Taking Care of Mom and Dad: Using Annuities
As I've mentioned before, annuities are good tools for matching financial resources to life expectancy. An individual retirement annuity is an IRA set up with a life insurance company through the purchase of a special annuity contract. These annuities are probably the best vehicle to protect your parents from outliving their money.
An individual retirement annuity operates like a traditional IRA. The main difference is that an individual retirement annuity involves purchasing a contract from an insurance company.
Retirement annuities are described in the federal government's Internal Revenue Code Section 408(b) -- right after the section that describes traditional IRAs. An annuity is a reverse loan. It's a systematic withdrawal from an investment as a return of interest and principal. Your parents deposit a lump sum (usually from a retirement account) and withdraw a portion each year until it is all returned.
Annuities offer flexibility as to how income is paid. A popular option is "life with period certain" distribution, which guarantees an income will be paid out for the life of the annuitant, regardless of total payout -- and guarantees that a specific number of payments will be made, regardless of how long the annuitant lives.
Most annuities guarantee a minimum interest rate that will be credited to the annuity cash value. The guarantee rate is typically 3 to 4.5 percent when the contract is annuitized. Guarantees are based on the creditworthiness of the company issuing the annuity.
Distributions from the annuity must begin by April 1 of the year following the year the owner reaches age 70 1/2. Until that time, investments in a retirement annuity are usually tax deferred.
Your parents can set up an individual retirement annuity by purchasing an annuity contract or an endowment contract from a life insurance company. An individual retirement annuity must be issued in an individual parent's name as the owner; only the owner and either your other parent or a named beneficiary who survives the owner can receive payments.
An individual retirement annuity must meet all the following requirements:
- Your parent's entire interest in the contract must be nonforfeitable.
- The contract must provide that your parent cannot transfer any portion of it to any person other than the issuer.
- There must be flexible premiums so that if your parent's compensation changes, the annuity payments can also change.
- The contract must provide that contributions cannot be more than $3,000 in 2003 (or $3,500 if your parent is 50 or older), and that your parent must use any refunded premiums to pay for future premiums or to buy more benefits before the end of the calendar year after the year in which your parent receives the refund.
- If your parents borrow money against an IRA annuity contract, they must include in their gross income the fair market value of the annuity contract as of the first day of their tax year. And they may have to pay the 10 percent additional tax if they're younger than 59 1/2.
That last point is a killer. Your parents shouldn't borrow against a retirement annuity.
Moving money into a retirement annuity is relatively easy. Your parents can tell the trustee or custodian of their traditional IRA or other retirement account to use the amount in the account to buy an annuity contract for them. Documentation from the former custodian must be provided to clarify the tax status of the rollover distribution. As long as the tax status of the rollover is consistent, your parents will not be taxed when they receive the annuity contract -- but, in most cases, they will have to pay income tax when they start receiving payments under the annuity contract.
An important thing to point out is that a particular insurance company may not have anything that it calls an individual retirement annuity for sale. Often, the annuities go by other names:
- Single Premium Deferred Annuity (SPDA). With an SPDA, your parents contribute a lump sum of money into an annuity policy and defer an income payout until a later date (usually after age 59 1/2.)
- Flexible Premium Deferred Annuity (FPDA). With an FPDA, you make flexible payments into the annuity contract and defer taking an income from what you have contributed until a future date (usually age 59 1/2).
- Single Premium Immediate Annuity (SPIA). With an SPIA, you contribute a lump sum of money into the annuity, and start to receive an immediate income for a specified period of time.
Annuities vary from insurance company to insurance company. Many pay out bonus interest rates in the first year, but drop the interest rates significantly into the following years. Ultimately these annuities are less attractive than they may initially appear.
Your parents should pay close attention to the financial strength of the insurance company issuing the annuity. In most cases, annuities are not insured by the government. Your parents' money will be invested with this company -- so, it's important that the company is in good shape.
If your parents already have an annuity or endowment contract (an annuity that also provides life insurance protection) they may be able to use it as a retirement annuity. All endowment contracts issued before November 1978 can qualify as individual retirement annuities.
The important point to remember: No tax deduction is allowed for amounts paid under an endowment contract that are allocated to life insurance. For purposes of making the allocation, the cost of the current life insurance protection under a qualified endowment contract is the product of the net premium cost (determined by the IRS) multiplied by the excess of the death benefit payable under the contract during the taxable year over the cash value of the contract.
Why use an annuity to fund an IRA?
- It is the only funding device that guarantees a retirement income your parents cannot outlive.
- It guarantees a minimum rate of interest for the full accumulation period.
- It guarantees a minimum payout rate at retirement.
- It can be arranged to guarantee income for the lifetime of one of your parents, should the other die.
