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. There are three basic types of annuities that are deigned to meet different objectives. They are:
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.
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 to be an insurance product, not a security. 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 like mortgages and real estate. These are 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 company guarantees is not very high, the annuitant may suffer a loss of purchasing power due to inflation risk.
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. Because the annuitant bears the investment risk associated with a variable annuity, the contract is considered to be 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 was named this 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:
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. If the money in the separate account is actively managed and invested directly, then the separate account is considered to be an open-end investment company 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 no investment adviser is required to actively manage the portfolio. If the separate account purchases mutual fund shares, then the separate account is considered to be a unit investment trust under the Investment Company Act of 1940 and must register as such.
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. 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 like 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.
An insurance company that issues annuity contracts may offer incentives to investors who purchase their variable 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. 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 perspective 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.
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%, then 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%, then the investor's contract would be credited 7%. 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%, then the investor's account will only be credited 9%.
Most equity-indexed annuities combine the guarantee features of a fixed annuity with the potential for additional returns like that of a variable annuity. Equity-indexed annuities may also be referred to as equity-indexed contracts or EICs.
The following table compares the features of fixed and variable annuities:
| Feature | Fixed Annuity | Variable Annuity |
| Payment received | Guaranteed/fixed | May vary in amount |
| Return | Guaranteed minimum | No guarantee/return may vary in amount |
| Investment risk | Assumed by insurance co. | Assumed by investor |
| Portfolio | Real estate, mortgages, and fixed income securities | Stocks, bonds, or mutual fund shares |
| Portfolio held in | General account | Separate account |
| Inflation | Subject to inflation risk | Resistant to inflation |
| Representative registration | Insurance license | Insurance and securities license |
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. 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 which 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. 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 which 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 investment advisers 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.
An investor may purchase an annuity contract in one of three ways. They are:
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. 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 immediate annuity, the investor funds the contract completely with one payment and begins receiving payments from the contract immediately, normally within 60 days. 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 accounts portfolio fluctuates.
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. 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 account's portfolio.
An accumulation unit represents the investor's proportionate ownership in the separate account's portfolio during the accumulation or differed 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. 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.
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 their accumulation units for 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 they annuitize a contract is based upon the payout option selected, the annuitant's age, sex, the value of the account, and the assumed interest rate.
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. The following is a list of typical payout options in order from the largest monthly payment to the smallest. They are:
This payout option will give the annuitant the largest periodic payment from the contract and the investor will receive payments from the contract for their entire life. However, when the investor dies, there are no additional benefits paid to their estate. 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 their account.
A life with period certain payout option will pay out from the contract to the investor or to their estate for the life of the annuitant or for the period certain, whichever is longer. If an investor selects a 10-year period certain when they annuitize the contract and the investor lives for 20 years, payments will cease upon the death of the annuitant. However, if the same investor died only two years after annuitizing the contract, payments would go to their estate for another eight years.
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. The payments received by the wife could be at the same rate as when the husband was alive or at a reduced rate, depending upon the contract. The monthly payments will initially be based on the life expectancy of the youngest annuitant.
All of the following determine the size of the annuity payments:
When an investor annuitizes a contract, they trade their accumulation units in 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 or 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 upon the actual performance of the separate account. The assumed interest rate 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 their payments to increase. If the separate account's performance fell below the AIR, the investor could expect their payment to decrease. 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.
Contributions made to an annuity are made with after-tax dollars. The money the investor deposits becomes their cost base and is allowed to grow tax deferred. When the investor withdraws money from the contract, only the growth is taxed. Their cost base is returned to them tax free. All money in excess of the investor's cost base is taxed as ordinary income.
An investor may begin withdrawing money from an annuity contract through any of the following options:
Both lump sum and random withdrawals are done on a last in, first out (LIFO) basis. 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 age 59.5 and takes a lump sum or random withdrawal, the withdrawal will be subject to a 10% tax penalty, 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. As long as interest is charged on the loan and the loan is repaid by the investor, the investor will not be subject to taxes.
When an investor annuitizes the contract and begins to receive monthly payments, part of each payment is the return of the investor's cost base and a portion of each payment is the distribution of the account's growth. To determine how much of each payment is taxable and how much is the return of principal, the investor would look at the exclusion ratio.
Contracts that are annuitized prior to age 59.5 under a life-income option are not subject to the 10% tax penalty nor are withdrawals due to disability or death.
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.
The individuals running the separate account are professionals and are compensated for their management of the account through a fee-based agreement. A fee is deducted from the separate account to cover this management expense. The more aggressive the portfolio, the larger the management fee will be. The management fee, sales charges, and other expenses and fees will all reduce the return.
| Feature | Variable Annuity | Mutual Fund |
| Maximum sales charge | No max | 8.5% |
| Investment adviser | Yes | Yes |
| Custodian bank | Yes | Yes |
| Transfer agent | Yes | Yes |
| Voting | Yes | Yes |
| Management | Board of managers | Board of directors |
| Taxation of growth and reinvestments | Tax-deferred | Currently taxed |
| Lifetime income | Yes | No |
| Costs and fees | Higher | Lower |
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. 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. Series 65 candidates will see a fair number of questions on the exam dealing with retirement plans. The following table compares the key features of qualified and nonqualified plans.
| Feature | Qualified | Nonqualified |
| Contributions | Pretax | After-tax |
| Growth | Tax-deferred | Tax-deferred |
| Participation must be allowed | For everyone | Corporation may choose who gets to participate |
| IRS approval | Required | Not required |
| Withdrawals | 100% taxed as ordinary income | Growth in excess of cost base is taxed as ordinary income |
Individuals may set up a retirement plan for themselves that are qualified and allow contributions to the plan to be made with pretax dollars. Individuals also may 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.
All individuals with earned income may establish an IRA for themselves. 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. The level of adjusted gross income that allows an investor to deduct their IRA contributions has been increasing since 1998. These tax law changes occur too frequently to make them a practical test question. Our review of IRAs will focus on the four main types, which are:
A traditional IRA allows an individual to contribute a maximum of 100% of earned income or $5,500 per year or up to $11,000 per couple. If only one spouse works, the working spouse may contribute $5,500 to an IRA for themselves and $5,500 to a separate IRA for their spouse, under the nonworking spousal option. Investors over 50 may contribute up to $6,500 of earned income to their IRA. Regardless of whether the IRA contribution was made with pretax 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. Withdrawals from an IRA prior to age 59.5 are subject to a 10% penalty tax as well as ordinary income taxes. The 10% penalty will be waived for first-time homebuyers or educational expenses for the taxpayer's child, grandchildren, or spouse. The 10% penalty will also be waived if the payments are part of a series of substantially equal payments. Withdrawals from an IRA must begin by April 1 of the year following the year in which the taxpayer reaches 70.5. 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 $5,500, 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.
A Roth IRA is a nonqualified account. All contributions made to a Roth IRA are made with after-tax dollars. The same contribution limits apply for Roth IRAs. An individual may contribute the lesser of 100% of earned income to a maximum of $5,500 per person or $11,000 per couple. Any contribution made to a Roth IRA reduces the amount that may be deposited in a traditional IRA and vice versa. 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 59.5 and the assets have been in the account for at least five years. A 10% penalty tax will be charged on any withdrawal of earnings prior to age 59.5, 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.
The following table details contribution limits that have been in place for IRA contributions for the last several years:
| Year | Age 49 & Below | Age 50 & Above |
| 2012 | $5,000 | $6,000 |
| 2013 | $5,500 | $6,500 |
| 2014 | $5,500 | $6,500 |
| 2015 | $5,500 | $6,500 |
A 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. 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 $52,000 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.
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. The employee must be at least 21 years old, have worked during three of the last five years for the employer, and have earned at least $550. All eligible employees must participate as well as the employer.
The employer may contribute between 0% to 25% of the employee's total compensation to a maximum of $52,000. Contributions to all SEP IRAs, including the employer's SEP IRA must be made at the same rate. An employee who is over 70.5 must also participate and receive a contribution. All eligible employees are immediately vested in the employer's contributions to the plan.
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. Employees may begin to withdraw money from the plan at age 59.5. All withdrawals are taxed as ordinary income and withdrawals prior to age 59.5 are subject to a 10% penalty tax.
Contributions to IRAs must be made by April 15 of the following calendar year, regardless of whether an extension has been filed by the taxpayer. 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.
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.
Individuals who establish IRAs have a wide variety of investments to choose from when deciding how to invest the funds. Investors should always choose investments that fit their investment objectives. The following is a comparison of allowable and nonallowable investments:
| Allowable | Nonallowable |
| Stocks | Margin accounts |
| Bonds | Short sales |
| Mutual funds /ETFs/ETNs | Tangibles/collectibles/art |
| Annuities | Speculative option trading |
| UITs | Term life insurance |
| Limited partnerships | Rare coins |
| U.S. minted coins | Real estate |
With rare exceptions an IRA may purchase real estate provided that very strict rules are followed regarding the property.
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. 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.
An individual may want or need to move their IRA from one custodian to another. There are two ways by which this can be accomplished. An individual may rollover their IRA or they may transfer their IRA.
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. 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 59.5.
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.
Should the owner of an IRA die, the account will become the property of the beneficiary named on the account by the owner. If the beneficiary is the spouse of the owner special rules apply. The spouse may elect to rollover the IRA in to their own IRA or retirement plan such as a 401k. If this is elected there will be no tax presently due on the money. However, the spouse is still subject to the required minimum distribution rule at age 70½. The surviving spouse may also elect to cash in the IRA. The distributions will be subject to income tax but will not be subject to the 10% penalty tax. If the beneficiary is not the spouse the money may not be rolled in to another IRA or retirement account. If the account owner died prior to age 70½ when the required distributions need to be made the money must all be distributed prior to the end of the fifth year or the money may be distributed in equal installments based upon the beneficiary's life expectancy. If the account owner has died after the start of the required minimum distributions the payment schedule of distributions will now be based on the life expectancy of the beneficiary.
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 the age of 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. 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 is subject to a 10% penalty tax as well as ordinary income taxes.
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 that 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 by 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. Collage savings account are not state specific and do not lock in a tuition rate. 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 majority. The funds may be used to meet the student's educational needs and the growth may be withdrawn federally tax-free. Most states also allow the assets to be withdrawn tax free. Any funds used for nonqualified 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, then 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.
A Keogh 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.
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 $52,000. 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 $52,000 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 nonqualified contribution to their Keogh plan; however, the total of the qualified and nonqualified contributions may not exceed the maximum contribution limit. Any excess contribution may be subject to a 10% penalty tax.
An eligible employee is defined as one who:
Employees who participate in a Keogh plan must be vested after five years. Withdrawals from a Keogh may begin when the participant reaches 59.5. Any premature withdrawals are subject to a 10% penalty tax. Keoghs, like IRAs, may be rolled over every 12 months. In the event of a participant's death, the assets will go to the individual's beneficiaries.
Tax-sheltered annuities and tax-deferred accounts are established as retirement plans for employees of nonprofit and public organizations such as:
TSAs and TDAs are qualified plans and contributions are made with pretax dollars. The money in the plan is allowed to grow tax deferred until it is withdrawn. TSAs and TDAs offer a variety of investment vehicles for participants to choose from such as:
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 by a state agency. State-supported schools are:
Any individual who works for a public school, regardless of their position, may participate in the school's TSA or TDA.
Organizations, which 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:
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 one year.
In order to participate in a TSA or TDA, the 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 one year of 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 $18,000 per year. Employer contributions are limited to the lesser of 25% of the employee's earnings or $52,000.
All distributions for TSAs and TDAs are taxed as ordinary income in the year in which the distribution is made. Distributions from a TSA or TDA prior to age 59.5 are subject to a 10% penalty tax, as well as ordinary income taxes. Distributions from a TSA/TDA must begin by age 70.5 or be subject to an excess accumulation tax.
A corporate retirement plan can be qualified or nonqualified. We will first review the nonqualified plans.
Nonqualified 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. Distributions from a nonqualified plan, which exceed the investors cost base, are taxed as ordinary income. All nonqualified plans must be in writing and the employer may discriminate as to who may participate.
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. Contributions to a payroll deduction plan are made with after-tax dollars.
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 for themselves. 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. The employee may only claim the assets if they retire, 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 noncompete 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.
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.
There are two main types of qualified corporate plans: a defined benefit plan and a defined contribution plan.
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. 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 upon the participant's life expectancy and benefits promised.
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, along with the investment results of the plan. The employee's maximum contribution to a defined contribution plan is $18,000 per year. Some types of defined contribution plans are:
All withdrawals from pension plans are taxed as ordinary income in the year in which the distribution is made.
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. 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 15% of the employee's compensation or $52,000.
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. A “self-directed 401K plan” is one where the individual or plan participant selects the investments to be made in the account from a list of investment choices. The plan participant is the person who owns the account and is making contributions to the account to “plan” for their retirement. The employer, investment adviser, and plan administrator or trustee all have important roles in the creation and administration of a 401K plan.
The employer is the entity that creates the plan for its employees and is known as the creator or plan sponsor.
The investment adviser is the company who determines what investment choices will be offered to the participants and who executes the orders entered by the plan participants.
The plan administrator/trustee, also known as a third-party administrator, is the company that has physical custody of the plan's assets and provides communication to the participants regarding the plan.
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. 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.
Employers may establish stock option plans that allow employees to purchase shares of the employer's stock. Employees who operate in certain functions or who meet the criteria for inclusion in the plan may be granted stock options to purchase the common stock of the employer at a stated exercise price. Employee stock option plans may be established as nonqualified stock option plans or as incentive stock option plans. Under a nonqualified stock option plan, the employee may exercise the options at the stated exercise price and sell the shares at the higher market price. The difference between the cost or the exercise price and the sales proceeds for the stock under the plan will be treated as compensation and taxed as earned income. If certain plan requirements are met under an incentive stock option plan, any gain on the sale of the stock may be treated as a capital gain. If the employee has held the stock purchased under an ISO for at least two years from the grant date of the options and at least one year from the purchase/exercise date of the options, any appreciation will be treated as a capital gain. Incentive stock option plans must be approved by the board of directors and by the shareholders. Employee stock option plans may set any criteria the employer wishes to determine who may participate in the plan.
The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that 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 which would be considered settlor functions are:
ERISA also regulates all of the following:
All plans governed by ERISA may not discriminate among who may participate in the plan. All employees must be allowed to participate if:
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.
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:
All corporate plans must be in writing at inception and the employee must be given annual updates.
All plan participants must be allowed to select a beneficiary who may claim the assets in case of the plan participant's death.
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. This safe harbor is available so long as:
Life insurance is a contract between an individual and an insurance company that is designed to provide financial compensation to the policyholder's beneficiaries in the event of the policyholder's death. There are several different types of life insurance policies, and it is important that the individual chooses a policy that best fits his or her needs. The types of life insurance covered on the Series 65 exam are:
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. 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 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. 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.
Owners of variable life insurance policies must be allowed to exchange the policy for a whole life policy for 24 months. The insurance company may not require new evidence of insurability as a condition of exchange. The age to determine the premium will be the age when the insured originally purchased the variable life contract. Loans to policyholders must be made available after 3 years based on the cash value of the contract. The insurance company must make at least 75% of the cash value available in the form of a loan. The company is not required to make 100% of the cash value available. Should the death benefit become payable during the time the loan is outstanding the death benefit will be reduced by the amount of the loan. If the cash value of the contract falls into a negative balance while a loan is outstanding the insurance company can require that enough of the loan be repaid to restore a positive cash value.
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. 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. Representatives who sell universal life insurance policies must have their insurance licenses. 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.
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. 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.
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 life insurance is recognizing who the “owner” of the policy is. If the insured person is deemed to be the owner of the contract then 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.