Annuities and reverse mortgage

REGISTERED RETIREMENT SAVING PLANS - MODULE 4: ANNUITIES

Definition of Annuity

• An annuity is regarded as one of the simplest retirement income options available.

• It entails an agreement where a financial institution provides a series of regular payments over a defined period of time in exchange for a sum of money.

• Payments from annuities contain two components: interest and principal.

• These financial instruments are especially suitable for investors seeking to mitigate the unpredictability associated with investments.

• Assuris is an organization that protects annuity holder deposits in the event an issuer becomes insolvent.

Parties Involved in an Annuity

• Key parties involved in an annuity include:

  • Annuitant: The individual receiving the annuity payments.

  • Plan Owner: The person or entity that owns the annuity.

  • Issuer/Provider: The financial institution that issues the annuity.

Types of Annuities

1. Life Annuities

• Life Annuities are structured to guarantee payments for the duration of the annuitant's life.

• Offered only by life insurance companies, which must reserve funds to ensure payment obligations.

• Payments can be made from either non-registered or registered assets.

2. Term Certain Annuities

• This type ensures a specified series of payments for a defined time period, chosen at the time of purchase.

• The annuity ceases once the last scheduled payment is made.

• If the annuitant passes away before the term ends, remaining payments may be directed to a beneficiary or the commuted value is released to them.

Types of Life Annuities

• Single Life Annuity: Payments inevitably continue for as long as the annuitant lives, ceasing at their death.

• Joint Life Annuity: Payments extend throughout the lifetimes of two individuals (often partners), with conditions that can change the amount paid after the first death.

  • Payments may continue at full or reduced amounts based on the contract terms.

• Single Life with Guarantee Period: Includes a minimum guarantee that payments will continue for either the annuitant's lifetime or a minimum period specified in the contract. In case of death during the guarantee period, residual payments may go to a beneficiary.

• Joint Life with Guarantee Period: Similar to the single life but applies to two individuals. Death before the guarantee period results in continued payments to the beneficiary until the term concludes.

Temporary Annuities

• Offered by life insurance companies, banks, and trust companies, they can be derived from either registered or non-registered assets.

• Payments last for a fixed duration rather than the annuitant's life.

Impaired Annuities

• Targeted towards those with decreased life expectancy due to serious health issues, offering higher income than regular annuities.

• Offered mainly by life insurance companies and evaluated based on specific illnesses, including:

  • Cancer

  • Diabetes

  • Stroke

  • Parkinson’s disease

  • Alzheimer's disease

  • Chronic heart disease

  • Severe hypertension

  • Multiple sclerosis

  • Congestive cardiac failure

  • Renal, liver, or respiratory failure

Features of Annuities

Immediate vs. Deferred Annuities

• Immediate Annuity: Payments commence shortly after the purchase, typically within one month to one year. This type is designed to provide immediate income. All registered annuities, such as those converted from an RRSP or RRIF, must be immediate, ensuring a full year of payments in the subsequent year after conversion.

• Deferred Annuity: Payments are set to begin on a future date, usually beyond one year post-purchase. During the deferral period, the capital typically grows tax-deferred, making it a suitable option for individuals planning for retirement income in the distant future.

Fixed vs. Variable Annuities

• Fixed Annuities: These are the most prevalent type, offering guaranteed payments for a specified period or the annuitant's lifetime. The payment amount is predetermined and does not change, providing predictable and secure income regardless of market fluctuations.

• Variable Annuities: These are newer forms that transfer investment risks to the annuitant. Payments fluctuate based on the performance of underlying investment options, often referred to as sub-accounts, chosen by the annuitant. While they offer potential for higher returns and inflation protection, they also carry the risk of lower payments if investments perform poorly.

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Indexation in Annuities

• Given that many annuities provide fixed payments, inflation poses a significant risk as it can steadily erode the purchasing power of these payments over time, diminishing the annuitant's real income.

• Indexed Annuities: To counteract the negative effects of inflation, indexed annuities are designed to incorporate annual increases to payment amounts.

  • These increases are typically tied to a specific inflation index, such as the Consumer Price Index (CPI), or are set at a predetermined fixed percentage.

  • The annual increases are often capped at a maximum percentage (e.g., $1\%$ to $3\%$ per year) to manage the insurer's risk and the cost to the annuitant.

  • The inclusion of this indexation feature adds to the initial cost of the annuity or results in lower starting payments compared to a non-indexed annuity, due to the guarantee of steady, increasing future payouts that protect against inflation over the long term.

  • This feature is particularly valuable for individuals with long life expectancies who want to ensure their retirement income maintains its buying power throughout their golden years.

Income Tax Implications of Annuities

Registered Annuities

• Fully taxable in the year received by the annuitant, as these annuities are typically funded with pre-tax dollars (e.g., from an RRSP or RRIF) or have benefited from tax-deferred growth throughout their accumulation phase. This means every payment received is considered income and is subject to the annuitant's marginal tax rate.

Non-Registered Annuities

• Funds used are after-tax dollars; thus, a portion of each payment represents a return of the annuitant's original capital, which remains non-taxable. Only the interest earned within the annuity payments is subject to taxation. This is a crucial distinction as it prevents double taxation of the initial investment.

Tax Treatment

Tax Treatment

• Non-Prescribed Taxation: Under this method, a disproportionately higher interest portion is recognized and taxed in the early years of the annuity's life. This occurs because the Canadian tax system generally assumes that interest income is received first, followed by the return of capital. This front-loads the taxable income. Consequently, annuitants may face higher initial tax liabilities, which gradually decrease over the term of the annuity as the capital repayment component increases. This treatment can lead to less predictable after-tax income, especially in the early years. This treatment is often applied by default to non-registered annuities unless a specific election for prescribed taxation is made or the annuity inherently qualifies as prescribed.

• Prescribed Taxation: This method allows for level payment tax treatment, where the interest and capital components of each payment are averaged out over the expected life of the annuity. This means a consistent proportion of each payment is considered interest and taxed annually, deferring the high initial tax liabilities associated with non-prescribed taxation and providing a more consistent and predictable tax burden each year. To qualify for prescribed taxation, several conditions must be met, primarily that the annuity be issued by a licensed insurer (e.g., life insurance company) and the contract stipulates it as a "prescribed annuity" under subsection $12.2(1)$ of the Income Tax Act. Additionally, ownership and payment structures (e.g., no lump sum payments, regular payouts) must adhere to the

• Prescribed Taxation: This method allows for level payment tax treatment, where the interest and capital components of each payment are averaged out over the expected life of the annuity. This defers the high initial tax liabilities associated with non-prescribed taxation, providing a more consistent and predictable tax burden each year. To qualify for prescribed taxation, certain conditions must be met, and the annuity contract must be issued as a "prescribed annuity" under the Income Tax Act.

Calculation of Taxable Portion in Non-Registered Annuities

Non-registered annuities are funded with after-tax dollars, meaning the initial capital invested has already been subjected to income tax. Therefore, only the interest earned on this capital throughout the annuity's life is subject to taxation. The following steps outline how to determine what portion of each payment represents a return of your original, non-taxable capital versus the taxable interest income.

1. Step One: Identify Capital Element.

   • This refers to the original principal amount (the initial sum of after-tax money) that the annuitant invested to purchase the annuity. This amount is crucial because it represents the non-taxable return of principal over the annuity's life.

2. Step Two: Determine the Number of Annuity Payments (calculated as life expectancy x payments per year).

   • This step projects the total number of payments the annuitant is expected to receive over the annuity's duration. It involves multiplying the annuitant's estimated life expectancy (or the term certain for a term certain annuity) by the frequency of payments per year (e.g., $12$ for monthly payments, $4$ for quarterly payments).

3. Step Three: Compute Capital Proportion of Each Payment (Capital / Total payment amount).

   • To calculate the proportion of each total payment that is considered a return of capital, divide the identified capital element (from Step One) by the total expected payments over the annuity's life (calculated as the total number of payments from Step Two multiplied by the individual payment amount).

   • This ratio indicates the percentage of each payment that is essentially a non-taxable recovery of the initial investment.

4. Step Four: Calculate Capital Element of Each Payment (Payment amount x Capital Proportion).

   • Multiply the regular annuity payment amount by the capital proportion determined in Step Three. This gives the specific dollar amount within each payment that represents a non-taxable return of capital.

   • The remaining portion of the payment (Total Payment - Capital Element of Each Payment) is then considered the taxable interest income.

Examples

• Kylie's case:

  • Kylie's initial capital: $300,000$

  • Monthly payment: $2,000$

  • Life expectancy: $18.21$ years

  • Payments per year: $12$

  • Step Two Calculation: Payments expected = $18.21 ext{ years} imes 12 ext{ payments/year} = 218.52$ payments.

  • Full Value of Expected Payments: $218.52 ext{ payments} imes 2,000 ext{ per payment} = 437,040$

  • Step Three Calculation: Capital proportion = (Initial Capital / Total Expected Payments) = $(300,000 / 437,040) imes 100 ext{ percent} = 68.64 ext{ percent} ext{ (approximately } 69 ext{ percent as stated in original note)}$

  • Step Four Calculation: Capital Element of Each Payment = Monthly Payment x Capital Proportion = $2,000 imes 0.69 = 1,380$

  • Taxable Portion Calculation: Taxable portion amounts to (Total Monthly Payment - Capital Element of Each Payment) = $(2,000 - 1,380) = 620$

  • This means that out of each $2,000$ payment, $1,380$ is a tax-free return of her initial investment, and $620$ is considered taxable interest income.

• In scenarios regarding annuities purchased at varying capital amounts or life expectancies, similar calculative methodologies are applied to derive taxable portions. It is essential to re-evaluate these steps for each unique annuity contract to accurately determine the non-taxable and taxable components of ongoing payments.

Reverse Mortgage Overview

• Allows individuals to access home equity while still residing in the property.

Nature of Reverse Mortgages

• Distinct from traditional mortgages that require regular, ongoing payments, reverse mortgages are structured so that the debt (including principal and accumulated interest) accrues over time and is only settled upon specific events.

• These events typically include the homeowner's death, the sale of the property, or when the homeowner permanently moves out of the residence (e.g., into a long-term care facility).

• Throughout the life of the reverse mortgage, the homeowner retains full ownership and title to their property, meaning they continue to live in, maintain, and are responsible for property taxes, insurance, and upkeep.

• The loan amount is typically determined by the homeowner's age, the property's appraised value, and current interest rates; older homeowners and properties with higher values generally qualify for larger loan amounts.

• Crucially, homeowners cannot outlive a reverse mortgage; even if the loan balance grows to exceed the home's value, the homeowner is not personally liable for the difference, as it is a non-recourse loan.

Features of Reverse Mortgages

• Higher interest rates and upfront fees compared to traditional mortgages: Reverse mortgages typically carry higher interest rates due to the increased risk incurred by lenders (no regular payments, debt repaid later) and the long-term nature of the loan. Upfront costs can include origination fees, appraisal fees, closing costs, and mortgage insurance premiums (MIP), which can add a significant amount to the initial cost.

• Withdrawal equalization with government benefits like OAS and GIS: The funds received from a reverse mortgage are generally considered loan proceeds and not taxable income. Therefore, they do not directly affect eligibility for income-tested government benefits such as Old Age Security (OAS) or Guaranteed Income Supplement (GIS). This is a significant advantage for retirees who rely on these benefits, as they can access home equity without compromising their public benefits.

• Compounding interest on the total debt balance; older borrowers qualify for larger amounts: Interest accrues on the outstanding loan balance, including previously accrued interest, leading to compound interest. This causes the total debt to grow significantly over time. Lenders determine loan amounts based on factors such as the homeowner's age (older homeowners qualify for larger amounts as their shorter life expectancy means less time for interest to compound and a shorter repayment period for the lender), the property's appraised value, and prevailing interest rates.

• No monthly payment requirement but interest accumulates over time: A key feature is the absence of monthly mortgage payments. Homeowners are not required to make any principal or interest payments while they live in the home. Instead, the interest is added to the loan balance, causing the debt to grow. The loan becomes due and payable when the last borrower moves out permanently, sells the home, or passes away.

Types of Reverse Mortgages

• Primarily categorized as:

  • Reverse Annuity Mortgage (RAM): This type combines a reverse mortgage with an immediate annuity. A portion of the loan proceeds is used to purchase a life annuity, providing the homeowner with a guaranteed stream of regular, tax-free payments for life. The remaining portion of the loan can be taken as a lump sum or line of credit. The annuity payments are generally non-taxable as they represent a return of principal.

  • Line of Credit Reverse Mortgage: This is the most flexible option, allowing homeowners to draw funds as needed up to a maximum credit limit. Interest is only charged on the amount actually drawn. The unused portion of the line of credit often grows over time, meaning the amount available for future draws may increase.

  • Fixed Term Reverse Mortgage: This type provides a fixed monthly payment for a specified period, regardless of the homeowner's life expectancy. It's suitable for homeowners who need a consistent income stream for a defined number of years, perhaps to bridge a gap until another income source begins. At the end of the term, the loan becomes due and payable, though options for refinancing or repayment may exist.

Taxation of Reverse Mortgages

• Investment income from non-registered investments attracts tax liabilities, and typically considered a non-prescribed investment subject to income under the specific CRA guidelines.

Exercises and Testing Understanding

• Exercises designed to recognize different annuities and reverse mortgage structures and how they apply in practical scenarios.

• Scenarios probing for comprehension of taxable amounts, particularly with prescribed tax treatments on payments from non-registered annuities.

Conclusion

Understanding both registered and non-registered annuities is essential for making informed retirement income decisions. This deep understanding allows individuals to strategically align their annuity choice with their overall financial goals and tax situation.

• Registered Annuities are typically funded with pre-tax dollars from vehicles like RRSPs or RRIFs. Consequently, the entire payment received from a registered annuity is fully taxable as income, reflecting the tax-deferred growth achieved during the accumulation phase. Their primary benefit lies in providing a predictable income stream that complements other registered retirement savings.

• Non-Registered Annuities, conversely, are funded with after-tax dollars. This crucial distinction means that only the interest portion of each payment is subject to taxation, while the return of the original capital remains non-taxable, preventing double taxation of the initial investment. The choice between registered and non-registered depends heavily on factors such as an individual's tax bracket, current income sources, and the desire to manage future tax liabilities.

Thorough comprehension of taxable portions, life expectancies, and annuity payment calculations is critical for financial success in retirement planning. Misjudging these elements can lead to unexpected tax burdens or an inability to meet living expenses.

• Taxable Portions: Understanding how the income from an annuity is taxed is paramount. For non-registered annuities, the chosen tax treatment (non-prescribed vs. prescribed) significantly impacts cash flow. Non-prescribed taxation front-loads the interest, leading to higher tax liabilities in early years, while prescribed taxation levels out the tax burden over the annuity's life, providing more predictable after-tax income. For registered annuities, the entire payment is taxable, making it crucial to account for marginal tax rates when budgeting. Accurate calculation of the non-taxable return of capital in non-registered annuities ensures that annuitants correctly report income and avoid overpayment of taxes.

• Life Expectancies: This element is central to the design and payout of life annuities. A longer life expectancy for the annuitant generally results in lower individual payments but guarantees income over an extended period. For instance, impaired annuities offer higher income to individuals with reduced life expectancies. When determining calculations for non-registered annuities, life expectancy directly influences the total number of payments expected, which in turn impacts the capital proportion and the taxable interest component of each payment. Accurately assessing life expectancy (or the term for term certain annuities) is fundamental to projecting long-term income sustainability.

• Annuity Payment Calculations: These calculations are vital for determining the exact amount of income an annuitant will receive, both gross and net of taxes. The detailed four-step process for non-registered annuities—identifying capital, determining the number of payments (life expectancy x payments per year), computing the capital proportion, and calculating the capital element of each payment—allows for precise financial planning. Mastering these calculations ensures that annuitants can accurately forecast their after-tax income, manage their retirement budget effectively, and make adjustments to their spending or investment strategies as needed. Furthermore, understanding how payment frequency (e.g., monthly, annually) impacts cash flow is key for day-to-day financial management during retirement. These combined insights enable retirees to navigate their financial landscape with confidence, ensuring stable and sufficient income throughout their golden years.

• Thorough comprehension of taxable portions, life expectancies, and annuity payment calculations is critical for financial success in retirement planning.