The annuity guy dropped off the proposal and it has occurred to you that you don’t really know what an annuity is. Or you left my office, and I suggested that a Medicaid Compliant annuity (we’ll get to those later — see below) might be a good strategy.

And you still don’t know what the heck an annuity is!

Let’s take a couple of posts and clear up some confusion. Also, if you are an annuity expert . . . chill! I’m explaining the basics.

The Stick Figure Version of Annuities

Stripped of all the gee-whiz terminology and extra bells and whistles, an annuity is really rather simple.

Someone transfers a pile of cash to another (usually, but not always, an insurance company). The person transferring the cash is called the “owner,” and the entity receiving the cash (the “issuer”) promises to pay the money back in some form or fashion. The cash transferred by the owner to the issuer is called a “premium.” The contractual arrangement between the owner and the issuer is called an “annuity.”

In reality the transferor/owner is lending money to the issuer. Yep! Daddy has loaned the company money.

The company/issuer promises to pay back the money in some form or fashion. With interest. The company is betting that it will be able to play around with Daddy’s money and make more with it than what it will have to pay back to Daddy or whomever he directs.

If the issuer promises to start paying right away (or pretty soon), the annuity is called an “immediate annuity.” If the issuer promises to pay starting (maybe) in 3, 4 or 5 years (or maybe more) or over the life of some designated person then the annuity is called a “deferred annuity.” “Immediate annuity” and “deferred annuity” are ways of describing when benefits will be paid.

The amount of time over which the annuity will payout is called the “term.” If the term of the annuity is pegged to the life of an individual that individual is called the “annuitant.” Often, if not usually, the annuitant and the owner are the same person.

That’s basically “it.” The issuer may dress it up with fancy trade names like the “Flex Golden Years Express American Hero” annuity . . . but stripped down to the stick figure version that will be the basic structure.

Other Fancy Terms

The owner may pay the premium to the issuer in a single lump sum (a “single premium annuity”) or perhaps over some other time and in varying amounts (a “flexible premium annuity”). Those terms have to do with how an annuity is purchased.

Other ways of looking at an annuity have to do with how the cash value of the annuity is invested. If the issuer promises the owner that his cash investment will not be subject to any market risk, it is a “fixed annuity.” If the issuer and the owner agree that the premiums can be invested in the market and that the owner will come along for the ride (whether smooth or bumpy!) it will be called a “variable annuity.” A variable annuity payout will . . . vary . . . depending upon how well the investments have performed.

But Wait . . . Taxes! 

How an annuity is taxed will depend upon what sort of money the owner used to pay for the annuity (I know, I know: “’mericun money, Bob!”). If the annuity was paid for with money that had already been taxed (for example, money that Daddy had laying around in an investment account he had been accumulating) the annuity will be a “non-qualified annuity” to differentiate it from a “qualified annuity,” which will be an annuity purchased with IRA or qualified retirement plan money.

Non-Qualified Annuities

Daddy has a $100,000 CD maturing and wants to buy an annuity. He doesn’t want to tie the money up for too long, but he sees that a deferred annuity will pay him more than an immediate annuity (which makes sense because the issuer gets to play with Daddy’s money longer before it has to start paying back). So, he selects a 3-year deferred annuity with a 5-year term. In other words, in 3 years the issuer will begin paying him back (an annuity stream) over 5 years.

For the sake of mathematical simplicity, the annuity will pay him 10% or $22,000 for a total of $110,000 over the 5-year term.

Over the 5-year term the issuer is returning the owner’s original investment . . . that part is not taxed because it doesn’t represent any income . . . it was the owner’s money to begin with. The $10,000 paid over the original investment represents income (“that’s my profit,” according to one client).

For income tax purposes, each annuity payment will represent a partial return of the original investment (not taxable) and a partial payment of the “profit” on the annuity.

In the example, each payment of $22,000 will represent a $20,000 return of the original investment and a $2,000 payment of taxable income.

From a tax standpoint, Daddy is deferring the tax liability over a period of years while the annuity is accumulating (the first 3 years) and spreading the tax liability out over the period that the annuity is in payout status (5 years). Which is why many annuities are called “tax deferred” . . . not to be confused with “tax qualified” or “qualified” annuities.

Qualified Annuities

Many people have Individual Retirement Accounts. The IRA may have been funded as the owner deposited funds to the account over many years, or it may have been set up when the owner retired or changed employment and rolled a profit sharing or 401(k) plan balance into an IRA.

Think of an IRA as a “tax qualified” wrapper or container that can hold all sorts of investment assets (with some restrictions). All IRAs have the advantage of allowing tax deferred growth and traditional IRAs usually allow tax deductible contributions. Of course, the trade-off comes in the form of complex rules regarding when distributions must begin and how much those distributions must be.

One of the many types of assets an IRA may invest in is an annuity. In fact, some annuities can be structured as both the “wrapper” and the investment, and these are called Individual Retirement Annuities.

In any event, the complex rules that apply to IRAs also apply to annuities structured as IRAs.

Unlike the “non-qualified” annuity Daddy bought in the example above, where a portion of an annuity payment will be tax free and another portion will be taxable, ALL of each annuity payment from an IRA will be taxable.

Clients are often puzzled when I quiz them about their annuities during an initial meeting. What I am doing is trying to determine if we are dealing with a qualified annuity or a nonqualified annuity. The answer tells me which set of tax rules to apply.

Up next: How Annuities Can Help With Medicaid.