Annuities Explained

Annuities in Retirement Planning:

An annuity is an insurance contract that returns payments of capital and interest on a regular basis. The insurance company makes fixed or increasing payout amounts at regular intervals for a specified time or for the annuitant’s lifetime. Annuities have no rescission rights and do not allow changes once the insurance company issues the contract.

Term Certain Annuities

The insurance company pays the holder of a term certain annuity for the specified period, such as five, 10 or 20 years or up until a specified age of the annuitant.

Life Annuities

Life annuities are a form of life insurance and contain a mortality element however, they provide protection for the risk of living too long, the opposite of typical life insurance. The older one is, when the life income starts, the larger the annuity income based on returning the capital during the shortened life expectancy.

A life annuity may have a minimum guaranteed period. The longer the guarantee period, the lower the annuity income. If death occurs after the guaranteed period has expired, the insurance company pays nothing more.

Annuitants living beyond the average life expectancy receive more than those who do not. Those with life-threatening health problems, significantly shortening life expectancy, may be eligible for impaired annuities with more generous payments.

The life annuity payment varies with the age of the annuitant, and type of life annuity. A life annuity may be a joint and last survivor annuity, where the income goes to one annuitant until death and then the survivor until death. Since two people combined have longer life expectancy than one, the amount of annual annuity income is lower.

Registered Annuities

Registered funds, including funds that come from registered retirement savings plans, registered pension plans and deferred profit sharing plans, can be used to purchase an annuity. If a pension plan, a locked-in RRSP or LIRA is used to buy an annuity, pension regulations will require the use of “unisex” mortality rates and usually a joint and survivor annuity with a 60% guarantee to the survivor. The Income Tax Act includes the full amount of each payment from a registered annuity in the annuitant’s taxable income, and may allow tax credits.

Non-Prescribed Annuities

A non-prescribed annuity is taxed like a mortgage investment; only the interest income, and not the portion attributable to return of capital, is taxable. The interest portion will be larger in the initial years and smaller over time.

Prescribed Annuities

A prescribed annuity contract (PAC) receives special tax treatment under the Income Tax Act. (See 12.2ITA reference 12.2 ). There is no tax on the return of capital, however the interest that is included in the annuitant’s income is level throughout the term of the annuity. The taxable amount is lower than a non-prescribed annuity in the early years and higher in later years. Given the time-value of money, this tax treatment is more favourable to the annuitant than is the taxation of a non-prescribed annuity.

To qualify as a PAC, only individuals, not corporations or partnerships, may own the annuity. The policy owner and the annuitant must be the same person, or the policy owner may be a spouse trust or testamentary trust. Annuity payments must be for equal amounts. If a joint and last survivor contract, the annuitants are limited to spouses or siblings of each other. Age plus any guarantee period cannot exceed 91. The annuitant cannot surrender or commute the annuity, except on death.

Immediate or Deferred Annuities

Immediate annuity contracts have no accumulation period. The purchaser pays a lump sum and receives annuity payments immediately. With a deferred annuity, contributions accumulate with interest during an accumulation period, the annuity payments starting at maturity. Except in the case of policies subject to a grandfathering rule, since 1990 the accumulating interest in a deferred annuity is taxable annually during the accumulation period. Otherwise, the Income Tax Act taxes dispositions of non- registered annuities like dispositions of life insurance, See section 12.2, ITA.

Charitable Gift Annuities

A person can buy an annuity from a charity, provide the charity immediate cash, and receive fixed annual lifetime payments. The number of annual payments that donors can expect to receive based on their age at the time they purchase the annuity is available from the CCRA (See IT-111R2). Tax is payable only on the amount of payments in excess of the original sum given to the charity. As long as the total payments a person expects to receive from the charity for life are less than the sum the person gave to the charity, the payments are tax free. A person will also be entitled to a tax credit for the difference as a charitable donation.

There are alternatives to the purchase of a charitable gift annuity. Since the cost of these instruments is usually more than a similar product from an insurance company, the insurance annuity could be purchased and the savings difference be donated to the charity as an outright gift. Another approach would be to buy a more generous annuity from the insurance company and donate periodically to the charity. Also, the periodic donation could pay the premiums on a life insurance policy with a charity as the owner and beneficiary.

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