Qualified Annuities and Payout Schedules

This week, Gail explains the difference between a "qualified" and "non-qualified" variable annuity, and explains the various payout options for annuity beneficiaries.


I enjoyed your columns about the possibility of deducting the entire loss from a variable annuity. (Click Here and Here for those columns -- Gail)

My question is: does it matter if the VA is qualified or non-qualified?



Dear Wesley,

In a nutshell, you BET it matters!

First, a "qualified" variable annuity is one that is part of a retirement plan such as a 401(k), 403(b) or IRA. The "qualified" part means that the retirement plan adheres to certain federal requirements. While there are severe penalties -- for you and the plan -- if these regulations are violated, there are significant tax benefits if you play by the rules.

First, contributions to such plans are generally on a pre-tax basis, meaning the amount you contribute is subtracted from that year's taxable income. As a result, you avoid having to pay tax on this income in the year it was earned. Income tax on both your contributions and any gains your account earns is "deferred" until you start withdrawing money, presumably in retirement. Thus, you can postpone paying taxes on contributions and earnings for potentially decades.

As you might expect, a "non-qualified" investment does not have to meet the strict federal regulations which cover retirement plans and, as a result, it does not qualify for special tax treatment. Contributions are made with after-tax money and earnings are subject to income tax in the year in which they are earned. This would include a regular mutual fund account, individual stocks that you own through a broker, etc. However, by its very nature, a variable annuity provides tax-deferred growth, so you still get this benefit in a "non-qualified" VA.

April Caudill is Managing Editor of Tax Facts, a reference guide CPAs across the country turn to when they need answers to thorny tax issues.

When it comes to figuring out whether you can "take a loss" on an investment, Caudill says it helps to remember this: losses on money you have never paid tax on are not deductible.

In other words, assume you contributed $75,000 in pre-tax dollars to your 401(k). If your account is now worth $50,000, you do not get to deduct a $25,000 "loss." If you did, you'd be getting a tax deduction for income you never (in the eyes of the IRS) had to begin with because you didn't pay income tax on it.

You only get to deduct a loss when it involves money that you paid income tax on and which is now gone. In tax-speak this is known as "basis."

Which is a long way of saying, you can only deduct losses in non-qualified variable annuities, i.e. an investment made with after-tax money.




About 5 years ago my mother decided to retire. She was concerned about her finances and suddenly adjusting to living on a fixed income. She had an annuity worth about $200,000 through a retirement plan offered by her employer. It was explained to her that her monthly payments would be higher if she named the annuity as the beneficiary.

When I suggested to her recently that she change the beneficiary of the annuity to the grandkids, she said that she couldn't do that. They told her at the time it was irrevocable Is this true? Legal? My mom is living comfortably and would like to leave something for her 15 grandkids to help pay for their college.


Dear Mike -

Annuities can be a bit complicated and I suspect your mom is a bit confused. It is not possible to name the "annuity" itself as the beneficiary.

When you "annuitize" an annuity, you trigger a payout schedule. The insurance company which provides the annuity is then obligated to pay you a certain amount of income based on the length of time you select. The basic timeframes are:

Life: payments continue as long as you live.

Period Certain: payments are made over a specific number of years, say 10, 15, or 20. If you die before receiving all of the payments, someone else (your beneficiary) will get them.

Life plus Period Certain: payments continue as long as you live and no less than, say, 10 years. Again, your beneficiary receives the payments if you die before the "period certain" is up.

Joint Life (generally for a couple): payments continue for as long as one of you is alive.

Based on the value of your account before you annuitize and the length of your payout, the insurance company estimates how much it can pay you each month. If you choose any payout that involves a "period certain," the insurance company has a pretty good idea of the total amount it will be shelling out.

However, if you choose one of the "life" payouts, there is the risk you will live longer than "average" and the insurance company will end up paying more than it expected. (But, hey, managing risk is what they do for a living). On the other hand, if you choose a "life" payout option and die prematurely, then the insurance company saves money.

Because they have annuities on literally thousands of people, insurance companies calculate that, while some folks will live longer than expected, they will be offset by those who die early and that, on average, the numbers will work out.

It sounds as if your mother chose the "life" payout option since this generally provides the greatest monthly income for an older person. However, there is no going back and changing things. "Once you make an income election and begin receiving income, your decision is irrevocable," says Amy Floyd, Senior Director of Advanced Planning and Support at Allstate Financial.

That's because, as Floyd explains, "when you annuitize, the insurance company calculates how much it needs to earn on your money in order to make the payments it promised you. It invests the money you turn over to it in a permanent portfolio of investments in order to meet that obligation."

In my opinion, one of the greatest gifts a parent can give a child is the peace of mind that comes from knowing mom can take care of herself financially, i.e. that she won't need to depend upon the child for financial help. You mother has apparently done a great job at this. Be grateful. This frees up you and your siblings to fully devote your own resources to save for your children's education.

And with regard to saving money for that education, click on the "Archive" button at the top of this page and scroll down for past columns on 529 plans, dad!


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