a bank peretock brokerage firm, or life insurer Contributions to a traditional IRA ea be le Year OF up to the due not including extensions, ieee HyPes of traditional IRAs: (1) a retirement acc an individu: fetitement anmaigant S20UNE and (2) an individ made any date for fi TTeRUgMa Retirement Account, An individu Seog ROR SSeOMEIS a trust or csstodial accout holder tHe exclusive benefit of the accout isaries. The trustee or custo Bee teraliy insured cea coir POY ag 1980 insticution, or an enti % £0 act as trustee or cust “an. Contributions must be in cash, except fContributions (discussed later) that ca he form of property o1 ler Bieereriburione ©.cr SE ance policy. Likewise, IRA ween pledged as collateral for 3 Joan. idual Retirement Annuit . an also be established by purches Feces! hag Ese rect cere cae ste fy owner”s interest in the contract must be feitable. The contract must be nomen by the owner. In addition, the annuity permit flexible premiums so that if earmnea ge, the IRA contributions can be changed ell, Contributions cannot exceed the annual Timit, and the distributions must begin il 1 of the year following the year in which ity owner reaches age 70%, A traditional iments IRA contributions can be @ variety of investments, including cer- deposit, mutual funds, and individual nd bonds in a self-directed brokerage Contributions can also be invested in U.S. coins and certain precious metals. , the contributions cannot be invested in ge contracts or collectibles, such as stamps Account A rollover is a tax-free distri- h or other property from one retirement ch is then deposited into another retirement unt you roll over is tax free but gener- taxable when the new plan pays out that y you of to your beneficiary. For example, our job and receive a lump-sum distribu employer's qualified retirement plan, a be rolled over or deposited into a special favcount, If you receive the funds directly Fer must withhold 20 percent for federal ss. The withholding can be deferred, how- mployer transfers the funds directly into account. [A that provides ual contribution itional IRA also is another type of IR. advantages. The ann earlier for a tradi ANNUITiE SAND NP INDIVIDUAL RETIREMENT ACCOUNTS ‘The annual contributions to a Roth IRA are not tax deductible, However, the investment income accumulates income-tax free, and qualified distributions are not taxable if certain requirements are met. A qualified distribution is any distribution from a Roth IRA that (1) is made after a five-year holding period beginning with the first tax year for which a Roth contribution is made, and (2) is made for any of the following reasons: = The individual is age 59% or older. = The individual is disabled. = The distribution is paid to a beneficiary or to the estate after the individual's death, «= The distribution is used to pay qualified first-time home-buyer expenses (maximum of $10,000). Unlike a traditional IRA, contributions to a Roth TRA can be made after age 70% and the minimum, distribution rules after attainment of age 70% do not apply to Roth IRAs. Income Limits For 2012, for a single person or head of household, the maximum contribution to a Roth IRA is limited to workers with modified AGI under $110,000. The Roth IRA contributions are phased out if modified AGI is between $110,000 and $125,000. For 2012, for married couples fil- ing jointly, the maximum contribution to a Roth. IRA js limited to couples with modified AGI under $173,000 and is phased out for couples with a modi- fied AGI between $173,000 and $183,000. Conversion to a Roth IRA A traditional IRA can be converted to a Roth IRA. Although the amount converted is taxed as ordinary income, qualified distributions from a Roth IRA are received income- tax free, The right to convert earlier was limited to taxpayers with annual adjusted gross incomes of $100,000 or less. However, beginning in 2010, the $100,000 income limit on converting a traditional TRA to a Roth IRA has been eliminated. As such, wealthier taxpayers can convert their traditional IRAs to a Roth IRA. Many investment firms pro- vide interactive calculators on theit Web sites to determine if conversion to a Roth IRA is financially: desirable. ‘Based on the preceding discussion, you can see that the Roth IRA has different characteristics than ‘a traditional IRA. Exhibit 2 summarizes the major differences between them.242 ANNUITIES Al Exnisrr 2 No iInpIvIDUAL R 1s eTIREMENT ACCOUN Comparison ofa Traditional IRA with a Roth IRA Traditional IRA Roth IRA Taxfree distributions = Tirade aban a ag ‘Have taxable compensation below certain egiaticerialn annual limit hae ‘annual limits (see text) (see text) Ig lii sree ines seve 22 7 oa ‘= Contribution limit 1s Tax deduction for RA contributions. For 2012, $5000 ($6000 age 50 and older) Fully deductible up tothe annual c rota participant in the employer's income; fully deductible or partially contribution limit fyou are tetirement plan, regardless of “deductible up to the annual Contributions are not deductible ‘compensation, if contribution lit depending on your taxable compens you are a participant in the employer's retirement pl ‘Tax on investment 1 Tax on distributions contributions 1 Penalty for early with- drawals certain exceptions Investment income accumulates tex free ‘Taxed as ordinary income; no tax on nondeductible 10% federal tax on early withdrawals before age 59% with ‘Same Distributions are ta ifyou meet certain cond) (see text) Contributions can be with drawn tax-free. There is 2 10 ppenalty tax on withdrawal ‘earnings before age 59? certain exceptions {= Minimum distribution Required after age 70% None requirement ADEQUACY OF IRA FUNDS The IRA assets can be paid out as income when the worker retires. However, unless a life annuity is purchased, the retiree faces the risk of still being alive after the IRA account is exhausted, The dura- tion of benefit payments, however, depends on the rate of return on the invested assets after the worker retires and withdrawal rates. Because retired work- ers can spend 25 or 30 years in retirement, or even longer, financial planners generally recommend that the initial withdrawal rate should be limited to 4 to S percent of the IRA assets. Traditionally, tables have been prepared that show how long your IRA funds will last based on average rates of return on the invested assets and annual withdrawal rates, The problem, however, is that such tables assume that the average rate of return remains comsts! over the projection period, In reality, this is inc rect because actual returns will vary significant!) depending on fluctuations in the stock marke’. bond market, and other security markers, To ¢ with this problem, many financial planners 10 tse Monte Carlo simulation techniques that i'¢ 4 more realistic outlook of the future. These te: Didues simulate a wide variety of potential mar! marker sett fake into account fluctuations | Insight 4 eats and different investment portiole~ late ovides an example of the Monte Cs"? simulation tech; f investment fem mtu Of One financial plannhas an interactive Retirement Incr Cael Ba Govvtovercaconiac ier posien¢ Kalation of your retirement funds. Ietead ot lations on a single average rate of retucn ove he prio, the Monte Caro technique generates simulations of what ray happen Fypothetcaly sss over specie using» pareaar ree strategy. Over the chosen time horizon, ech of [ations produces an ending balance forthe por fon that paicular sequence of hypothetical market alysis incorporates the potental for market lo and negate. Each ofthe 1000 simulations abslanceofat least Sis considered a success * Income Calculator combines the ests ofall fora given strategy to determine that sratepys succes ate” (e,the percentage ofthe simulations ina postive ending balance) simulation success forbigher's considered» good number. fosbased on a fed annval ate of eturn ver the petod can resultin ending balances that are ANNUITIES AND INDIVIDUAL RETIREMENT ACCOUNTS Will You Have Enough Money at Retirement? ¢ Carlo Simulations Can Be Helpful My Rests substantially diferent from the projected ending balances based on the Monte Carlo simulations. Theoretically, 0 11 percent return one year and a 7 percent return the follow: ing year will average 9 percent, but the sequence of returns you actually experience in retirement may be quite diferent from the averages, potentially resulting ina lower ending bal- ance than the ore you would have received using fixed nual return projections ‘The box below illustrates one example of the Monte Carlo simulation technique based on the Retirement Income Celeulator. It assumes a male, age 67, has $300,000 of assets with an asset allocation of 60% stocks, 0% bonds, and 10% ‘ash before retirement and 40% stocks, 40% bonds, and 208 cash after retirement. He desires $4000 monthly (in Today's dolar) to be paid over a 28-year retirement period and 1s planning on retiring immediately. He will receive $2000 monthly (in today’s dollars) from Social Security ‘The simulation results indicate that the monthly retirement spending should not exceed $3,032 monthly to have 2 suc cess rate of 8%. i reduce Spending by: $368/0 Bi our Personal irvestments:$1023/m0, i social Security & Other in mage and te “My Ress” bx shown ane Trek produce by. Rowe PCE. come; $,000/m0- sre mie it person oT, awe Pe CO 08, gl 4 bore he str0ire er = ssn econ What we think you ere pee asa meee ca ct mn com Sc s ‘Savings Last Until Age: 95.244 ANNUITIES AND INDIVID Investors can invest in a wide variety of annuities and can also use different annuity setlement options 10 ‘meet specific retirement needs, For each ofthe following, retirement objectives, identify either (1) a specific ann ity or (2) an annuity settlement option that ean be used to mect the objective. Treat each situation separately. a. James, age 35, isa sales representative and plans serie eo 67 i host ane ‘would like to invest in an annuity that allows him to change the frequency and amount of premium payments. - Nancy, age 67, plans to retire in six months. She has {$200,000 in a savings account. She would like to receive lifetime monthly income tha is guaranteed. «. Jennifer, age 63, plans to retire in 90 days. She has $100,000 to invest in an annuity and would like Scott and Allison are married and flea joint tax return. Scott is a graduate student who works part-time and «carned $15,000 in 2012, He isnot eligible to participate in his employer’ retirement plan because he isa part time worker. Allison isa high school teacher who earned $50,000 in 2012 and isan active participant in the school distrie’s retirement plan. Assume you are a financial planner and the couple asks for your advice. Based on the preceding fact, answer each ofthe following questions. a, Is Scott eligible to establish and deduct contribus tions to a traditional IRA? Explain your answer, b, Is Allison eligible to establish and deduct contribu- tions toa traditional IRA? Explain your answer, , Assume that Scott graduates and the couple's modified adjusted gross income is $130,000 in ® Fred, age 70, recently retired and has $50.0 UAL RETIREMENT ACCOUNTS Se aa Pe ey cis, However, nie cerned that she might die before she receiv theamouneinvened. invest for additional income. He wants the ret benefit to be protected against the risk of inflat . Mary, age 75, is a widow with no deper who needs additional retirement income. Sh §25,000 to invest in an annuity. She war receive the maximum amount of monthly ao; income possible. Kathy, age 32, would lke to invest in the tock m: but she is conservative and risk averse. She woul to participate in any stock market gains, but she ‘wants her principal guaranteed against loss CASE APPLICATION 2 2012. Both Scott and Allison participate i ‘employers’ retirement plans. Can cither Sco Allison, or both, establish a Roth IRA? Fxpl your answer, | Allison has a baby and withdraws from the labor force to raise the child. She is no longer an act Participant in the school district's retirement pla Scott receives a promotion and continues to partic Pate in his employer's retirement plan, His anni Salary is $110,000 in 2012. Can Allison make 2 taxcdeductible contribution to a traditional 1k. Explain your answer. Fsplait t0 Scott and Allison the advantages of a Roth IRA over a traditional IRA. a= tidRY provides periodic payments to an annuitant, continue for either a fixed period or for the dura, gf a designated lie or lives. The fundamental pur. ife annuity is to provide lifetime income that be outlived. ad annuity pays periodic income payments to an that are guaranteed and fixed in amou ad annuity can be purchased so that the income start immediately, or the payments can be dito some later date. Deferred annuities typically jor flexible premiums. lement options typically include the following: ne (no refund) ne with guaranteed payments refund option d-survivor annuity option indexed annuity option d. The purpose of this type of annuity is to pro- ion hedge by maintaining the real purchas er of the periodic payments. payments will change over time. anuities typically pay a guaranteed death ben he annuitant dies before retirement. The typical isthe higher of two amounts: the account ‘annuity or the amount of total premiums for any withdrawals. nuities have numerous fees and charges. ges include an investment management fee, a r administrative expenses, a management and ‘charge for the guaranteed death benefit and s, and a surrender charge that declines the aggregate, total fees and expenses can ANNUIT HES AND INDIVIDUAL RETIREMENT ACCOUNTS. An equity-indexed annuity s a fixed, deferred anni ity that allows the annuity owner to participate in growth of the stock market. It also provides downside protection against the loss of principal and prior inter- cst carnings ifthe annuity is held t0 term. The key elements of an equity-indexed annuity are (1) the participation rate, (2) the maximum cap rate, (3) the indexing method used, and (4) the guaranteed minimum value. An exclusion ratio is used to determine the nontaxable and taxable portions of the periodic annuity payments. ‘The exclusion ratio is determined by dividing the invest- ‘ment in the contract by the expected return. ‘The major types of IRAs are (1) a traditional IRA and (2)a Roth IRA. [A traditional IRA allows workers to deduct part oF all of theie IRA contributions. The investment income accumulates incomestax free on a tax-deferred basis, and the distributions are taxed as ordinary income, ‘To be eligible for a traditional IRA, the participant must have taxable compensation and be younger than age 70¥. For 2012, the maximum annual IRA contribution for an individual worker is limited to $5000 ($6000 if age $0 or older) of 100 percent of taxable compensa tion, whichever is less. IRA contributions to a traditional IRA are income-tax deductible ifthe participant (1 isnot an active participant in an employer-sponsored retirement plan or (2) has tax able compensation below certain income thresholds, Distributions from a traditional IRA are taxed as ordi- nary income, except for any nondeduetible IRA contri- butions, which are received income-tax free. With certain exceptions, distributions from a traditional IRA before age 59¥ are considered to be a premature distribution, A 10 percent tax penalty must be paid on the amount ofthe distribution included in gross income, Distributions from a traditional IRA must stat no later than April 1 of the year following the calendar year in which the individual attains age 7044, IRA contributions to a Roth IRA are not income-tax deductible. However, the investment income accumu lates free of taxation, and qualified distributions are received income-tax fee if certain requirements are met. se246 ANNUITIES AND INDIVIDUAL & = A qualified distribution from a Roth IRA is any distr bation that (1) is made after a five-year holding period beginning with th first tax year for which a Roth co tribution is made, and (2) is paid when the individual attains age 59¥4, becomes disabled, dies, or uses the money to pay qualified first-time home-buyer expenses. Unlike a traditional IRA, contributions to a Roth IRA can be made after age 70%, and the minimum distribu- tion rules after attainment of age 70% do not apply. KEY CONCEPTS AND TERMS Accumulation period Joint-and-survivor annuity Accumulation unit ‘option Annuitant Life annuity (n0 refund) Annuity Life annuity with Annuity sertlement options guaranteed payments Annuity unit (life annuity with period Cash refund option certain) Deferred annuity Liquidation period Equity-indexed annuity Longevity insurance Exclusion ratio Nondeductible IRA Fixed annuity Roth IRA Hlexible-premium annuity Single-premium deferred Immediate annuity annuity Individual retirement Spousal IRA account (IRA) ‘Traditional IRA Inflation-indexed annuity Variable annuity ‘option Installment refund option IRA rollover account REVIEW QUESTIONS, 1, How does an annuity diffe from life insurance? 2. Describe the major characteristics of fixed annuity, 3. Identify the annuity settlement options tha are typically found ina fixed annuity. 4, Describe the basic characteristics ofa variable annuity 5, Explain the major characteristics ofan equity-indexed annuity. 6. Explain the eligibility requirements for a traditional IRA. What are the annual contribution limits to an IRA? eTIREMENT ACCOUNTS 8, Explain the basic characteristics of a traditions, 9, Describe the major characteristics of a Roth 1R., 110, What is an IRA rollover? APPLICATION QUESTIONS 1, Although both fixed and variable wide lifetime income to annuitants, they ditt important ways. Compare and contrast (1) a fix annuity with (2) a variable annuity with respec ‘each of the following: a. Determining how the premiums are invested bs, Stability of income payments after retiremer €. Death benefits if the annuitant dies before retiren 2, An equity-indexed annuity and a variable annuic both similar and different in many respects ‘a, Explain the major similarities between an cow indexed annuity and a variable annuity. b. Identify the major differences between an cu indexed annuity and a variable annuity 3. Mario, age 65, purchased an immediate annwit {$120,000 that pays a lifetime monthly incom $1000. The annuity has no refund feature. Based ‘the IRS actuarial table, Mario has a life expectancy « 20 years. If Mario receives 12 monthly payments $1000 the first year, how much taxable income mus he report on his tax return? 4. Travis, age 25, graduated from college and obtained 3 Position asa tax accountant, He is ineligible ro parti pate in his employer's retirement plan for one year 4. Assume that Travis has a starting salary of 555,000 for 2012 and does not participate in the employer's fetirement plan. Is Travis eligible to establish «ts Aitional tax-deductible IRA? Explain your ans by Assime the Same facts in (a) Is Travis cligible to ‘stablish a Roth IRA? Explain your answer. A traditional IRA and a + evan tee ie # Roth A both similar @ Income-tax treatment : ns and Goan ement OF IRA contribution Isom limits for lity termining how the TRA contributions » ifany, OF spouse who is notin the pa! * foresto make an IRA contribution‘T RESOURCES Provides annuity guox about fred, ey inde a od annuities. Visit the site at am 0m is an online magazine thee annually. The ste provides reele gion on immediate annuities. Visit the sive ar is a site thar specializes in indexed site provides considerable information on indexed annuity products. Visit the ste at provides informative articles and infor- fetirement planning, annuities, and individ nt accounts (IRAs). Visi the site at ts offers timely information on retie ‘annuities, and IRAs, including interactive for making IRA decisions. Vist the site at ities.com claims its the nation’s leading ker. The company helps consumers purchase cliabe life income annuities for thei rtire- the ste at rites. com ‘provides timely information on annuities, fother insurance products. Visit the site at ‘Web site is devoted to Roth IRAs and pro- erable amount of consumer information Of IRA. The site provides links to articles, ‘calculators, IRS documents, and a mes- Roth IRAs. Visit the site at of accurate informa source ce * and IRAs. Visit planning, annuities ANNUITIES ANDI NDIVIDUAL RETIREMENT ACCOUNTS 1 The Vanguard Group provides timely information on ‘avlable annuities, IAs and eiement planniag Vise vanguard.com SELECTED REFERENCES Graves, Edward E., ed. McGill's Life Insurance, 8° ed. Bryn Mawr, PA: The American College, 2011, Ch. 6. Internal Revenue Service. General Rule for Pensions and Annuities, Publication 939. Internal Revenue Service. Individual Retirement Arrangements (IRAs), Publication 590. Internal Revenue Service, Pension and Annuity Income, Publication $75 Kaster, Nicholas, et al. 2012 U.S. Master Pension Guide. ‘Chicago, IL: CCH Ine., 2012. Kuykendall, avonne, “Making the Case To Buy an Annuity,” ‘The Wall Street Journal, March 8, 2011, p-C1S. Myers, Randy, "A Guide to Annuities & Retirement Income,” The Wall Street Journal, November 12, 2008, pp. DS-D11. Myers, Randy, “Private Wealth Management, Annuities ‘and Retirement Satisfaction,” The Wall Stret Journal, November 16,2011, p. C7. Scism, Leslie, “Annuity Fine Print: Guarantees Aren't Always Guaranteed,” The Wall Street Journal, june 1, 2009, pp. RI, R6. ‘Tergesen, Anne, and Leslie Scism. “Getting Smart About “Annuities,” The Wall Street Journal, April 18-19, 2009, pp. RI, RA. NOTES 1. A deduction for administrative expenses and sales expenses is ignored. 2, The actual number of annuity units will depend on the market value of the account, attained age of the annui- tant, number of guaranteed payments, conversion rates, assumed investment return, and other factors. 3, Randy Myers, “Private Wealth Management, Annuities and Retirement Satisfaction,” The Wall Street Journal, November 16, 2011, p. C7. 44. The 10 percent penalty tax doesnot apply to individu als who attain age 594% or become totally disabled; ‘when the distribution is received by a beneficiary oris essentially, fon your tax rex, student d income exclusi, ction, exclusion «; eeeig gson who receives the periodic = periodic payment eriodic payment to an individual that continues d period or for the duration of « designated A etrement annuity that pro some future date. she ES fnmuity A fixed, deferred annuity that fed participation inthe stock marker tag the principal again loss if the contract Calculation to determine the taxable and Portions of annuity payment, which i dl by dividing the investment in the coneract ‘annuity An annuity contract that ‘owner to vary the size and frequency Payments. The amount of retirement pends on the accumulated sum in the ‘An annuity where the first payment is ayment period from the date of purchase. yent Account (IRA) Individual retire- that can be established by a person with je. An IRA plan enjoys favorable income ‘annuity Pays the annuitant a lifetime but if death occurs before receiving payments ANNUIT: ES AND INDIVIDUAL RETIREMENT ACCOUNTS ‘equal to the purchase price, the income payments con tunue tothe beneficiary. Joint-and-surviver annuity Annuity based on the lives ‘of two or more annuitants. The annuity income (ether the fll amount of the original iacome of only two-thirds or one-half of the original income when the first annuitant dies) i paid until the death of the last annuitant. is Life annuity with guaranteed payments Pays a life income to the annuitant with a certain number of guaranteed payments. - Longevity insurance A generic name fora single-premium ‘defer annuity that begins paying benefits only at an advanced age, typically age 85. Roth IRA An IRA in which the contributions are not income-tax deductible but distributions are received income-tax fre if certain conditions are met. Singlepremium deferred annuity A retirement annuity that is purchased with a single premium with benefits to start at some future date. Traditional RA An IRA that allows workers to deduct part of all oftheir IRA contributions if taxable com- pensation is under a certain limit. Distributions are taxed as ordinary income: Variable annuity Annuity whose periodic lifetime pay- ‘ments vary depending on the level of common stock prices (or other investments), based on the assumption thae cost of living and common stock prices are cor- related in the long run. Its purpose is to provide an inflation hedge.