Variable Annuities, Retirement Plans, and Life Insurance
Investment Policy Statement The investment adviser to the plan must design a portfolio in line with the plan's investment policy statement. Advisers who do not adhere to the investment policy statement may be held liable to plan participants for any losses.
The investment policy statement governs the way the assets of the plan are invested. It sets guidelines for diversification and acceptable levels of risk.
Types of Plans
There are two main types of qualified corporate plans: a defined benefit plan and a defined contribution plan.
Sales Charges
There is no maximum sales charge for an annuity contract. The sales charge that is assessed must be reasonable in relation to the total payments over the life of the contract. Most annuity contracts have back-end sales charges or surrender charges similar to a contingent deferred sales charge.
Employee Stock Ownership Plans/ESOP
ESOP plans are established by employers to provide a way for the employees to benefit from ownership of the company's stock. The plan allows the employer to take a tax deduction based on the market value of the stock.
SEP IRA Taxation Employees may begin to withdraw money from the plan at age 59-1/2. All withdrawals are taxed as ordinary income and withdrawals prior to age 59-1/2 are subject to a 10% penalty tax. The employer may contribute up to 25% of the employee's income, up to $61,000.
Employer's contributions to a SEP IRA are immediately tax-deductible by the employer. Contributions are not taxed at the employee's rate until the employee withdraws the funds.
Nonprofit Organizations/Tax-Exempt Organizations (501C3) All employees of organizations that qualify under the Internal Revenue Code 501C3 or 403B are eligible to participate as long as they are at least 21 years old and have worked full time for at least 1 year.
Organizations that qualify under the Internal Revenue Code 501C3 as a nonprofit or tax-exempt entity may set up a TSA or TDA for their employees. Examples of nonprofit organizations are: Private hospitals. Charitable organizations. Trade schools. Private colleges. Parochial schools. Museums. Scientific foundations. Zoos.
Funding
Plan funding requirements set forth guidelines on how the money is deposited into the plan and how the employer and employee may contribute to the plan.
401K Thrift Plans
401K and thrift plans allow the employee to contribute a fixed percentage of their salary to their retirement account, and have the employer match some or all of their contributions. The employer's contributions provide a current tax deduction to the employer and the employee is not taxed on the contributions until they are withdrawn.
Keogh Plans (HR-10)
A Keogh plan is a qualified retirement plan set up by self-employed individuals, sole proprietors, and unincorporated businesses. If the business is set up as a corporation, a Keogh may not be used.
Roth IRA All contributions deposited in a Roth IRA are allowed to grow tax-deferred, and all of the growth may be taken out of the account tax-free, provided that the individual has reached age 59-1/2 and the assets have been in the account for at least 5 years. A 10% penalty tax will be charged on any withdrawal of earnings prior to age 59-1/2 unless the owner is purchasing a home, has become disabled, or has died. There are no requirements for an individual to take distributions from a Roth IRA by a certain age.
A Roth IRA is a nonqualified account. All deposits that are made to a Roth IRA are made with after-tax dollars. The same contribution limits apply for a Roth IRA. An individual may contribute the lesser of 100% of earned income, to a maximum of $6,000 per person or $12,000 per couple. Any contribution made to a Roth IRA reduces the amount that may be deposited in a traditional IRA and vice versa.
Deferred Compensation Plans The employee may only claim the assets if they retire or become disabled; or, in the case of death, their beneficiaries may claim the money owed. Money due under a deferred compensation plan is paid out of the corporation's working funds when the employee or their estate claims the assets. Should the employee leave the corporation and go to work for a competing company, they may lose the money owed under a non-compete clause. Money owed to the employee under a deferred compensation agreement is traditionally not invested for the benefit of the employee, and as a result, does not increase in value over time. The only product that traditionally is placed in a deferred compensation plan is a term life policy. In the case of the employee's death, the term life policy will pay the employee's estate the money owed under the contract.
A deferred compensation plan is a contract between an employee and an employer. Under the contract, the employee agrees to defer the receipt of money owed to the employee from the employer until after the employee retires. After retirement, the employee will traditionally be in a lower tax bracket and will be able to keep a larger percentage of the money. Deferred compensation plans are traditionally unfunded and, if the corporation goes out of business, the employee becomes a creditor of the corporation and may lose all of the money due under the contract.
Variable Universal Life/Universal Variable Life A variable universal life insurance policy will remain in effect as long as there is enough cash value in the policy to support the cost of insurance. A variable universal life insurance policy may have a minimum guaranteed death benefit but does not have to. Representatives who sell variable universal life polices must have both insurance and securities licenses.
A variable universal life policy allows the policyholder the ability to determine when premiums are paid and to decide how large those payments are. The net premium is invested in the insurance company's separate account, and the policy's cash value and variable death benefit are determined by the investment experience of the separate account.
IRA Accounts
All IRA accounts are held in the name of the custodian for the benefit of the account holder. Traditional custodians include banks, broker dealers, and mutual fund companies.
Communication
All corporate plans must be in writing at inception and the employee must be given annual updates.
Tax Treatment of Distributions
All distributions for TSAs/TDAs are taxed as ordinary income in the year in which the distribution is made. Distributions from a TSA/TDA prior to age 59-1/2 are subject to a 10% penalty tax as well as ordinary income taxes. Distributions from a TSA/TDA must begin by age 72 or be subject to an excess accumulation tax.
Participation The employee must be at least 21 years old, and have worked during three of the last 5 years for the employer, and have earned at least $550. All eligible employees must participate as well as the employer.
All eligible employees must open an IRA to receive the employer's contribution to the SEP. If the employee does not open an IRA account, the employer must open one for them.
Annuities The three types of annuities are: Fixed annuity Variable annuity Combination annuity Although all three types allow the investor's money to grow tax-deferred, the type of investments made and how the money is invested varies according to the type of annuity.
An annuity is a contract between an individual and an insurance company. Once the contract is entered into, the individual becomes known as the annuitant. The three basic types of annuities are designed to meet different objectives.
Rolling Over a Pension Plan When the employee rolls over their pension plan, they take physical possession of the assets. The plan administrator is required to withhold 20% of the total amount to be distributed and the employee has 60 calendar days to deposit 100% of the assets into another qualified plan. The employee must file with the federal government at tax time to receive a return of the 20% of the assets that were withheld by the plan administrator.
An employee who leaves an employer may move their pension plan to another company's plan or to another qualified account. This may be accomplished by a direct transfer or by rolling over the plan. With a direct transfer, the assets in the plan go directly to another plan administrator and the employee never has physical possession of the assets.
Rollover vs. Transfer
An individual may want or need to move their IRA from one custodian to another. There are two ways this can be accomplished. An individual may rollover their IRA or they may transfer their IRA.
Annuity Payout Options The following is a list of typical payout options in order from the largest monthly payment to the smallest: Life only/straight life Life with period certain Joint with last survivor
Annuity contracts are not subject to the contribution limits or the required minimum distributions of qualified plans. An investor in an annuity has the choice of taking a lump sum distribution or receiving scheduled payments from the contract. If the investor decides to annuitize the contract and receive scheduled payments, once the payout option is selected it may not be changed.
Taxation The growth portion of the contract is always considered to be the last money that was deposited and is taxed at the ordinary income rate of the annuitant. If the annuitant is under the age of 59-1/2 and takes a lump sum or random withdrawal, the withdrawal will be subject to a 10% penalty tax, as well as ordinary income taxes. An investor who needs to access the money in a variable annuity contract may be allowed to borrow from the contract, and so long as interest is charged on the loan and the loan is repaid by the investor, the investor will not be subject to taxes.
Contributions made to an annuity are made with after-tax dollars. The money the investor deposits becomes the investor's cost basis and is allowed to grow tax-deferred. When the investor withdraws money from the contract, only the growth is taxed. The investor's cost base is returned tax-free. All money in excess of the investor's cost base is taxed as ordinary income. Both lump sum and random withdrawals are done on a last in, first out (LIFO) basis.
IRA Contributions Contributions may be made between January 1 and April 15 for the previous year, the current year, or both. All IRA contributions must be made in cash.
Contributions to IRAs must be made by April 15th of the following calendar year, regardless of whether or not an extension has been filed by the taxpayer.
Direct Investment If the money in the separate account is actively managed and invested directly, then the separate account is considered an open-end investment company under the Investment Company Act of 1940 and must register as such.
If the money in the separate account is invested directly into individual stocks and bonds, the separate account must have an investment adviser to actively manage the portfolio.
Indirect Investment If the separate account purchases mutual fund shares directly, then the separate account is considered a unit investment trust (UIT) under the Investment Company Act of 1940 and must register as such.
If the separate account uses the money in the portfolio to purchase mutual fund shares, it is investing in the equity and debt markets indirectly, and an investment adviser is not required to actively manage the portfolio.
Public Educational Institutions (403B) State supported schools are: Elementary schools. High schools. State colleges and universities. Medical schools. Any individual who works for a public school, regardless of their position, may participate in the school's TSA or TDA.
In order for a school to be considered a public school and qualify to establish a TSA/TDA for their employees, the school must be supported by the state, the local government, or a state agency.
Contributions Each year a new salary reduction agreement must be signed to set forth the contributions for the new year. The employee's elective deferral is limited to a maximum of $20,500 per year. Employer contributions are limited to the lesser of 25% of the employee's earnings or $61,000.
In order to participate in a TSA or TDA, employees must enter into a contract with their employer agreeing to make elective deferrals into the plan. The salary reduction agreement will state the amount and frequency of the elective deferral to be contributed to the TSA. The agreement is binding on both parties and covers only 1 year of contributions.
Individual Plans
Individuals may set up a retirement plan that is qualified and allows contributions to the plan to be made with pre-tax dollars. Individuals may also purchase investment products, such as annuities, that allow their money to grow tax-deferred. The money used to purchase an annuity has already been taxed, making an annuity a nonqualified product.
Contributions An eligible employee is defined as one who: Works full time (at least 1,000 hours per year). Is at least 21 years old. Has worked at least 1 year for the employer. Employees who participate in a Keogh plan must be vested after 5 years. Withdrawals from a Keogh may begin when the participant reaches 59-1/2. Any premature withdrawals are subject to a 10% penalty tax. A Keogh, like an IRA, may be rolled over every 12 months. In the event of a participant's death, the assets will go to the individual's beneficiaries.
Keoghs may only be funded with earned income during a period when the business shows a gross profit. If the business realizes a loss, no Keogh contributions are allowed. A self-employed person may contribute the lesser of 25% of their post-contribution income or $61,000. If the business has eligible employees, the employer must make a contribution for the employees at the same rate as their own contribution. Employee contributions are based on the employee's gross income and are limited to $61,000 per year. All money placed in a Keogh plan is allowed to grow tax-deferred and is taxed as ordinary income when distributions are made to retiring employees and plan participants. From time to time a self-employed person may make a non-qualified contribution to their Keogh plan; however, the total of the qualified and non-qualified contributions may not exceed the maximum contribution limit. Any excess contribution may be subject to a 10% penalty tax.
Profit Sharing Plans In order for a profit sharing plan to be qualified, the corporation must have substantial and recurring profits. The maximum contribution to a profit sharing plan is the lesser of 100% of the employee's compensation or $61,000.
Profit sharing plans let the employer reward the employees by letting them "share" in a percentage of the corporation's profits. Profit sharing plans are based on a preset formula and the money may be paid directly to the employee or placed in a retirement account.
Tax-Sheltered Annuities/Tax-Deferred Account TSAs/TDAs are qualified plans and contributions are made with pre-tax dollars. The money in the plan is allowed to grow tax-deferred until it is withdrawn. TSAs/TDAs offer a variety of investment vehicles for participants to choose from, such as: Stocks. Bonds. Mutual funds. CDs.
Tax-sheltered annuities (TSAs) and tax-deferred accounts (TDAs) are established as retirement plans for employees of nonprofit and public organizations such as: Public educational institutions (403B). Nonprofit organizations (IRC 501C3). Religious organizations. Nonprofit hospitals.
Life Only/Straight Life If an investor has accumulated a large sum of money in the contract and dies unexpectedly shortly after annuitizing the contract, the insurance company keeps the money in its account.
This payout option will give the annuitant the largest periodic payment from the contract, and the investor will receive payments from the contract for the rest of his or her life. When the investor dies, however, no additional benefits are paid to the investor's estate.
Vesting Three- to 6-year gradual vesting schedule Three-year cliff: the employee is not vested at all until 3 years, when they become 100% vested
Vesting refers to the process of how the employer's contribution becomes the property of the employee. An employer may be as generous as they like, but may not be more restrictive than either one of the following vesting schedules:
Annuity Units The number of annuity units is fixed and represents the investor's proportional ownership of the separate accounts portfolio during the payout phase. The number of annuity units that the investor receives when the contract is annuitized is based on the payout option selected, the annuitant's age and sex, the value of the account, and the assumed interest rate.
When an investor changes from the pay-in or deferred stage of the contract to the payout phase, the investor is said to have annuitized the contract. At this point, the investor trades in his or her accumulation units for annuity units.
Defined Benefit Plan Other defined benefit plans are structured to pay participants a fixed sum of money for life. Defined benefit plans require the services of an actuary to determine the employer's contribution to the plan based on the participant's life expectancy and benefits promised.
A defined benefit plan is designed to offer the participant a retirement benefit that is known or "defined." Most defined benefit plans are set up to provide employees with a fixed percentage of their salary during their retirement such as 74% of their average earnings during their five highest paid years.
Fixed Annuity Representatives who sell fixed annuity contracts must have an insurance license. Because fixed annuities offer investors a guaranteed return, the money invested by the insurance company will be used to purchase conservative investments such as mortgages and real estate, investments whose historical performance is predictable enough so that a guaranteed rate can be offered to investors. All of the money invested into fixed annuity contracts is held in the insurance company's general account. Because the rate that the insurance guarantees is not very high, the annuitant may suffer a loss of purchasing power due to inflation risk.
A fixed annuity offers investors a guaranteed rate of return regardless of whether the investment portfolio can produce the guaranteed rate. If the performance of the portfolio falls below the rate that was guaranteed, the insurance company owes investors the difference. Because the purchaser of a fixed annuity does not have any investment risk, a fixed annuity is considered an insurance product, not a security.
Life with Period Certain If an investor selects a 10-year period certain when the contract is annuitized and the investor lives for 20 years more, payments will cease upon the annuitant's death. However, if the same investor died only 2 years after annuitizing the contract, payments would go to the investor's estate for another 8 years.
A life with period certain payout option will pay out from the contract to the investor or to the investor's estate for the life of the annuitant or for the period certain, whichever is longer.
Simplified Employee Pension IRA (SEP IRA) The contribution limit for a SEP IRA far exceeds that of traditional IRAs. The contribution limit is the lesser of 25% of the employee's compensation or $61,000 per year. Should the employee wish to make their annual IRA contribution to their SEP IRA, they may do so, or they may make their standard contribution to a traditional or Roth IRA.
A simplified employee pension (SEP) IRA is used by small corporations and self-employed individuals to plan for retirement. A SEP IRA is attractive to small employers because it allows them to set up a retirement plan for their employees rather quickly and inexpensively.
Health Savings Accounts The money in the account grows tax free and can be used tax free for qualified medical expenses. The individual may use the money to pay the expense directly to the health care provider to reimburse themselves for payments they have made for qualified medical expenses incurred for themselves, their spouse or any dependent claimed on their tax return. Prescription drugs are considered to be qualified medical expenses. If the person requires a nonprescription drug to be covered the person still must get a prescription from their doctor. If money is used for non-qualified medical expenses the money will be subject to income taxes and could be subject to a 20% penalty tax. The money is allowed to accumulate over time and any unused amounts may be carried over to future years. If the owner of an HSA dies the account will pass to the owner's spouse and will be treated as the spouse's HSA. If the beneficiary is not the spouse the account will cease to be an HSA and the amount will be taxable to the beneficiary in the year in which the owner dies.
A tax advantaged health savings account may be established to help offset the potential impact of medical expenses incurred by individuals who maintain a high deductible health insurance plan. Many individuals select a health insurance plan with a high deductible to lower the monthly premium expenses. A high deductible health plan is often used to insure against catastrophic illness. Individuals covered by these plans may elect to establish a health savings account. The individual, their employer or both may make contributions to the health savings account. The contribution limit varies and is based on the person's age and the type of health insurance coverage. If a person is eligible on the first day of the last month of the year, the person may make a full contribution for that year. This is known as the "last month rule." Contributions to the health savings account may be made with pretax dollars.
Universal Life The policy will stay in effect as long as there is enough cash value in the policy to support the payment of mortality and expense costs. The net premium payments are invested in the insurance company's general account, and a universal life policy is considered an insurance product. Universal life insurance policies have two interest rates associated with them: a contract rate, which sets a minimum interest rate that will be paid to the holder, and an annual rate that is set each year based on prevailing interest rates. Representatives who sell universal life insurance policies must have their insurance licenses.
A universal life insurance policy, unlike whole and variable life policies, has no scheduled premium payments and a face amount that can be adjusted according to the policyholder's needs. A universal life policy allows the policyholder to decide when premiums are paid and to determine how large those payments will be. Should the insured determine that he or she needs to change the amount of the insurance, the face amount of the policy may be adjusted up or down. The policyholder has no scheduled premium payments, but the insured must make payments frequently enough to support the policy.
Variable Life The cash and securities held by the insurance company are invested in the insurance company's separate account and are kept segregated from the insurance company's general account. The separate account is required to register as either an open-end investment or as a UIT under The Investment Company Act of 1940. Representatives who sell these policies must have both a securities license and an insurance license. The insured is covered from the date of issuance to the date of death, as long as the premiums are paid.
A variable life insurance contract is both an insurance policy and a security because of the way the insurance company invests the cash reserves. A variable life policy is a fixed-premium plan that offers the contract holder a minimum death benefit. The holder of a variable life insurance policy may choose how the cash reserves are invested. A variable life policy typically offers stocks, bonds, mutual funds, and other portfolios as investment options. Although the performance of these investments may tend to outperform the performance of more conservative alternatives, the cash value of the policy is not guaranteed.
Whole Life The policy's cash value increases each year as the premiums are paid and invested. The death benefit and the premium payments are fixed by the insurance company at the time of issuance and remain constant for the life of the policy. The policyholder is covered from the date of issuance to the date of death, as long as the premiums are paid.
A whole life insurance policy provides the insured with a guaranteed death benefit that is equal to the face amount of the policy as well as a guaranteed cash value that the policyholder may borrow against. The cash value of the policy is held in the insurance company's general account and is invested in conservative investments such as mortgages and real estate.
ERISA 404C Safe Harbor This safe harbor is available so long as: The participant exercises control over the assets in their account. Participants have ample opportunity to enter orders for their account and to provide instructions regarding their account. A broad range of investment options is available for the participant to choose from and the options offer suitable investments for a variety of investment objectives and risk profiles. Information regarding the risks and objective of the investment options is readily available to plan participants.
All individuals and entities acting in a fiduciary capacity must act solely in the interest of the plan participants. Investment advisers, trustees, and all individuals who exercise discretion over the plan, including those who select the administrative personnel or committee, are considered to be fiduciaries. ERISA Rule 404C provides an exemption from liability or a "safe harbor" for plan fiduciaries and protects them from liabilities that may arise from investment losses that result from the participant's own actions.
Individual Retirement Accounts (IRAs) question. Our review of IRAs will focus on the four main types: Traditional Roth SEP Educational
All individuals with earned income may establish an Individual Retirement Account (IRA). Contributions to traditional IRAs may or may not be tax deductible depending on the individual's level of adjusted gross income and whether the individual is eligible to participate in an employer-sponsored plan. Individuals who do not qualify to participate in an employer-sponsored plan may deduct their IRA contributions regardless of their income level.
Factors Affecting the Size of the Annuity Payment
All of the following determine the size of the annuity payment: Account value Payout option selected Age Sex Account performance vs. the assumed interest rate (AIR)
Beneficiaries
All plan participants must be allowed to select a beneficiary who may claim the assets in case of the plan participant's death.
Plan Participation All employees must be allowed to participate if: They are at least 21 years old. They have worked at least 1 year full time (1,000 hours) or 500 hours per year for 3 years.
All plans governed by ERISA may not discriminate among who may participate in the plan.
Qualified Plans
All qualified corporate plans must be in writing and set up as a trust. A trustee or plan administrator will be appointed for the benefit of all plan holders.
Accumulation Units An investor will only own accumulation units during the accumulation stage, when money is being paid into the contract or when receipt of payments is being deferred by the investor, such as with a single-payment deferred annuity.
An accumulation unit represents the investor's proportionate ownership in the separate account's portfolio during the accumulation or deferred stage of the contract. The value of the accumulation unit will fluctuate as the value of the securities in the separate account's portfolio changes. As the investor makes contributions to the account or as distributions are reinvested, the number of accumulation units will vary.
Educational IRA If all of the funds have not been used for educational purposes by the time the student reaches 30 years of age, the account must be rolled over to another family member who is under 30 years of age or distributed to the original student and subject to a 10% penalty tax as well as ordinary income taxes.
An educational IRA allows individuals to contribute up to $2,000 in after-tax dollars to an educational IRA for each student who is under 18 years of age. The money is allowed to grow tax-deferred and the growth may be withdrawn tax-free as long as the money is used for educational purposes.
Bonus Annuity Another type of bonus offered to annuitants is the ability to withdraw the greater of the account's earnings or up to 15% of the total premiums paid without a penalty. Although the annuitant will not have to pay a penalty to the insurance company, there may be income taxes and a 10% penalty tax owed to the IRS. Bonus annuities often have higher expenses and longer surrender periods than other annuities, and these additional costs and surrender periods need to be clearly disclosed to prospective purchasers. In order to offer bonus annuities the bonus received must outweigh the increased costs and fees associated with the contract. Fixed annuity contracts may not offer bonuses to purchasers.
An insurance company that issues variable annuity contracts may offer incentives to investors who purchase their annuities. Such incentives are often referred to as bonuses. One type of bonus is known as premium enhancement. Under a premium enhancement option, the insurance company will make an additional contribution to the annuitant's account based on the premium paid by the annuitant. For example, if the annuitant is contributing $1,000 per month, the insurance company may offer to contribute an additional 5%, or $50 per month, to the account.
Annuity Purchase Options
An investor may purchase an annuity contract in one of three ways: Single-payment deferred annuity Single-payment immediate annuity Periodic-payment deferred annuity
Transfer
An investor may transfer their IRA directly from one custodian to another by simply signing an account transfer form. The investor never takes possession of the assets in the account and the investor may directly transfer their IRA as often as they like.
Variable Annuity Because the annuitant bears the investment risk associated with a variable annuity, the contract is considered both a security and an insurance product. Representatives who sell variable annuities must have both their securities license and their insurance license. The money and securities contained in a variable annuity contract are held in the insurance company's separate account. The separate account is named as such because the variable annuity's portfolio must be kept separate from the insurance company's general funds. The insurance company must have a net worth of $1,000,000 or the separate account must have a net worth of $1,000,000 in order for the separate account to begin operating. Once the separate account begins operations, it may invest in one of two ways. Directly Indirectly
An investor seeking to achieve a higher rate of return may elect to purchase a variable annuity. Variable annuities seek to obtain a higher rate of return by investing in stocks, bonds, or mutual fund shares. These securities traditionally offer higher rates of return than more conservative investments. A variable annuity does not offer the investor a guaranteed rate of return and the investor may lose all or part of their principal.
Traditional IRA Withdrawals from an IRA prior to age 59-1/2 are subject to a 10% penalty tax as well as ordinary income taxes. The 10% penalty will be waived for first-time homebuyers; for educational expenses; for the taxpayer's children, grandchildren, or spouse; if the account holder becomes disabled; or if the payments are part of a series of substantially equal payments. Withdrawals from an IRA must begin by April 1st of the year following the year in which the taxpayer reaches 72. If an individual fails to make withdrawals that are sufficient in size and frequency, the individual will be subject to a 50% penalty on the insufficient amount. An individual who makes a contribution to an IRA that exceeds 100% of earned income or the annual limit, whichever is less, will be subject to a penalty of 6% per year on the excess amount for as long as the excess contribution remains in the account.
Currently, a traditional IRA allows an individual to contribute a maximum of 100% of earned income, or $6,000 per year or up to $12,000 per couple. If only one spouse works, the working spouse may contribute $6,000 to an IRA for him- or herself and $6,000 to a separate IRA for his or her spouse under the nonworking spousal option. Investors over age 50 may contribute up to $7,000 of earned income to an IRA. Regardless of whether the IRA contribution was made with pre- or after-tax dollars, the money is allowed to grow tax-deferred. All withdrawals from an IRA are taxed as ordinary income regardless of how the growth was generated in the account.
Payroll Deductions Contributions to a payroll deduction plan are made with after-tax dollars.
The employee may set up a payroll deduction plan by having the employer make systematic deductions from the employee's paycheck. The money, which has been deducted from the employee's check, may be invested in a variety of ways. Mutual funds, annuities, and savings bonds are all usually available for the employee to choose from.
Equity-Indexed Annuities Equity indexed annuities may also set a floor rate and a cap rate for the contract. The floor rate is the minimum interest rate that will be credited to the investor's account. The floor rate may be zero or it may be a positive number depending on the specific contract. The contract's cap rate is the maximum rate that will be credited to the contract. If the return of the index exceeds the cap rate, the investor's account will only be credited up to the cap rate. If the S&P 500 index returns 11% and the cap rate set in the contract is 9%, the investor's account will only be credited 9%.
Equity-indexed annuities offer investors a return that varies according to the performance of a set index, such as the S&P 500. Equity-indexed annuities will credit additional interest to the investor's account based on the contract's participation rate. If a contract sets the participation rate at 70% of the return for the S&P 500 index, and the index returns 5%, the investor's account will be credited for 70% of the return, or 3.5%. The participation rate may also be shown as a spread rate. If the contract had a spread rate of 3% and the index returned 10%, the investor's contract would be credited 7%.
Combination Annuity The money invested in the fixed portion of the contract is invested in the insurance company's general account and used to purchase conservative investments such as mortgages and real estate. The money invested in the variable side of the contract is invested in the insurance company's separate account and used to purchase stocks, bonds, or mutual fund shares. Representatives who sell combination annuities must have both their securities license and their insurance license.
For investors who feel that a fixed annuity is too conservative and that a variable annuity is too risky, a combination annuity offers the annuitant features of both a fixed and variable contract. A combination annuity has a fixed portion that offers a guaranteed rate and a variable portion that tries to achieve a higher rate of return. Most combination annuities will allow the investor to move money between the fixed and variable portions of the contract.
Retirement Plans Both corporate and individual plans may be qualified or nonqualified, and it is important for an investor to understand the difference before deciding to participate.
For most people, saving for retirement has become an important investment objective for at least part of their portfolio. Investors may participate in retirement plans that have been established by their employers, as well as those they have established for themselves.
It Is Unwise to Put a Municipal Bond in an IRA The advantage of an IRA is that money is allowed to grow tax-deferred; therefore, an individual would be better off with a higher yielding taxable bond of the same quality.
Municipal bonds or municipal bond funds should never be placed in an IRA because the advantage of those investments is that the interest income is free from federal taxes. Because their interest is free from federal taxes, the interest rate that is offered will be less than the rates offered by other alternatives.
Employer Contributions An employee who is over 72 must also participate and receive a contribution. All eligible employees are immediately vested in the employer's contributions to the plan.
The employer may contribute between 0 and 25% of the employee's total compensation to a maximum of $61,000. Contributions to all SEP IRAs, including the employer's SEP IRA, must be made at the same rate.
Non-Qualified Corporate Retirement Plans Distributions from a non-qualified plan that exceed the investor's cost base are taxed as ordinary income. All non-qualified plans must be in writing and the employer may discriminate as to who may participate.
Non-qualified corporate plans are funded with after-tax dollars and the money is allowed to grow tax-deferred. If the corporation makes a contribution to the plan, they may not deduct the contribution from their corporate earnings until the plan participant receives the money.
529 Plans Contributions to a 529 plan are made with after-tax dollars and are allowed to grow tax deferred. The assets in the account remain under the control of the donor, even after the student reaches the age of maturity. The funds may be used to meet the student's educational needs and the growth may be withdrawn free of federal taxes. Most states also allow the assets to be withdrawn tax free. Any funds used for non-qualified education expenses will be subject to income tax and a 10% penalty tax. If funds remain or if the student does not attend or complete qualified higher education, the funds may be rolled over to another family member within 60 days without incurring taxes and penalties. There are no income limits for the donors and contribution limits vary from state to state. 529 plans have an impact on a student's ability to obtain need-based financial aid. However, because the 529 plans are treated as parental assets and not as assets of the student, the plans are assessed at the expected family contribution (EFC) rate of 5.64%. This will have a significantly lower impact than plans and assets that are considered to be assets of the student. Student assets will be assessed at a 20% contribution rate.
Qualified tuition plans, more frequently referred to as 529 plans, may be set up either as a prepaid tuition plan or as a college savings plan. With the prepaid tuition plan, the plan locks in a current tuition rate at a specific school. The prepaid tuition plan can be set up as an installment plan or one where the contributor funds the plan with a lump sum deposit. Many states will guarantee the plans but may require either the contributor or the beneficiary to be a state resident. The plan covers only tuition and mandatory fees. A room and board option is available for some plans. A college cost-savings account may be opened by any adult and the donor does not have to be related to the child. The assets in the college savings plan can be used to cover all costs of qualified higher education including tuition, room and board, books, computers, and mandatory fees. These plans generally have no age limit when assets must be used. College savings accounts are not guaranteed by the state and the value of the account may decline in value depending on the investment results of the account. College savings accounts are not state specific and do not lock in a tuition rate.
The Department of Labor Fiduciary Rules However the rule requires that the client receive significant disclosures relating to the fees and costs associated with the servicing of the account. Simply charging the lowest fee will not ensure compliance with the fiduciary standard. Both the firm and the individual servicing the account must put the interests of the client ahead of their own. Broker dealers and advisory firms must establish written supervisory procedures and training programs designed to supervise and educate their personnel on the new requirements for retirement accounts. Many representatives will now be required to obtain the Series 65 or Series 66 license to comply with the new Department of Labor rules.
The Department of Labor has been working to enact significant new legislation for financial professionals who service and maintain retirement accounts for clients. These new rules subject financial professionals to higher fiduciary standards. These standards require financial professionals to place the interest of the client ahead of the interest of the broker dealer or investment advisory firm. Professionals who service retirement accounts are still permitted to earn commissions and/or a fee based on the assets in the account and may still offer proprietary products to investors.
Recommending Variable Annuities Illustrations regarding performance of the contract may use a maximum growth rate of 12% and all annuity applications must be approved or denied by a principal based on suitability within 7 business days of receipt. A Series 24 or Series 26 principal may approve or deny a variable annuity application presented by either a Series 6 or Series 7 registered representative. 1035 exchanges allow investors to move from one annuity contract to another without incurring tax consequences. 1035 exchanges can be a red flag and a cause for concern over abusive sales practices. Because most annuity contracts have surrender charges that may be substantial, 1035 exchanges may result in the investor being worse off and may constitute churning. FINRA is concerned about firms who employ compensation structures for representatives that may incentivize the sale of annuities over other investment products with lower costs and may be more appropriate for investors. Firms should guard against incentivizing agents to sell annuity products over other investments. Members should ensure proper product training for registered representatives and principals for annuities and they must have adequate supervision to monitor sales practices and to test their product knowledge. The focus should be on detecting problematic and abusive sales practices. L share annuity contracts are designed with shorter surrender periods, but have higher costs to investors. The sale of L share annuity contracts can be a red flag for compliance personnel and may constitute abusive sales practices
There are a number of factors that will determine if a variable annuity is a suitable recommendation for an investor. Variable annuities are meant to be used as supplements to other retirement accounts such as IRAs and corporate retirement plans. Investors who purchase variable annuities should have income as their investment objective and must be comfortable with the lack of liquidity, costs and tax considerations. Most annuities have initial surrender periods during which the investor will have to pay a substantial penalty to access their funds. Variable annuities should not be recommended to investors who are trying to save for a large purchase or expense such as college tuition or a second home. Variable annuity products are more appropriate for an investor who is looking to create an income stream. A deferred annuity contract would be appropriate for someone seeking retirement income at some point in the future. An immediate annuity contract would be more appropriate for someone seeking to generate current income and who is perhaps already retired. Many annuity contracts have complex features and cost structures that may be difficult for both the representative and investor to understand. The benefits of the contract should outweigh the additional costs of the contract to ensure the contract is suitable for the investor.
Tax Implications of Life Insurance If the insured person is deemed to be the owner of the contract, the amount of the death benefit payable on the contract will be included in the value of the person's estate for estate tax purposes. The owner of the policy is the person who has the right to name a beneficiary, borrow from the policy, transfer ownership, and determine how dividends or cash value are invested. To ensure that the policy is not considered to be an asset of the estate when determining estate taxes, oftentimes people will establish the policy so that the policy is owned by their spouse or by an irrevocable life insurance trust (ILT). By establishing the ownership of the life insurance policy in an ILT, the death benefit will not impact the value of the insured's estate.
There are a number of tax implications that need to be understood by people who buy life insurance contracts. Generally, the premiums paid to the insurance company for the life insurance policy are not tax deductible for federal income tax purposes. However, should the death benefit become payable, the amount paid out to the beneficiary will be received tax free. Of critical importance when determining the tax implications of a life insurance policy is recognizing who the "owner" of the policy is.
Life Settlements The market for life insurance policies is illiquid, and pricing of policies can vary greatly. FINRA requires any firm that assists in the selling of client policies obtain multiple bids for the policy to ensure that the client receives a fair price. The firm may not enter into any arrangement that would require the firm to sell all or substantially all of its client life insurance policies to any one buyer. FINRA requires agents assisting in the sale of life settlements, as well as the supervisors of the agents, to receive training relating to life settlements. FINRA further requires that the training be documented for each agent and supervisor.
There may be times when the owner of a life insurance policy elects to sell the interest in the policy to a third party in exchange for a lump sum payment during the insured's lifetime. The sale of the life insurance policy is known as a life settlement. The sale of a variable life insurance policy is considered to be the sale of a security and is regulated by both FINRA and the SEC. The buyer of the policy agrees to make all future premium payments and will be entitled to receive the payment of the death benefit upon the death of the insured.
Employee Retirement Income Security Act of 1974 (ERISA) Choosing the type of plan, or options in the plan. Amending a plan, including changing or eliminating plan options. Requiring employee contributions or changing the level of employee contributions. Terminating a plan, or part of a plan, including terminating or amending as part of a bankruptcy process. ERISA also regulates all of the following: Pension plan participation Funding Vesting Communication Beneficiaries
This establishes legal and operational guidelines for private pension and employee benefit plans. Not all decisions directly involving a plan, even when made by a fiduciary, are subject to ERISA's fiduciary rules. These decisions are business judgment type decisions and are commonly called "settlor" functions. This caveat is sometimes referred to as the "business decision" exception to ERISA's fiduciary rules. Under this concept, even though the employer is the plan sponsor and administrator, it will not be considered as acting in a fiduciary capacity when creating, amending, or terminating a plan. Among the decisions that would be considered settlor functions are:
The Assumed Interest Rate (AIR) The separate account's performance is always measured against the AIR, never against the previous month's performance. An investor's annuity payment is based on the number of annuity units owned by the investor multiplied by the value of the annuity unit. When the performance of the separate account equals the AIR, the value of the annuity unit will remain unchanged, and so will the investor's payment. Selecting an AIR that is realistic is important. If the AIR is too high and the separate account's return cannot equal the assumed rate, the value of the annuity unit will continue to fall, and so will the investor's payment. The opposite is true if the AIR is set too low. As the separate account outperforms the AIR, the value of the annuity unit will continue to rise, and so will the investor's payment. The AIR is only relevant during the payout phase of the contract when the investor is receiving payments and owns annuity units. The AIR does not concern itself with accumulation units during the accumulation stage or when benefits are being deferred.
When an investor annuitizes a contract, the accumulation units are traded for annuity units. Once the contract has been annuitized, the insurance company sets a benchmark for the separate account's performance, known as the assumed interest rate (AIR). The AIR is not a guaranteed rate of return; it is only used to adjust the value of the annuity units up or down based on the actual performance of the separate account. The AIR is an earnings target that the insurance company sets for the separate account. The separate account must meet this earnings target in order to keep the annuitant's payments at the same level. As the value of the annuity unit changes, so does the amount of the payment that is received by the investor. If the separate account outperforms the AIR, an investor would expect his or her payments to increase. If the separate account's performance falls below the AIR, the investor can expect his or her payments to decrease.
Joint with Last Survivor The payments received by the wife could be at the same rate as when the husband was alive or at a reduced rate, depending on the contract. The monthly payments will initially be based on the life expectancy of the youngest annuitant.
When an investor selects a joint with last survivor option, the annuity is jointly owned by more than one party and payments will continue until the last owner of the contract dies. For example, if a husband and wife are receiving payments from an annuity under a joint with last survivor option and the husband dies, payments will continue to the wife for the rest of her life.
Defined Contribution Plan Some types of defined contribution plans are: 401K Money purchase plan Profit sharing Thrift plans Stock bonus plans All withdrawals from pension plans are taxed as ordinary income in the year in which the distribution is made.
With a defined contribution plan, only the amount of money that is deposited into the account is known, such as 6% of the employee's salary. Both the employee and the employer may contribute a percentage of the employee's earnings into the plan. The money is allowed to grow tax-deferred until the participant withdraws it at retirement. The ultimate benefit under a defined contribution plan is the result of the contributions into the plan as well as the investment results of the plan. The employee's maximum contribution to a defined contribution plan is $20,500 per year.
Periodic-Payment Deferred Annuity During the accumulation stage, the terms are flexible and, if the investor misses a payment, there is no penalty. The money invested in a periodic-payment deferred annuity is used to purchase accumulation units. The number and value of the accumulation units fluctuate with the securities in the separate portfolio.
With a periodic-payment annuity, the investor purchases the annuity by making regularly scheduled payments into the contract. This is known as the accumulation stage.
Single-Payment Deferred Annuity Money being invested in a single-payment deferred annuity is used to purchase accumulation units. The number and value of the accumulation units varies as the distributions are reinvested and the value of the separate account's portfolio changes.
With a single-payment deferred annuity, the investor funds the contract completely with one payment and defers receiving payments from the contract until some point in the future, usually after retirement.
Single-Payment Immediate Annuity The money that is invested in a single-payment immediate annuity is used to purchase annuity units. The number of annuity units remains fixed and the value changes as the value of the securities in the separate account's portfolio fluctuates.
With a single-payment immediate annuity, the investor funds the contract completely with one payment and begins receiving payments from the contract immediately, normally within 60 days.
Rollover The investor has 60 days from the date of the distribution to deposit 100% of the funds into another qualified account or they must pay ordinary income taxes on the distribution and a 10% penalty tax if the investor is under 59-1/2.
With an IRA rollover, the individual may take possession of the funds for a maximum of 60 calendar days prior to depositing the funds into another qualified account. An investor may only rollover their IRA once every 12 months.
