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Generally, there are four potential parties to an annuity contract; the owner, the annuitant, the beneficiary, and the issuing insurance company. As a general overview, think of the owner as the person who purchases the annuity and the annuitant as the individual whose life will be used in determining how payments under the contract will be made. The beneficiary is the individual or entity that will receive any death benefits that become payable under the annuity contract and the issuing insurance company is the organization that accepts the owner’s premium and promises to pay the benefits spelled out in the contract.
Although there are four potential parties to each annuity contract, the most common situation involves only three parties since the owner and the annuitant are more often than not the same individual. Thus, the three parties are the owner-annuitant, a second individual or entity who is the beneficiary, and the insurance company.
The Owner. Every annuity contract must have an owner. Usually, the owner is referred to as either the owner, the contract owner or the annuity owner. The owner is usually a real person, someone who has decided to purchase the annuity as part of a financial plan for retirement or some other purpose, including Medicaid planning. However, there is no real requirement that the owner be a real person, as there is with the annuitant. Any entity can own an annuity contract, including various types of trusts. As the term “owner” implies, the owner of the annuity contract holds a number of rights under the contract. It is the owner of the annuity who names the individual who will serve as the annuitant as well as the individual or entity who will be the beneficiary under the contract.
The Annuitant. As mentioned above, the annuitant is the individual named under the annuity contract whose life will serve as the measuring life for purposes of determining benefits to be paid out under the contract. According to the Internal Revenue Code, the annuitant is the individual whose life is of primary importance in affecting the timing or amount of the payout under the contract. Thus, it seems obvious that the annuitant, unlike the owner and the beneficiary of the annuity contract, must be a real flesh-and-blood person. Although it is the most common arrangement, there is no requirement that the owner of the annuity contract and the annuitant be the same individual.
The Beneficiary. Similar to the beneficiary of a life insurance policy, the annuity contract beneficiary receives a death benefit when another party to the annuity contract dies. The beneficiary has no rights under the annuity contract, other than the right to receive payment of the death benefit. Likewise, the beneficiary cannot change the payout settlement option, alter the starting date for benefit payments, and cannot make any withdrawals or partial surrenders against the contract. Unlike the party named as the annuitant under an annuity contract, there is no requirement that the beneficiary be a flesh-and-blood individual. Often, a trust or other entity such as a charitable organization is named as the annuity contract beneficiary.
The Insurance Company. It is the insurance company who issues the annuity contract and, in doing so, assumes a number of financial obligations to the owner, the annuitant, and the beneficiary. In a very general sense, the insurance company that issues an annuity contract promises to invest the owner’s premium payments responsibly, credit interest to the funds placed in the annuity, and pay the settlement option selected by the contract owner.
The Basic Rule. The basic rule for the income taxation of payments received from an annuity contract is designed to return the purchaser’s investment in equal tax-free amounts over the payment period. The balance of each payment received must be included in gross income. Each payment, therefore, is generally part non-taxable return of cost and part taxable income.
The Exclusion Ratio. To determine what portion of the annuity payment is taxed and what portion is not, an exclusion ratio must be determined for the contract. The exclusion ratio may be expressed as a fraction or as a percentage and is arrived at by dividing the investment in the contract by the expected return. This exclusion ratio is applied to each annuity payment to find the portion of the payment that is excluded from gross income; the balance of the guaranteed annuity payment is included in gross income for the year received.
For example, let’s assume that Mrs. Smith purchases a single premium immediate annuity for $100,000, which calls for 93 monthly payments of $1,227.03 each. The total number of payments equal $114,113.79. The exclusion ratio is determined by dividing as follows:
Exclusion Ratio = $100,000 / $114,113.79 = 87.6%
For each payment received, 87.6% or $1,074.88 is return of principal, while $152.14 or 12.4% of each payment is taxable income. In a full year, or 12 monthly payments, Mrs. Smith can expect to receive a 1099 from the annuity company showing a total annual payout of $14,724.36, of which $1,825.82 is taxable income.