Investment Configuration
STUDENT: How much do they earn?
MR. WATSON: Fixed annuities are invested in bonds and mortgages. This is the same as what we talked about with fixed life insurance policies. In a fixed annuity the insurance company guarantees the principal, the interest rate, and the payout. The amount of the monthly check will not go up or down, even if the market decreases or increases.
MR. WATSON: Variable annuities are invested into the stock market, in mutual funds. They are designed to offset inflation. The policy-owner chooses the investments. When you annuitize, your check each month is based on the value of the investments, so the amount you receive will fluctuate over time. And remember, variable insurance products (including variable annuities) are kept in the separate account and are regulated by the state and SEC, the Securities and Exchange Commission, the same thing we said with variable life insurance policies.
MR. WATSON: An Equity indexed annuity is invested into the S&P 500. The S&P 500 is invested into the stock market with an average on the return of 500 stocks. Equity indexed annuities are a type of fixed product because the principal is guaranteed, so you don’t need a securities license to sell them. They are timed annuities, usually 5 to 7 years. So let’s say you invest for 5 years. During that time, your interest returns are based on the S&P but you can’t lose your principal. You cannot annuitize during that time. Equity indexed annuities are for accumulation. After the 5 years or 7 years, whichever you choose, you can move the money into a fixed annuity or variable annuity or split it between both and annuitize those, or you can keep it in an indexed annuity and go for another 5 or 7 years.
Taxation
MR. WATSON: Now let's talk taxation. Don't worry about the math, just the formula. We talked taxation on withdrawals, Last In, First Out, LIFO. Beer & foam. But what if you annuitize? Again, only the interest portion is taxable. I’ll show you how this works.
MR. WATSON: I have $150,000 in the annuity. I'm going to annuitize my annuity. I'm 65 years old. The mortality tables say I am going to live to age 85, just an example. The annuity is earning 5% interest.
MR. WATSON: I am going to receive about $10,000 a year. Everybody agree with that?
ALL: Yes.
MR. WATSON: A part of the $10,000 represents principal, (money going in that has already been taxed, the beer), and a part represents interest, the foam. (Remember, the interest has not yet been taxed.) The part that represents principal is received tax-free. The part that represents interest is taxed as ordinary income, not capital gains. Now, how do we find out how much of this is taxable?
MR. WATSON: We use an exclusion ratio. Write this down. Understand it. This tells us what percentage is not taxed.
MR. WATSON: You take the amount invested, and you divide it by the expected return. (in/out).
MR. WATSON: How much was invested? $150,000. How much am I expected to get back? $10,000 a year by how many years?
MAN: 20 years. So $200,000 is the expected return.
MR. WATSON: So if I invested $150,000, I am expected to get back $200,000 during my life expectancy. How much is excluded from taxes? Come on, guys, we've done this.
MR. WATSON: 75%. We divide the amount invested ($150,000) by the expected return ($200,000). We get 75%. 75% of the monthly amount (or annual amount of $10,000) is excluded from taxes. Be able to identify the formula, amount invested/expected return.
