What Is a Private Annuity?

An annuity is a specific financial instrument generally used for creating a long-term savings or retirement plan. Simply put, the term “annuity” refers to the contract that a person would enter into with an insurance or finance company in which they agree to make a series of payments. These payments will eventually be returned to person at some point in the future.

There are several different types of annuities. The two most commonly used categories are broken down by how quickly they pay out, immediately versus on a deferred basis. These two overarching categories are then further divided into five others, which will be discussed in detail below.

Deciding which annuity structure to choose will depend on a number of factors, such as:

• How quickly a person wishes to be paid out;
• Their income goals; and
• How willing they are to take financial risks.

Each type of annuity comes with its own advantages and disadvantages, and may differ depending on what the insurance or finance company is offering as part of their contract terms.

Generally speaking, the following is a list of the five main types of annuities:

• Fixed Annuities: Fixed annuities are mostly issued by insurance companies, as opposed to financial firms. They are structured to provide a standard rate of interest, and are relatively low in cost. Additionally, they are useful for those who are seeking a predictable source of income for when they retire. There are usually no fees for fixed annuity plans, and they are the simplest to comprehend out of the five types listed here;
• Variable Annuities: In contrast to fixed annuities, variable annuities will not pay out every year. Instead, the money will be invested into various mutual funds and securities, which are managed by the insurance company. Although these can be structured with an attached rider stating that the person can receive a fixed stream of income, they are usually formed without the rider. Further, because variable annuities are based on the stock market, the amount disbursed will fluctuate. Variable annuities are also associated with the highest fees, and may have penalties for early withdrawal. They do not pay out regularly;
• Fixed-Indexed annuities: These annuities are a combination of fixed and variable. They provide a minimum standard income, but they also generate a fluctuating rate of interest based on stock market indices. An example of this would be the S&P 500. However, there is generally a cap on how much the person can receive if the market index performs well. As such, what could be a high return under variable annuities would be capped in a fixed-index annuity. There also may be fees;
• Immediate annuities: Immediate annuities offer the highest payouts and operate similarly to life insurance policies. The person will hand over a large lump sum payment, which will then begin distribution about a year later. These annuities work best for those who are willing to sacrifice funds up front, and are looking for a high income stream later in life. Additionally, there are rarely any fees associated with them; and
• Deferred annuities: Deferred annuities delay disbursements until over one year has passed. There are average fees attached to deferred annuities, and they are usually offered by insurance companies. They also tend to be cheaper overall due to the fact that the insurance company will not need to immediately return any payments. The downside is that the person must wait until they start generating an income stream.

What Is a Private Annuity? How Are Private Annuities Structured?

A private annuity is another estate planning strategy in which you can transfer property from your estate to your children prior to your death. Provided that the private annuity is correctly established, you can avoid estate and gift taxes while realizing income for the remainder of your life.

This involves the sale of an asset to your children or other beneficiaries. In return, they give an unsecured promise to compensate you with yearly payments for the rest of your life. Because the asset is transferred to another party, it will not be included in your estate. However, the annual payments that you receive in exchange for the asset will be included in your estate.

Every annuity payment that you receive is a return of your basis that is partially tax-free. Additionally, each payment represents an amount of money that is partly made up of capital gain and interest. Your beneficiaries will receive a basis in the property that is the equivalent of the annuity payments that they make to you. When the annuity’s value is equal to that of the property’s value, your beneficiaries may immediately sell the property without having to pay capital gains taxes. They can then reinvest the proceeds from the sale however they wish.

When Should I Use a Private Annuity?

It is very beneficial to use a private annuity when you are in possession of property with a low basis. Capital gains are recognized over the course of several years in lieu of all in one year. Additionally, if the property is one to which the rules of depreciation recapture apply, the recapture is drawn out over the course of several years while you receive payments. Because of this, a private annuity is commonly used for assets such as:

• Real estate;
• Securities;
• Business interests; and
• Cash.

A private annuity structure is considered to be especially advantageous when applied to property that is more likely to yield large capital gains.

How Do I Establish My Annuity Payments? How Important is My Life Expectancy?

When you are setting up your annuity payments, you will need to find out the fair market value of your property. The actual amounts of the annuity payments are then determined by consulting the IRS annuity tables, specifically under Internal Revenue Code (“IRC”) §7520.

According to the tables, if you live as long as your life expectancy, you will receive the entirety of the value and interest from the property. However, if you do not live as long as your life expectancy, the beneficiary will no longer need to make any annuity payments after your death. Living beyond your life expectancy will likely result in you receiving an amount in excess of the property’s value, plus interest.

To reiterate, the amounts of the annuity payments are determined by your life expectancy. The payments are likely to be higher if you are older. According to the IRS, the tables cannot be used if you are terminally ill, or if you are unlikely to live beyond one year from the annuity date. Although the IRS has attempted to forbid the use of the tables in cases involving an annuitant who is not in good health, although not necessarily terminally ill, it has been unsuccessful.

When Do I Need to Hire an Attorney for Annuity Issues?

An attorney is not necessary to set up an annuity. However, it can be useful to consult an attorney when you are deciding which type of annuity would best suit your needs. If you are considering entering into an annuity arrangement, you should contact a local business lawyer for further advice. An experienced and local business attorney can ensure you understand your state’s specific laws regarding annuities.

Additionally, you should consult with an annuity lawyer if there is a dispute over the annuity with the insurance company. One conflict that frequently arises in connection with annuities is non-payment in accordance with contract terms. Your attorney will also be able to represent you in court as needed.