Annuity premium and timing structures

Two questions, answered separately

Every annuity contract is described by two choices the buyer makes independently of each other: how the contract is paid for, and when income payments begin. Exam items in this area are almost always testing whether you keep those two axes apart, because the product names people use in the field -- SPIA, SPDA, FPDA -- are just the two axes glued together.

• Premium structure asks: one payment, or many?
• Payout timing asks: does income start now, or after an accumulation period?

Premium structure

Single premium. The contract is fully funded at issue by one consideration and accepts no further deposits. It is the structure used for rollovers, lump-sum settlements, inheritances, and the proceeds of a maturing policy -- money that arrives all at once.

Flexible premium. The owner chooses the amount and the timing of each deposit, subject only to the contract's stated minimum deposit and any maximum. Skipping a year does not lapse the contract; the accumulated value simply keeps earning. This is the structure built for someone saving out of income over a working career.

Periodic level premium. A scheduled, fixed contribution -- the disciplined middle ground between the two. Treat it as a constrained form of the flexible structure: more than one payment, but on a schedule the contract sets rather than the owner.

Payout timing

The pivot is the annuity starting date, defined as the first day of the first period for which an amount is received as an annuity (26 U.S.C. s. 72(c)(4)). Everything before it is the accumulation period; everything after it is the payout, or annuity, period.

Immediate annuity. Income begins one payment interval after purchase -- one month later on a monthly mode, one quarter later on a quarterly mode. There is no accumulation period at all. Federal tax law defines an immediate annuity as one purchased with a single premium (26 U.S.C. s. 72(u)(4)), which is the statutory version of the point below.

Deferred annuity. Purchase and payout are separated by an accumulation period that may run for decades. During it the contract value grows, deposits may continue if the contract allows them, and surrender charges typically apply to withdrawals above the free-withdrawal amount. Annuitization happens later, at a date the owner elects.

Three products exist, and one cannot

Cross the two axes and you get the three structures sold in the market:

• SPIA -- single premium immediate annuity: lump sum in, income out at once.
• SPDA -- single premium deferred annuity: lump sum in, income out years later.
• FPDA -- flexible premium deferred annuity: deposits over time, income out years later.

The fourth cell is empty, and knowing why is the most commonly tested point here: a flexible premium immediate annuity cannot exist. Flexibility requires an accumulation period in which to accept a second premium, and an immediate annuity has none -- it is already paying out. Every immediate annuity is a single premium annuity; only a deferred annuity can be flexible.

Timing is what drives the taxation

Amounts received as an annuity are includible in gross income (26 U.S.C. s. 72(a)(1)), but only in part. During the payout period the exclusion ratio splits each payment: the excluded portion bears the same ratio to the payment as the investment in the contract bears to the expected return under the contract, both measured as of the annuity starting date (26 U.S.C. s. 72(b)(1)). A 100,000 dollar investment against a 200,000 dollar expected return excludes 50 percent of every payment.

Two limits ride on that ratio. Once the entire investment has been recovered, nothing further is excluded (26 U.S.C. s. 72(b)(2)) and payments become fully taxable. If the annuitant instead dies before recovering it, the unrecovered investment is allowed as a deduction on the last taxable year (26 U.S.C. s. 72(b)(3)).

Timing also decides who may own the contract tax-efficiently. A deferred annuity held by a non-natural person -- a corporation, not a trust holding as agent for an individual -- loses its deferral: the income on the contract is treated as ordinary income each year (26 U.S.C. s. 72(u)(1)). An immediate annuity is expressly excepted from that rule (26 U.S.C. s. 72(u)(3)(E)), which again is the deferral, not the premium, doing the work.

Matching the structure to the client

Neither axis has a right answer in the abstract; the answer comes from the consumer. A recommendation must be based on consumer profile information that includes, among other things, the client's financial time horizon, liquidity needs, and the financial resources used to fund the annuity (Fla. Stat. s. 627.4554(3)(d)). Those three fields map directly onto the two axes: the time horizon decides immediate against deferred, the liquidity need tests whether a surrender charge period is tolerable, and the source of the money usually decides single against flexible before anyone discusses it.