Annuities may help you meet some of your mid- and long-range goals, such as planning for your retirement and for a child's college education. This Financial Guide tells you how annuities work, discusses the various types of annuities, and helps you determine which annuity product (if any) suits your situation. It also discusses the tax aspects of annuities and explains how to shop for both an insurance company and an annuity, once you know which type youll need.
While traditional life insurance guards against "dying too soon," an annuity, in essence, can be used as insurance against "living too long." In brief, if you buy an annuity (generally from an insurance company, which invests your funds), you will receive in return a series of periodic payments that are guaranteed as to amount and payment period. Thus, if you choose to take the annuity payments over your lifetime (there are many other options), you will have a guaranteed source of "income" until your death. If you "die too soon" (that is, you don't outlive your life expectancy), you will get back from the insurer far less than you paid in. On the other hand, if you "live too long" (and do outlive your life expectancy), you may get back far more than the cost of your annuity (and the resultant earnings). By comparison, if you put your funds into a traditional investment, you may run out of funds before your death.
The earnings that occur during the term of the annuity are tax-deferred. You are not taxed on them until they are paid out. Because of the tax deferral, your funds have the chance to grow more quickly than they would in a taxable investment.
The two primary reasons to use an annuity as an investment vehicle are:
Annuities lend themselves particularly well to funding retirement and, in certain cases, education costs.
One negative aspect of an annuity is that you cannot get to your money during the growth period without incurring taxes and penalties. The tax code imposes a 10% premature-withdrawal penalty on money taken out of a tax-deferred annuity before age 59-1/2 and insurers impose penalties on withdrawals made before the term of the annuity is up. The insurers penalties are termed "surrender charges," and they usually apply for the first seven years of the annuity contract.
These penalties lead to a de facto restriction on the use of annuities primarily as an investment. It only makes sense to put your money into an annuity if you can leave it there for at least ten years and the withdrawals are scheduled to occur after age 59-1/2. These restrictions explain why annuities work well for either retirement needs or for cases of education funding where the depositor will be at least 59-1/2 when withdrawals begin.
Annuities can also be effective in funding education costs where the annuity is held in the childs name under the provisions of the Uniform Gifts to Minors Act. The child would then pay tax (and 10% penalty) on the earnings when the time came for withdrawals.
The available annuity products vary in terms of (1) how money is paid into the annuity contract, (2) how money is withdrawn, and (3) how the funds are invested. Here is a rundown on some of the annuity products you can buy:
You can purchase a single-premium annuity, in which the investment is made all at once (perhaps using a lump sum from a retirement plan payout). The minimum investment is usually $5,000 or $10,000.
With the flexible-premium annuity, the annuity is funded with a series of payments. The first payment can be quite small.
The immediate annuity starts payments right after the annuity is funded. It is usually funded with a single premium, and is usually purchased by retirees with funds they have accumulated for retirement.
With a deferred annuity, payouts begin many years after the annuity contract is issued. You can choose to take the scheduled payments either in a lump sum or as an annuityi.e., as regular annuity payments over some guaranteed period.
Deferred annuities are used as long-term investment vehicles by retirees and non-retirees alike. They are used to fund tax-deferred retirement plans and tax-sheltered annuities. They may be funded with a single or flexible premium.
With a fixed annuity contract, the insurance company puts your funds into conservative fixed income investments such as bonds. Your principal is guaranteed and the insurance company gives you an interest rate that is guaranteed for a certain minimum periodfrom a month to several years. This guaranteed interest rate is adjusted upwards or downwards at the end of the guarantee period. Thus, the fixed annuity contract is similar to a CD or a money market fund, depending on the length of the period during which interest is guaranteed. The fixed annuity is considered a low-risk investment vehicle.
All fixed annuities also guarantee you a certain minimum rate of interest of 3 to 5% for the entirety of the contract.
The fixed annuity is a good choice for investors with a low risk tolerance and a short-term investing time horizon. The growth that will occur will be relatively low. Fixed annuity investors benefit if interest rates fall, but not if they rise.
The variable annuity, which is considered to carry with it higher risks than the fixed annuityabout the same risk level as a mutual fund investment gives you the ability to choose how to allocate your money among several different managed funds. There are usually three types of funds: stocks, bonds, and cash-equivalents. Unlike the fixed annuity, there are no guarantees of principal or interest. However, the variable annuity does benefit from tax deferral on the earnings.
The variable annuity is a good annuity choice for investors with a moderate to high risk tolerance and a long-term investing time horizon.
When its time to begin taking withdrawals from your deferred annuity, you have various choices. Most people choose a monthly annuity-type payment, although a lump sum withdrawal is possible.
The size of your payout (settlement option) depends on:
Here are summaries of the most common forms of payout:
This type gives you a fixed monthly amountchosen by you-that continues until your annuity is used up. The risk of using this option is that you may live longer than your money lasts. Thus, if the annuity is your only source of income, the fixed amount is not a good choice. If you die before your annuity is exhausted, your beneficiary gets the rest.
This option pays you a fixed amount over the time period you choose. For example, you might choose to have the annuity paid out over ten years. If you are seeking retirement income before some other benefits start, this may be a good option. If you die before the period is up, your beneficiary gets the remaining amount.
Lifetime or Straight Life
This form of payments continues until you die. There are no payments to survivors. The life annuity gives you the highest monthly benefit of the options listed here. The risk is that you will die early, thus leaving the insurance company with some of your funds. The life annuity is a good choice if (1) you do not need the annuity funds to provide for the needs of a beneficiary and (2) you want to maximize your monthly income.
Life With Period Certain
This form of payment gives you payments as long as you live (as does the life annuity) but with a minimum period during which you or your beneficiary will receive payments, even if you die earlier than expected. The longer the guarantee period, the lower the monthly benefit.
This option pays you as long as you live and guarantees that, should you die early, whatever is left of your original investment will be paid to a beneficiary. Monthly payments are less than with a straight life annuity.
Joint And Survivor
In one joint and survivor option, monthly payments are made during the annuitants' joint lives, with the same or a lesser amount paid to whoever is the survivor. In the option typically used for retired employees (employment model), monthly payments are made to the retired employee, with the same or a lesser amount to the employee's surviving spouse or other beneficiary. The difference is that with the employment model , the spouse's (or other co-annuitant's) death before the employee won't affect what the survivor employee collects. The amount of the monthly payments depends on the annuitants' ages, and whether the survivor's payment is to be 100% of the joint amount or some lesser percentage.
The way your payouts are taxed differs for qualified and non-qualified annuities.
A tax-qualified annuity is one used to fund a qualified retirement plan, such as an IRA, Keogh plan, 401(k) plan, SEP (simplified employee pension), or some other retirement plan. The tax-qualified annuity, when used as a retirement savings vehicle, is entitled to all of the tax benefitsand penaltiesthat Congress saw fit to attach to such qualified plans.
The tax benefits are:
If you withdraw money from a qualified plan annuity before the age of 59-1/2, you will have to pay a 10% penalty on the amount withdrawn in addition to paying the regular income tax. There are exceptions to the 10% penalty, including an exception for taking the annuity out in a series of equal periodic payments over the rest of your life.
Once you reach age 70-1/2, you will have to start taking withdrawals in certain minimum amounts specified by the tax law (with exceptions for Roth IRAs and for employees still working after age 70-1/2).
A non-qualified annuity is purchased with after-tax dollars. You still get the benefit of tax deferral on the earnings. However, you pay tax on the part of the withdrawals that represent earnings on your original investment.
If you make a withdrawal before the age of 59-1/2, you will pay the 10% penalty only on the portion of the withdrawal that represents earnings.
With a non-qualified annuity, you are not subject to the minimum distribution rules that apply to qualified plans after you reach age 70-1/2.
If your annuity is to continue after your death, other taxes may apply to your beneficiary (the person you designate to take further payments) or your heirs (your estate or those who take through the estate if you didn't designate a beneficiary).
Income tax: Annuity payments collected by your beneficiaries or heirs are subject to tax on the same principles that would apply to payments collected by you.
Exception: There's no 10% penalty on withdrawal under age 59-1/2 regardless of the recipient's age, or your age at death.
Estate tax: The present value at your death of the remaining annuity payments is an asset of your estate, and subject to estate tax with other estate assets. Annuities passing to your surviving spouse or to charity would escape this tax.
Although annuities are issued by insurance companies, they may be purchased through banks, insurance agents, or stockbrokers.
There is considerable variation in the amount of fees that you will pay for a given annuity as well in the quality of the product. Thus, it is important to compare costs and quality before buying an annuity.
First, Check Out The Insurer
Before checking out the product itself, it is important to make sure that the insurance company offering it is financially sound. Because annuity investments are not federally guaranteed, the soundness of the insurance company is the only assurance you can rely on. Consult services such as A.M. Best Company, Moodys Investor Service, Standard & Poors Ratings, Duff & Phelps Credit Rating Company, and Fitch IBCA, The International Rating Agency to find out how the insurer is rated.
Next, Compare Contracts
The way you should go about comparing annuity contracts varies with the type of annuity.
If a particular fund has a great track record, ascertain whether the same management is still in place. Although past performance is no guarantee, consistent management will grant you better odds.
Be sure to compare the following points when considering an annuity contract:
Find out the surrender charges (that is, the amounts charged for early withdrawals). The typical charge is 7% for first-year withdrawals, 6% for the second year, and so on, with no charges after the seventh year. Charges that go beyond seven years, or that exceed the above amounts, should not be acceptable.
Fees And Costs
Be sure to ask about all other fees. With variable annuities, the fees must be disclosed in the prospectus. Fees lower your return, so it is important to know about them. Fees might include:
These provisions are not costs, but should be asked about before you invest in the contract.
Some annuity contracts offer "bail-out" provisions that allow you to cash in the annuity if interest rates fall below a stated amount without paying surrender charges.
There may also be a "persistency" bonus which rewards annuitants who keep their annuities for a certain minimum length of time.
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In deciding whether to use annuities in your retirement planning (or for any other reason) and which types of annuities to use, professional guidance is advisable.
Books And Other Publications
At first glance, the immediate annuity would seem to make sense for retirees with lump-sum distributions from retirement plans. After all, an initial lump-sum premium can be converted into a series of monthly, quarterly, or yearly payments that represent a portion of principal plus interest and is guaranteed to last for life. The portion of the periodic payout that constitutes a return of principal is excluded from taxable income.
However, this strategy contains risks. For one thing, when you lock yourself into a lifetime of level payments, you fail to guard against inflation. Furthermore, you are gambling that you will live long enough to get your money back. Thus, if you buy a $150,000 annuity and die after collecting only $60,000, the insurer often gets to keep the rest. Unlike other investments, the balance doesn't go to your heirs. Finally, since the interest rate is fixed by the insurer when you buy it, you may be locking yourself into low rates.
You can hedge your bets by opting for a "period certain", or "term certain" which, in the event of your death, guarantees payment for some years to your beneficiaries. There are also "joint-and-survivor" options (which pay your spouse for the remainder of his or her life after you die) or a "refund" feature (in which some or all of the remaining principal is resumed to your beneficiaries).
Some plans offer quasi-inflation adjusted payments. One company offers a guaranteed increase in payments of $10 at three-year intervals for the first 15 years. Payments then get an annual cost-of-living adjustment with a 3% maximum. However, for these enhancements to apply, you will have to settle for much lower monthly payments than the simple version.
Recently, a few companies have introduced immediate annuities that offer potentially higher returns in return for some market risk. These "variable immediate annuities" convert an initial premium into a lifetime income; however, they tie the monthly payments to the returns on a basket of mutual funds.
Older seniors75 years of age and up may have fewer worries about inflation or liquidity. Nevertheless, they should question whether they really need such annuities at all.
If you want a comfortable retirement income, consider a balanced portfolio of mutual funds. If you want to guarantee that you will not outlive your money, you can plan your withdrawals over a longer time horizon.
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