What is the annuity?
Annuity is the process of converting a annuity investment in a series of periodic payments. Annuities can be annuitized for a specific period or for the lifetime of the they acquiesce. Annuity payments can only be made to the annuitant or to the annuitant and a surviving spouse under a joint ownership arrangement. Annuitants can arrange for beneficiaries to receive a portion of the annuity balance upon their death.
Key points to remember
- Annuizing is the process of converting an annuity investment into a series of periodic income payments.
- Annuities can be annuitized for a specific period or for the life of the annuitant.
- Annuity payments can only be made to the annuitant or to the annuitant and a surviving spouse under a joint ownership arrangement.
- Annuitants can arrange for beneficiaries to receive a portion of the annuity balance upon their death.
Understanding the annuity
The concept of annuity dates back centuries, but life insurance companies formalized it in a contract offered to the public in the 1800s.
Individuals can enter into a contract with a life insurance company involving the exchange of a lump sum of capital against a promise of periodic payments for a specified period or for the life of the individual who is the annuitant.
How the annuity works
Upon receipt of the capital, the life insurer performs calculations to determine the amount of the annuity. The main factors used in the calculation are the current age of the annuitant, life expectancy, and the projected interest rate that the insurer will credit to the balance of the annuity. The resulting payout rate establishes the amount of income the insurer will pay out, based on which the insurer will have returned the entire annuity balance plus interest to the annuitant at the end of the payout period.
The payment period can be a fixed period or the life expectancy of the investor. If the insurer determines that the investor’s life expectancy is 25 years, that becomes the payout period. The important difference between using a fixed term versus a lifetime term is that if the annuitant lives past their life expectancy, the life insurer must continue payments until the annuitant dies. . This is the insurance aspect of an annuity in which the life insurer assumes the risk of extended longevity.
Annuity payments based on a single life
Annuity payments based on a single life cease on the death of the annuitant and the insurer retains the remaining balance of the annuity. When payments are based on joint lives, payments continue until the death of the second annuitant. When an insurer covers the joint policyholders, the amount of the annuity is reduced to cover the longevity risk extra life.
Annuitants can designate a beneficiary to receive the balance of the annuity through a repayment option. Annuitants can choose repayment options for different periods during which, in the event of death, the beneficiary will receive the proceeds. For example, if an annuitant chooses a redemption option for a certain period 10 years, death must occur within this 10-year period for the insurer to pay the beneficiary. An annuitant can choose a lifetime repayment option, but the length of the repayment period will affect the payout rate. The longer the repayment period, the lower the repayment rate.
Annuity Changes in Retirement Accounts
In 2019, the US Congress passed the SECURE Lawthat changed pension plans, including those with annuities. The good news is that the new ruling makes annuities more portable. For example, if you change jobs, your 401(k) pension from your old job can be transferred to the 401(k) plan from your new job.
However, the SECURE law removed certain legal risks for pension schemes. The ruling limits the ability of account holders to sue the pension plan if it fails to pay annuity payments, such as in a bankruptcy. Note that a safe harbor provision in the SECURE Act prevents pension plans (not annuity providers) from being sued.
The SECURE Act also eliminated the stretch provision for beneficiaries who inherit an IRA. In years past, a beneficiary of an IRA could extend the minimum required distributions of the IRA over their lifetime, which has added to the tax burden.
With the new ruling, non-spouse beneficiaries must distribute all inherited IRA funds within 10 years of the owner’s death. However, there are exceptions to the new law. This article is by no means a comprehensive review of the SECURE Act. Therefore, it is important that investors consult a financial professional to review the new changes to retirement accounts, annuities and their named beneficiaries.
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