Regular annuities are a safe way to guarantee a stream of monthly income. You hand over a large amount of cash (typically $100,000 or more) and in return get a modest monthly payment. Most annuities are purchased with registered funds, such as in your RRSP or TFSA. However, a prescribed annuity uses savings outside your registered accounts and can offer tax advantages.
What is a prescribed annuity in Canada?
Before we talk about prescribed annuities, let’s look at annuities in general. Here’s how they work: You provide the insurance company with a lump sum of cash. In return, the institution provides you with a guaranteed income stream for the rest of your life.
With interest rates at record lows, there is renewed interest in annuities. They can provide better returns than investing in GICs, in addition to the tax advantages.
When to buy an annuity?
They are often sold when a person retires and wants to convert their RRSP to generate income. Financial advisors recommend buying an annuity between the ages of 65 and 70, when there are still plenty of years of life expectancy remaining. RRSPs must be converted to a RRIF or an annuity by age 71.
On the other hand, a prescribed annuity is purchased with non-registered funds and can have certain tax advantages. Like a regular annuity, a prescribed annuity contract provides a regular monthly payment. However, by using non-registered funds, only a portion of each payment is taxable. This is because the payments consist of both a repayment of the principal (not taxable) and interest income (taxable).
Tax minimization is the key advantage of a prescribed annuity. If you purchase a GIC, all of the interest is taxable. When you receive payments from a prescribed annuity, only the interest portion is taxable.
What are the differences between a prescribed and non-prescribed annuity?
There are several different types of annuities:
- A life annuity: This pays out until you die. In a sense it is a form of life insurance. If you happen to live to the age of 100 (or more) it just keeps paying. Therefore, it provides you with a guaranteed income to support you in your later years; if you simply relied on savings, your money might run out.
- Term annuity: This provides you with payments for the period of the term, which can be 5, 10 or 20 years.
- A joint or survivor option: This allows you and your spouse or common-law partner to both benefit from the annuity. It makes sense – when you die, your partner will still need a flow of income. However, this type of annuity provides a smaller payout since the payments are likely to continue for a longer period.
- Cash-back option: This clause provides for your estate to receive a cash payment if you die before receiving a specific amount of money (usually the amount you paid for the annuity).
- Variable annuity: The insurance company puts your money into equities. It pays you a small fixed amount plus a variable amount that depends on the performance of the equities. These are not common in Canada.
- Impaired annuity: People who have a shortened life expectancy due to health issues may be able to take advantage of this type of annuity. It provides larger payouts on the assumption that you will die at an early age.
As indicated, most annuities are purchased when a person retires and converts their RRSP into a flow of income. Since these use registered funds, the proceeds are taxable.
Prescribed annuities use non-registered funds. Therefore, the payments consist of repayment of part of the principal (not taxable) and interest (taxable).
Prescribed annuity rules
According to Canada’s Income Tax Act, there are certain requirements for a prescribed annuity:
- The policy holder must also be the annuitant. The annuitant is the person whose life the policy is based on
- It can be a joint life annuity policy, such as husband and wife
- It cannot be cashed in or transferred to another person
- Payments must start by Dec. 31 of the year following the purchase date
- Annuity payments must always stay the same and cannot be indexed to inflation
- Annuity payments can be for life or term – as long as the term payments do not exceed the policyholder’s 91st birthday
Prescribed annuity advantages
One of the main advantages of an annuity is that you no longer have to worry about stock market returns. It’s guaranteed income. Every month, you get a deposit. You need not fret if there’s a bear market and your stocks go down 10 percent (or more). This applies to both prescribed and non-prescribed annuities.
As indicated, there can be tax advantages when you use non-registered funds to purchase a prescribed annuity.
Prescribed annuity disadvantages
There are certain disadvantages to both prescribed and non-prescribed annuities.
The payouts are fairly small. For example, on a $100,000 non-registered investment, a 60-year-old man would receive a monthly payment of between $400 and $425. There is a 10-year guarantee so there is a minimum payout if you die within the first decade of purchasing the annuity.
If your annuity pays out $400 monthly the annual amount would be $4,800. With a 10-year guarantee, that would mean a minimum payment of $48,000. However, that’s compared with $100,000 that you initially invested.
You are handing over a large sum of cash. If you choose to live off your investments instead of buying an annuity, you may have money remaining upon your death and can provide an inheritance to your spouse or children.
Inflation can eat away at your payment. Yes, your monthly payment is fixed (at say $400). However, over 20 years of inflation at 3 percent per year, that payment will lose about half its value. So, a month of groceries that you once bought for $400 now cost a lot more.
How to buy an annuity
Your financial adviser or insurance company can help you purchase an annuity. However, make sure that the salesperson has explained all of the terms and conditions.
You should compare annuities with other investment options. For example, dividend-paying blue-chip stocks can provide a higher income with a modest level of risk. Be sure to consider the tax consequences of different types of investments.
Can I cancel my annuity?
Prescribed annuity contracts can be complex legal documents. Therefore, it’s important to understand all the terms and conditions – before you purchase.
However, if you change your mind there may be ways to back out. Some annuities have a cooling-off period (before you receive any payments) that allow you to cancel without penalty. Even after you have started the flow of payments, you may be able to cancel (with a penalty). Check to make sure that these conditions apply to the annuity you are purchasing.
