Test Your Annuity Acuity: An Advanced True/False Quiz

By Jamie P. Hopkins, Esq., CFP, RICP, Director of Retirement Research, Carson Wealth

Despite wanting and needing more guaranteed income in retirement, many Americans are hesitant to purchase an annuity to provide that income. Some of this hesitancy is due to misconceptions around the products and how they can best be used to support a secure retirement.

Most people do not understand annuities well. In fact, The American College of Financial Services tested a group of 60- to 75-year-olds, and they got only 20% of the annuity questions right on average — the lowest score of 12 distinct retirement income areas tested in the quiz.

A secure retirement plan requires you to make decisions about how to generate income and, in some cases, whether an annuity fits into your plan. With so many different annuity options on the market, it is important to understand the basics.

Test out your own annuity literacy with this 10-question true/false quiz.

Written by Jamie Hopkins, the Director of Retirement Research at Carson Wealth. Hopkins is a published author, speaker and thought leader in the area of retirement income planning. His most recent book, “Rewirement: Rewiring the Way You Think About Retirement,” details the behavioral finance issues that hold people back from a more financially secure retirement.

1: A fixed single premium immediate annuity (SPIA) is an investment product that allows the owner to withdraw money when the stock market is up and provides a steady stream of income when stocks decline.

  1. True
  2. False

The correct answer is B. False

A fixed single premium immediate annuity (SPIA) is not an investment product. It is an insurance product that is purchased with a single premium payment and pays a guaranteed income beginning immediately, or at an agreed upon starting date within 13 months.

Payments are guaranteed to last as long as specified in the contract. Most commonly payments are for life, but they can also be for a specified period of time. While annuities can be fixed or variable, fixed annuities will pay a fixed amount, while variable annuities’ payments fluctuate over time due to the performance of the underlying investment options. While immediate annuities can be variable, most offer fixed payments.

2: IRAs cannot hold annuities because, like life insurance, annuities are considered prohibited investments if held within an IRA.

  1. True
  2. False

The correct answer is B. False

While IRAs cannot hold life insurance, they can be a very strategic place to put an annuity. Annuities provide a systematic way to distribute your IRA savings and can last for life, ensuring that you do not run out of money in retirement.

Some experts feel that putting an annuity inside of an IRA is redundant because both allow for tax-deferred growth. However, by placing an annuity in an IRA you are not giving up the tax benefit, you would get it either way.

In addition, IRAs offer additional creditor protections. Certain annuities can even help reduce required minimum distributions (RMDs) from an IRA in the early years of retirement. The majority of annuities purchased today are done so with funds from some type of qualified (tax-deferred) retirement account. The biggest reason IRAs function as a place to purchase annuities is because that is where retirees have saved for retirement.

3: The first withdrawals from a non-qualified deferred annuity are considered taxable earnings and may be subject to a 10% early withdrawal penalty tax if made prior to age 59½.

  1. True
  2. False

The correct answer is A. True

With an annuity, the term non-qualified means that the annuity is not held inside of an IRA or other qualified retirement plan. Non-qualified annuities have their own tax treatment.

A deferred annuity starts off with the benefit stated as an account balance, similar to a bank account. Over time, some deferred annuities, like variable annuities, will have account values that fluctuate due to changes in the underlying investments.

Unlike an immediate annuity, payments do not start right away with a deferred annuity. At some later date the owner can convert this to an income contract (like the SPIA), although there is no requirement to do so. In the meantime, during the deferral period the account balance may be growing due to investment experience and possibly additional premium payments.

Withdrawals are allowed during the deferral period, but the tax treatment is not very favorable. The first distributions — those made up until the point where you start tapping into the principal — are treated as earnings. Those earnings are taxable at your ordinary income tax rate.

If withdrawals are made prior to age 59½, a 10% early withdrawal penalty will also apply. If on the other hand, a deferred annuity is annuitized instead of taking withdrawals from the annuity, taxation is done pro-rata where a portion of each annuity payment is treated as return of basis until all basis is recovered.

4: Generally, it is best to purchase a fixed single premium immediate annuity contract (SPIA) when interest rates are low because you will get a higher payout from the annuity than if you purchase the annuity in a high interest rate environment.

  1. True
  2. False

The correct answer is B. False

Annuity payout rates are impacted by current interest rates to some degree. Lower interest rates cause annuities to offer lower payouts. During higher interest rate environments, insurance companies can offer higher payouts.

5: One downside with all annuities is that payments stop at the death of the annuitant.

  1. True
  2. False

The correct answer is B. False

This is a common misconception. Benefits can continue beyond the life of the annuitant in many situations. For example, SPIAs can be purchased to provide income for a stated period of time (payments continue for the stated period after the death of the annuitant). Another option is to buy joint and survivor annuities, which make payments for the longer of two lives.

Of course, the added security these options provide comes at a price: They lower your annual payment amounts. With deferred annuities, the remaining account is generally the available death benefit that will be paid to the beneficiaries.

6: All deferred annuity contracts allow you to cash out your contract within the first two years and receive all of your funds back.

  1. True
  2. False

The correct answer is B. False

Typically, deferred annuity contracts are subject to surrender charges during the first few years of the contract. Deferred annuities are supposed to be used as part of a long-term insurance or investment strategy. As such, surrender charges work as a deterrent to taking your money out quickly and treating it as a short-term strategy.

Surender charges vary significantly from contract to contract, so it is crucial to carefully review any annuity contract for potential surrender charges. Some contracts have surrender charges that apply only for a few years, while others can last for 10 years or more. Some surrender charges decrease over time, while others stay consistent throughout the applicable time period. An example of a declining surrender charge would be one in which during the first year the charge would be 10%, and each year after it would decline by 1 percentage point.

Surrender charges limit full liquidity of the annuity. However, some annuities will offer additional liquidity options, such as a no-penalty or no-fee withdrawal provision that could give you access to a percentage the funds (i.e., 10%) each year without having to pay the surrender charge. Keep in mind that this withdrawal, while not subject to a contractual surrender charge, could be subject to ordinary income taxes and a 72(t) early withdrawal penalty tax from the federal government. As such, liquidity needs and long-term care goals are important factors to be considered with any annuity purchase.

7: A 50% qualified joint and survivor annuity offered from an employer’s pension plan will pay a stated monthly benefit as long as the participant is alive — and half that amount to a surviving spouse who is the stated beneficiary.

  1. True
  2. False

The correct answer is A. True

For defined benefit plans, a qualified joint and survivor annuity is the benefit option that is required by law to be offered by the plan as a distribution option to all married couples. While married couples can both sign a waiver and turn down the annuity in favor of a lump sum or other distribution option, the joint and survivor annuity option helps protect the income for both spouses.

A 100% joint and survivor annuity would continue in the same amount for the longer of both lives. Employer-sponsored retirement plans could offer a variety of annuity distribution options, not just the qualified joint and survivor annuity.

Some plans offer single-life or term annuities. These benefits are typically similar to benefits available through commercial annuities. A retiree looking for regular income should look at all available options to seek the best option for them.

8: One benefit of holding annuities inside of an IRA is that it exempts the entire IRA from required minimum distributions (RMDs).

  1. True
  2. False

The correct answer is B. False

IRAs that hold annuities are still subject to RMDs at age 70½. However, there is an annuity called a qualified longevity annuity contract (QLAC), which can allow the lesser of $130,000 (in 2019) or 25% of your IRA value paid as premiums to be excluded from RMDs up until age 85, and be held in an IRA. However, at that time the annuity must begin making payments and be subject to RMD rules.

While a QLAC allows you to push RMDs to a later age, the biggest benefit is not in the deferral of RMDs but in the lifetime income payments that start later in life to help offset longevity risk. It is important to note that purchasing a QLAC can reduce your liquidity as the premiums cannot be withdrawn again as a lump sum.

QLACs are fairly straightforward products but can also be purchased with an inflation rider to help protect against a decline in purchasing power, or a return of premium rider to ensure you at least get your premiums back if you die before you turn on payments.

9: When annuities are sold to an individual, the adviser, insurance agent or broker needs to make sure the annuity is suitable for the individual based on their financial situation, financial objectives, risk tolerance, income and other statutorily defined factors.

  1. True
  2. False

The correct answer is A. True

The sale of an annuity needs to meet suitability requirements under state law. But consumers should be aware that the suitability standard is not the highest standard possible (that would be the fiduciary standard), so they still need to do their due diligence before buying.

The National Association of Insurance Commissioners (NAIC) developed model regulations in the early 2000s to govern the suitability of annuity sales. Under these regulations, which have been adopted by most states, the age, annual income, financial situation and needs, financial experience, finical objectives, intended use of the annuity, financial time horizon, existing assets, liquidity needs, liquid net worth, risk tolerance, and tax status of the individual should be considered when determining whether the annuity is suitable for their situation.

However, under the suitability standard an annuity that is considered “suitable” for an investor may also come with higher fees or sales incentives for the person selling it. The fiduciary standard, on the other hand, requires the investment to be not just suitable, but the best choice possible — regardless of what is best for the person selling the product.

10: A deferred variable annuity with substantial tax-deferred internal growth can be exchanged tax-free for another annuity.

  1. True
  2. False

The correct answer is A. True

Annuities can be exchanged for other annuities by way of a 1035 exchange. This allows the annuitant owner to exchange his or her existing annuity for a more suitable annuity for their current situation.

A 1035 exchange has two major tax benefits over surrendering an annuity. It can help the owner protect their basis in the annuity if the annuity has a lower account value than basis (as their basis will carry over to the new policy) and can allow any tax-deferred growth to be transferred without triggering a taxable event.

However, exchanging your existing annuity for another is not always the best thing to do. Any exchange must be done carefully and after examining all that you might give up by exchanging your current annuity. For instance, the new annuity could have higher fees or costs, a longer surrender period, or lower guarantees. Also be aware that the original annuity could be subject to a surrender charge for a set period of time, so it is often best to wait until that time horizon has passed before exchanging the annuity.

Investment advisory services offered through CWM, LLC, an SEC Registered Investment Advisor. Carson Group Partners, a division of CWM, LLC, is a nationwide partnership of advisers.

This article is designed to provide accurate and authoritative information on the subjects covered. It is not, however, intended to provide specific legal, tax, or other professional advice. For specific professional assistance, the services of an appropriate professional should be sought.

This article provided by NewsEdge.