Equity-indexed annuities, or EIA, are a unique type of annuity. It's one that's based on a stock market index, such as the S&P 500, Dow Jones Industrial Average, or the Russell 1000. As a reminder, an annuity is defined as a contract with an insurance company in which the annuitant, or contract holder, agrees to make a payment or series of payments. In exchange, the insurance company agrees to supply the contract holder with a future source of income.
In this article, we're going to discuss how an equity-indexed annuity contract with an insurance company is structured. Then we're going to discuss the features unique to this type of annuity. Finally, we'll take a closer look at fees, charges, and tax implications of owning this type of contract.
Equity Index Contracts
As is the case with all annuities, an equity index contract involves a contract holder, or annuitant, and an issuer such as an insurance company. All annuities consist of two phases:
Accumulation Phase: during this initial phase of the agreement, the contract holder makes a lump-sum payment, or a series of payments, and the insurance company credits the account with a rate of return that is based on an equity index.
Payout Phase: during this phase of the contract, the insurance company returns to the annuitant their investment: principal and earnings. With an equity-indexed annuity, the value of the account, and therefore the income it provides, will depend on the performance of the index chosen.
The annuity's prospectus will outline the terms and conditions of the contract, including the index chosen. The contract will also explain when the annuitant will receive their promised income payments, and for how long. Since most annuities are purchased for retirement income, the buyer may elect to receive an immediate benefit, which is referred to as an immediate annuity. Alternatively, the contract holder may elect to delay receiving income benefits until a future date. This type of contract is referred to as a deferred annuity.
Contract Earnings
Equity-indexed annuities are usually structured to contain a minimum guaranteed rate of return. However, because of economic cycles, and their affect on market indices, the break-even point may take several years to reach.
Even though a contract may carry a guarantee, this rate of return may not be reached until the contract is held for several years. So if the contract holder decides they no longer want to own the annuity, the surrender charges, coupled with the short-term performance of the index, may result in a loss of principal. This means the buyer may receive less money than they've paid into the contract.
Tax Implications of Surrender
If an EIA is surrendered, the IRS may impose a 10% tax penalty. It is possible under Section 1035 to make a tax-free exchange from one annuity to another without a tax penalty. But if the transaction is not handled correctly, then the contract holder may owe federal income tax on the earnings as ordinary income - instead of a capital gain. It's important to consult with a financial planner, or tax professional, before surrendering an annuity.
Features of EIAs
Equity-indexed annuities contain features that are not found in fixed or variable annuities. Investors need to make sure they are thoroughly familiar with the features contained within their contract before buying into this type of investment. Specifically, the features found in a contract may have a direct impact on the computation of the earnings calculation including:
Interest Rate Caps: this is the maximum rate of interest, or the upper limit on the percentage gain, that an annuity can earn for the holder.
Rates of Participation: this rate determines how much of the gain in the index is passed onto the annuity. For example, if the participation rate is 80%, and the index gains 10% in a given year, then the rate of interest credited to the annuity is 80% x 10%, or 8%.
Administrative Fees: an equity-indexed annuity might also feature an administrative fee, sometimes referred to as margin or spread. This fee also influences how much of the index gain is passed onto the contract holder. For example, if the spread is 2%, and the index gains 10% in a given year, then the rate of interest credited to the annuity is 10% minus 2%, or 8%.
Indexing Methods
The return on EIAs may also be influenced by the indexing method, which determines how the gain in the index is calculated. Generally, there are three indexing methods in use today:
Annual Reset: this method will credit to the account any increase in the index during one calendar year, resetting itself at the start of a subsequent year.
Point-to-Point: this method will credit to the account the entire increase in the index's value from the first day of the contract until the contract term ends.
High Water Mark: this last method credits the annuitant's account with any gain in the index's value from the first day of the contract to the highest index value that occurs during the contract's term; typically, the purchase anniversary.
Fees and Charges
In addition to the above-mentioned indexing methods, some of which translate into annual fees, the following costs or charges may also be included in a contract:
Administrative Fees: this ranges from a flat annual fee to around 0.2% of the account's value each year. This charge covers recordkeeping, mailings, and other administrative costs associated with maintaining the account.
Surrender Charges: if money is withdrawn from an annuity before a pre-determined purchase period has expired, then a surrender fee may be charged. This fee is normally stated as a percentage of the contract's value. In some cases, this percentage will reduce over time and / or as the account's balance grows.
Free Look Provisions
Laws exist in many states that allow the buyer a certain number of days to evaluate the annuity after purchase. If the buyer decides they do not want to keep the annuity, then they can return the contract and receive a full refund. This type of arrangement is called a "right to return" or "free look" period.
If the law allows for this free-look period, then this feature will be prominently described in the contract.
Income Tax Implications
Equity-indexed annuities receive special tax treatment under current law. Federal income tax is not paid on earnings until withdrawn during the payout phase. In addition, state tax laws normally follow federal law by allowing tax-deferred accumulation of funds.
By deferring income taxes on the money earned in this type of account during the accumulation phase, the contract holder may be in a lower tax bracket upon withdrawal, especially if this takes place during retirement. This results in a reduction in the annuitant's overall tax burden.
Upon withdrawal, a portion of the payment received will be a return of premiums paid into the account on an after-tax basis. This portion of the payment is received tax-free. A second portion of the payment received will be a return of the earnings on the account. This represents the taxable portion of the payments received.
A tax penalty of 10% may be imposed if withdrawal takes place before age 59 1/2. In addition, if the annuity is received by a beneficiary after the contract holder passes away, then taxes are owed on the entire amount received.
Additional Resources
A fixed annuity is an insurance contract in which the issuing company promises to make fixed dollar payments to the contract holder, the annuitant, for a pre-determined length of time. In return for payment of the contract premium, the issuing company also guarantees both the earnings on the account and the principal balance.
Moneyzine EditorNovember 20th, 2023
It's somewhat ironic that retirees often worry about longevity. They want to live a long and rewarding life, but if that comes to fruition, then they need to worry about outliving their assets. That's the primary reason many retirees invest in annuities. Unfortunately, those same annuities didn't protect against inflation, until recently.Moneyzine EditorDecember 11th, 2023
