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Questions about Annuities
What Is an Annuity?
Most Common Usage Of Annuities
How Do Annuities Differ from Life Insurance?
How Much Should I Invest in an Annuity?
Advantages Of an Annuity
Single vs. Flexible-Payment Annuities
Fixed vs. Variable Annuities
Deferred Annuities.
Withdrawing Money from a Deferred Annuity
Why Buy a Deferred Annuity?
Immediate Annuities
Why Buy an Immediate Annuity?
Options with Guarantees
What Is an Annuity?
An annuity is a contract between an individual ("annuitant") and an insurance company. The annuitant agrees to pay the insurance company a single payment or a series of payments, and the insurance company agrees to pay the annuitant an income, starting immediately or at a later date, for a specified time period. Under current tax law, money put into an annuity grows on a tax-deferred basis until the annuitant begins receiving his accumulated fund as an income. That means that one hundred percent of your earnings are reinvested in an annuity and allowed to compound-- or grow -- without having to pay taxes on earnings.
Most Common Usage Of Annuities
Long considered a CD alternative, annuities have become very popular today. Paying higher rates than CD's and deferring taxes, many people on a fixed income find annuities are a better option than tieing up money in CD's or letting it warehouse in a money market account. Like a CD, you can place lump sums of money in annuities. You must leave the money in the annuity for a period of years, usually between 2 and 5 years. The longer you leave the money in, the higher your interest rate will be. Depending on the annuity purchased, a yearly amount is allowed to be withdrawn without a penalty. This amount is usually around 10%.
How Do Annuities Differ from Life Insurance?
Life insurance pays your family cash benefits when you die. Annuities typically begin paying you an income when you retire and may continue paying you an income for as long as you live. (Most annuities stop paying money when you die; though some annuities can continue paying money to your family after your death if you select that option.)
How Much Should I Invest in an Annuity?
How much money you put into an annuity depends upon your financial goals and the type of annuity you are purchasing. In general, a traditional annuity should be considered for its ability to build tax-deferred earnings from otherwise taxable investments such as mutual funds and CDs. An Equity Indexed Annuity should be purchased for participation in the stock markets while protecting principal from downside risk.
Advantages Of an Annuity
Beyond tax advantages, there are important reasons to invest in an annuity, especially when you consider the limitations of other types of investments. Annuities can provide:
Guaranteed income. An annuity can provide you with a guaranteed lifetime income, regardless of how long you live. No other investment instrument can provide this guarantee.
Unlimited contributions. Unlike other tax-advantaged investments, such as IRAs, you can contribute an unlimited amount of money to an annuity during the year, whether in periodic installments or a lump sum. Individual carriers may place a ceiling on the total amount you may put into an annuity without approval.
Bonus rates. Some annuities award investors with bonuses -- extra interest that further increases your investment -- at the end of your annuity's first year. The bonus increases the annuity's principal on which future interest will be calculated in subsequent years, thus providing a substantial boost to the ultimate value of an annuity fund.
No risk of loss ("fixed" annuities). Unlike other forms of stock or fund investments, annuities that are invested in mutual funds or are tied to the stock market performance may include minimum guarantees to limit the amount of investment risk.
No-penalty annual withdrawals. Most annuities have a provision that allows you to withdraw a certain amount per year penalty free.
No-penalty rollovers. Company pension or profit-sharing plan payouts may be reinvested without incurring current taxes or penalties.
No probate in case of death, as long as you specify beneficiaries. Which means your family will find it easier and less costly to obtain the value of the annuity.
No initial sales charges ("no load") or annual fees. Annuities are generally no-load, no-fee investments, which means more of your money is actually invested than with investments where some money is used to pay an initial or annual charge.
Shelter investment earnings. Retired people can use annuities to shelter investment earnings that would otherwise lead to taxation of Social Security benefits.
Single vs. Flexible-Payment Annuities
You can purchase an annuity in two ways:
Make one lump-sum payment to purchase a single-premium annuity. If you want to contribute more money at a later date, you will have to purchase another annuity.
Make ongoing contributions to a flexible-payment annuity. You can contribute money at regular or even irregular intervals anytime you want.
Fixed vs. Variable Annuities
There are two basic types of annuities you can buy, fixed and variable.
Fixed Annuities.
Fixed annuities earn a guaranteed rate of interest for a specific time period, such as one, three or five years. Once the guarantee period is over, a new interest rate is set for the next period. This guarantee of both interest and principal makes fixed annuities somewhat similar to Certificates of Deposit (CDs) purchased from a bank. Unlike a typical CD, however, an annuity is not backed by the Federal Deposit Insurance Corporation (FDIC); its security is directly related to the financial health of the insurance company that issues the annuity.
Variable Annuities.
Variable annuities typically offer a range of investment or funding options. These funding options may include stocks, bonds and money market instruments. The return on variable annuities can go up or down. Your principal and the return you earn are not guaranteed; they depend on the performance of the underlying investment options. If the funding options you choose for your annuity perform well, they may exceed the inflation rate or fixed annuity returns. If they don't, you may lose not only prior earnings, but even some of your principal. Some variable annuities offer, in addition to a range of investment options, a fixed account option that guarantees both principal and interest, much like a fixed annuity. This gives you the option of dividing your money between the low-risk fixed option and higher-risk vehicles such as stocks, all under the umbrella of just one annuity. Many variable annuities offer asset allocation programs to help you decide where to invest your assets based on your circumstances. Variable annuities also allow you to transfer money from one account to another without triggering a taxable event. In other words, if you transfer money to a different funding option within your variable annuity, you will not have to pay taxes on any earnings you have made. Tax-free switching let's you re-allocate money to suit changing market conditions, without worrying about the taxes.
Fixed and Variable Annuity Expenses.
Variable annuities usually have more features and higher fees than fixed annuities. With some fixed annuities, contract expenses ? such as maintenance and contract fees ? are taken into consideration when the company declares periodic interest rates or determines the payment amount.
Variable annuity fees are more complicated. They may include an annual contract charge that covers administrative expenses and surrender fees, as well as a mortality and expense risk charge. Variable annuities charge this latter fee to guarantee the death benefit, the availability of payout options and the level of expenses.
In addition, a variable annuity has fees for the management and operating expenses of the funding options in which your money is invested. These charges pay for everything from the fund manager's salary to the costs of printing the fund prospectus.
For a variable annuity, all fees and other important information will be explained in the prospectus that describes the variable annuity contract. The prospectus must be given to you when you are solicited to purchase a contract. Read it carefully before you invest or send money and be sure you understand exactly what your expenses will be.
Deferred Annuities
Deferred annuities can be a great way to accumulate money for retirement, if you want retirement income beyond what you will receive from Social Security or your pension plan. They are particularly effective if you have many years before retirement. Your money grows tax deferred, which means you pay no taxes on earnings until you begin to withdraw your money.
If the tax-deferred aspect of a deferred annuity is important to you, make sure the expenses do not outweigh the tax benefits. This can be a tough judgment call, but a good guideline is that if the expense charges are more than 1.5% greater than a comparable financial vehicle and your time horizon is less than 10 years, a deferred annuity may not be the option for you. Consult a tax advisor for assistance in making this determination.
A deferred annuity is not a vehicle for money you may need for current expenses. If you withdraw income before age 59 1/2, the IRS will usually apply a 10% penalty in addition to ordinary income tax, similar to the penalty for early IRA withdrawals. What's more, your insurer may impose its own early withdrawal penalty, known as surrender fees, if you cash in your deferred annuity (surrender it) within a specified period. These fees, similar to withdrawal penalties on a CD, usually cease seven years after your date of purchase. Often there is a separate surrender fee for each payment. So, a new payment may have a 7% fee if you take the new payment out right away, while a 10-year-old payment may have no surrender fee. The fee will usually decrease and be eliminated over time. Keep in mind, however, you can often withdraw small amounts (e.g., 10%) annually without any penalty from your insurer, but the IRS penalty may still apply. The IRS views all withdrawals as income, which are taxable, until all income has been paid out. If you switch annuities, you may also incur withdrawal charges from your current annuity. If a salesperson advises you to change annuities despite the fact that you will be penalized, make sure you know the reason. Do the benefits of the new annuity such as a higher interest rate, better investment choices or greater flexibility ? offset the withdrawal charges? Be sure the salesperson isn't benefiting from the switch at your expense. If you decide to exchange one annuity for another, be sure to request and complete the appropriate forms provided by your insurance company to ensure that the transaction will be treated as a tax-free exchange under the federal income tax law (Section 1035 of the Internal Revenue Code).
Withdrawing Money from a Deferred Annuity
When you're ready to start withdrawing money from your deferred annuity, you will need to choose how to receive your money. You can take it all out in a lump sum, take it as needed, or receive it in a steady stream of periodic payments ? so-called "annuitizing." If you annuitize, you can receive a stream of income that is guaranteed to continue for the rest of your life, no matter how long you live. And, the tax liability can be spread out for the rest of your life too. Some of the earnings are included in each payment and are taxable, meanwhile, any earnings continue to accumulate tax-deferred on the remaining principal and earnings that have not yet been distributed. So, receiving distributions as periodic payments after retirement may further reduce your income tax liability, if you are in a lower tax bracket. Some annuities also provide you with an option to have a set amount, determined by you, automatically withdrawn and deposited directly in your checking account during a regularly scheduled period, such as monthly. You have many options on how you receive your money, each with its own tax ramifications. Consult your tax or financial advisor to tailor a plan for your particular needs.
Why Buy a Deferred Annuity?
There are a number of good reasons to consider a deferred annuity as part of your financial retirement plan:
You postpone paying income taxes on any earnings until you withdraw money, typically during retirement, when you may be in a lower tax bracket. All earnings grow tax-deferred.
You can put in as much money as you want. Unlike Individual Retirement Accounts (IRAs), there is no IRS restriction on the amount that can be contributed annually to deferred annuities with your after-tax money. You can, however, use a deferred annuity to fund your traditional or Roth IRA, in which case you would operate within IRA limitations.
You can provide death benefits to your heirs. If you die prematurely, your annuity can offer a death benefit to your beneficiaries without the costs and delays of probate. Your beneficiaries will never receive less than what you have contributed (less any withdrawals). In addition, a spouse who inherits an annuity before distribution has begun can step in as the new owner of the annuity and the tax deferral continues until amounts are withdrawn. If distribution payments had begun, the benefits would generally have to be distributed to the beneficiary at least as rapidly as through the method in effect at the time of the annuitant's death. Taxation will continue to apply to those proceeds. Generally, a beneficiary who inherits an annuity before distribution begins can request a lump sum distribution without penalty but will be subject to full taxation on the accrued interest or gain on the contract.
Immediate Annuities
To purchase an immediate annuity, you make a one-time payment, and distributions typically begin within a month. Immediate annuities can be fixed or variable, just like deferred annuities. The income payments you receive from fixed immediate annuities are based on the amount you contribute, your age and the interest rate environment at the time of purchase. The payments to you will not change. The payments from variable immediate annuities fluctuate based on the performance of the investment options you choose. Although payments may go up or down, variable annuities are designed to provide income that can rise over time to help you keep pace with inflation.
The principal in an immediate annuity is not readily accessible. If you need more money than the income provided by the immediate annuity, you could minimize this drawback by keeping some of your retirement funds in a liquid account, such as a savings account or money market fund. There also is a chance you may lose some of your principal. If you choose an income for life option with no refund guarantee, and you should die before your principal is all paid out, the balance of your principal and any earnings will go to the insurance company rather than to your heirs. Fortunately, annuities offer several guaranteed payout options. For more information see Options with Guarantees.
When selecting the investment options for your immediate annuity, keep inflation in mind. You want investments that will keep pace with inflation. Variable annuities can let you participate in stock market growth, historically shown to be one of the best ways to combat inflation over the long term. However, the downside is that payments can drop if the market drops. Not only is this unnerving, but obviously it will make it harder for you to budget. If you still want the potential for higher payments, consider dividing your retirement savings between fixed and variable options to provide fixed payments, as well as growth potential.
Immediate annuities can provide dependable financial security: a stream of income payments guaranteed to continue for the rest of your life or for a period you select. If you are about to retire, an immediate annuity may be a good place to put a large lump sum of money accumulated for retirement through another savings or investment vehicle. You also can convert your deferred annuity into an immediate annuity to start receiving income.
Why Buy an Immediate Annuity?
Among the reasons to consider an immediate annuity are the following:
An immediate annuity is a financial vehicle that can provide guaranteed income for life. The income payments you receive can supplement your other income sources, such as Social Security and pension payments, which may not provide enough income by themselves.
You choose how often to receive your income payments. Whether monthly, quarterly, semi-annually or annually, there's a payout plan to fit your particular needs.
You pay income taxes only as you receive your payments. When you receive income payments, you will be taxed on the portion of the payments that is earnings. The portion that is principal, which represents your initial deposit made with money that had already been taxed, is not taxable.
You may lessen your financial worries. Financial management can be a burden in your retirement years. Because you don't know how long you'll live, it's hard to be sure your resources will last as long as you need them. If you withdraw too much of your nest egg, your future income can suffer or you may run out of money entirely. If you are too thrifty when it comes to spending your nest egg, your level of living may suffer. Immediate annuities can remove some of these burdens by providing you with a predictable fixed payment for life, so you can concentrate on enjoying your hard-earned retirement.
Options with Guarantees
You can choose from a number of options for receiving income from an annuity.
Lifetime Income for You. You can opt for income, guaranteed by the insurance company, for the rest of your life. Payments cease upon your death.
Lifetime Income with a Guaranteed Period. You will receive income for life. If you die before the guarantee period is over, your beneficiaries will receive the remaining number of guaranteed payments.
Lifetime Income for Two. You can opt for income guaranteed for the rest of your life and the life of another person, such as your spouse. Guaranteed income for two people is known as a joint and survivor option, which guarantees that income payments will continue for the life of the primary owner and a second person. The guarantee is made by the insurance company issuing the annuity.
There are many other options, which can be explained to you by a financial advisor or insurance representative. These options can usually be mixed and matched to provide an ideal income plan for your needs. For example, say you and your spouse retire at age 65 with 10 years left on your mortgage. You could choose the option to have income for two people with a 10 year guaranteed period, so that if you both die before the guarantee expires, the payments would continue until the end of the 10-year period to pay the mortgage for your beneficiaries. These guarantees are subject to the claims paying ability of the issuer.
Before You Buy an Annuity Consider the Following:
The money contributed to an annuity may be in post-tax dollars. When you contribute after-tax savings to an annuity, you can put in as much money as you like. Before you put after-tax savings into an annuity, it may be advisable for you to put the maximum pre-tax amount into a retirement plan such as your IRA, SEP, 401(k) or 403(b). Also note that annuities may fund an IRA, SEP, 401(k), 403(b). When an annuity is used to fund these vehicles there are contribution limits that apply, and federal tax laws generally require that you begin taking minimum distributions by April 1 of the calendar year following the year in which you reach age 70 1/2. Failure to do so will result in a tax penalty of 50% of the amount of the shortfall.
Expenses can vary. Make sure that the annuity contracts you consider have competitive fees. Independent rating services such as Morningstar and Lipper Analytical Services both publish reports that compare variable annuity fees. Your local library may have copies. While cheaper doesn't necessarily mean better, if a contract is too expensive it could offset gains from the tax-deferred status.
All earnings from annuities are taxed as ordinary income.* If your ordinary income rate at retirement is higher than the current capital gains rate for other investments, you would actually pay higher taxes. You do, however, have a tax deferral on any earnings. With some other investments, you could be subject to ordinary income as well as capital gains taxes annually, even if you have not cashed in the investment, which can reduce the value of your earnings.
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