Remember this to avoid common pitfalls that can be encountered with insurance products.
There is evidence that annuities may be the oldest form of life insurance, with some historians tracing the product back to the ancient Phoenicians--nearly 5,000 years ago! Thus, it is interesting to note that annuities, whether variable, fixed, or indexed, are the most popular type of insurance product currently offered by life insurers. Annuity premiums total many times the premiums for other life insurance products.
Equally interesting is the fact that annuities enjoy the widest distribution channels of any life insurance product. Not only traditional life-insurance agents, but stock-brokers, financial planners, and even banks all sell large quantities of the various types of annuities. Indeed, with well over a trillion dollars under management in annuities, they have become a mainstream product for the investment marketplace. It is little wonder that, with the increased emphasis on annuities as investment products, everyone concerned sometimes tends to forget that annuities are also insurance products and must be treated as such in order to avoid common pitfalls that can be encountered with insurance products.
Since annuities are insurance products as well as investments, it is necessary to bear in mind some of the technical elements that are always present with the sale and implementation of insurance products. It is also necessary to recognize that annuities have some peculiarities in their treatment under the Internal Revenue Code that must be considered in the sales process.
As a form of "life insurance," annuity contracts require similar concerns with ownership, beneficiary designations and settlement options that are present with any type of life insurance. Although annuities do not usually require health underwriting before an insurer will issue them, the insurer does have the responsibility to make sure that the annuity application and attendant documents are "in good order." In many instances, an insurer will attempt to get clarification when ownership, beneficiary or settlement information is lacking or inconsistent. However, it is also possible for annuities to have built in problems that can have adverse implications for the owner, annuitant or beneficiary.
Financial advisors who assist their clients with the purchase of annuities--whether variable, fixed or index products--need to understand the federal income tax implications that are present when an annuity is used. Annuities, if properly designed, have the benefit of avoiding current tax on investment while the annuity is in effect prior to actual distribution of the annuity's values. This "tax-deferred inside build-up" has been included in the Internal Revenue Code in order to give people incentive to purchase annuities to provide for their own retirement. However, this tax-deferred inside build-up is conditioned on the annuity qualifying for such favorable treatment. There are a number of rules that affect the tax status of annuities; some of which are specific to certain types of annuities. For instance, variable annuities have requirements that impose limitations on the investments that can underlie the product.
All annuities, regardless of whether they are variable, fixed, or indexed, must have features that are mandated by the Internal Revenue Code and by the Regulations promulgated under the Code. Section 72(s) of the Code requires any annuity contract, regardless of type, to have a provision requiring distributions of contract values on the death of the annuity's "holder." Thus, an annuity will not be treated as an annuity for purposes of the Internal Revenue Code unless the annuity contains a contract provision that requires distribution of contract values within certain specified time frames. The object of Section 72(s) was to prevent indefinite tax-deferral of annuity values after the death of the "holder." Section 72(s) provides that for the death of the "holder" after the annuity starting date, contract values must be distributed at least as fast as they were being distributed before death. For the death of the "holder" prior to the annuity's starting date, the entire contract value must be distributed over a five-year period after the death of the "holder," or for the life of the beneficiary, unless the beneficiary is the "holder's" spouse. If the beneficiary is the "holder's" spouse, then the spouse can step into the place of the "holder" and continue tax-deferral until death or annuitization.
From the time of the issuance of the first commercial annuity until the time Section 72(s) was enacted, the measuring life for all purposes involving an annuity was the "annuitant." The annuitant was, in effect, the "insured" under an annuity contract. The annuitant could be the owner of the contract, or the owner could be someone else other than the annuitant. However, regardless of whether the annuitant and the owner were the same person, it was the annuitant's life that was used to determine timing and duration of annuity payments, payment of death proceeds, etc. With the enactment of Section 72(s), this all changed. In order to comply with Section 72(s) all annuity contracts had to provide for payment on the death of the "holder" rather than on the death of the annuitant.
Almost immediately, the question arose as to whom the "holder" of an annuity was as specified in Section 72(s). The interpretation that was finally adopted was that the "holder," for purposes of Section 72(s) was the annuity's owner--not the annuitant. Unfortunately, most annuity contracts at the time Section 72(s) was enacted provided for payment of death benefits on the death of the annuitant, regardless whether death occurred before or after the annuity starting date. This required insurers to amend their annuity contracts to add the Section 72(s) requirement for distribution of contract values on the death of the "holder/owner." Unfortunately, many insurers left a requirement in their contracts for distribution of death proceeds on the death of the annuitant. Thus, distributions were required on the death of either the owner or the annuitant.