Financial options and planning are as broad as individual personalities. There are truly as many choices as there are individuals. This is the reason financial planning is an art in itself. Each financial plan must meet the needs of the individual client and their goals. The financial world can be confusing and offer solutions that are very complex. The choice of annuities is a controversial choice with many people. However, annuities can be a wise choice when utilized in the proper manner.
What is an annuity? An annuity is a contract between the contract holder—the annuitant—and an insurance company. In return for your contributions, the insurer promises to pay you a certain amount of money, on a periodic basis, for a specified period. Many people buy annuities as a kind of retirement income insurance, which guarantees them a regular income stream after they’ve left the workforce, often for the rest of their life.
Most annuities also offer tax advantages. The investment earnings grow tax-free until you begin to withdraw income. This feature can be attractive to retirement savers, who can contribute to a deferred annuity for many years and take advantage of tax-free compounding in their investments with guaranteed cash flows paid out in the future.
Annuities typically have provisions that penalize investors if they withdraw funds early. Also, tax rules generally encourage investors to postpone withdrawals until they reach a minimum age. However, most annuities allow investors to make withdrawals for qualified purposes without penalty, and some annuity contracts have provision for withdrawals of up to 10% – 15% for any purpose per year without penalty.
Compared with other types of investments, annuities can also have relatively high fees.
How Annuities Work
There are two main categories of annuities, based on when they begin to pay out: immediate and deferred.
With an immediate annuity (also known as an immediate payment annuity), you give the insurance company a lump sum of money and start receiving payments right away. Those payments can either be a fixed amount or a variable one, depending on the contract.
Annuities often have high fees, so shop around and make sure you understand all of the expenses before purchasing one.
Typically, you might choose this type of annuity if you have a one-time windfall, such as an inheritance. People who are close to retirement may also take a portion of their retirement savings and buy an immediate annuity as a way to supplement their income from Social Security and other sources.
Deferred annuities are structured to meet a different investor need—to accumulate capital over your working life, which can then be converted into an income stream for your later years.
The contributions you make to the annuity grow tax-deferred until you take income from the account. This period of regular contributions and tax-deferred growth is called the accumulation phase.
You can purchase a deferred annuity with a lump sum, a series of periodic contributions, or a combination of the two.
Types of Annuities
Within the broad categories of immediate and deferred annuities, there are also several different types from which to choose. Those include fixed, indexed, and variable annuities.
A fixed annuity provides a predictable source of retirement income, with relatively low risk. You receive a specific amount of money every month for the rest of your life or another period you’ve chosen, such as 5, 10, or 20 years.
Fixed annuities offer the security of a guaranteed rate of return. This will be true regardless of whether the insurance company earns a sufficient return on its own investments to support that rate. In other words, the risk is on the insurance company, not you. That’s one reason to make sure you’re dealing with a solid insurer that gets high grades from the major insurance company credit rating agencies.
The downside of a fixed annuity is that if the investment markets do unusually well, the insurance company, not you, will reap the benefits. What’s more, in a period of serious inflation, a low-paying fixed annuity can lose spending power year after year.
Your state’s department of insurance has jurisdiction over fixed annuities because they are insurance products. State insurance commissioners require that advisors have an insurance license to sell fixed annuities. You can find contact information for your state’s insurance department on the National Association of Insurance Commissioners website.
Indexed annuities, also called equity-indexed or fixed-indexed annuities, combine the features of a fixed annuity with the possibility of some additional investment growth, depending on how the financial markets perform. You’re guaranteed a certain minimum return, plus a return pegged to any rise in the relevant market index, such as the S&P 500. The amount of participation in the index, however, is generally capped.
Indexed annuities are regulated by state insurance commissioners as insurance products; in most states, agents must have both an insurance license and a securities license to sell them. The Financial Industry Regulatory Authority (FINRA), a self-regulatory organization (SRO) for the securities industry, also requires that its member firms monitor all products their advisors sell, so if you purchase Variable annuities that deal with a FINRA member firm, you might have another set of eyes unofficially watching the transaction. This FINRA investor alert has more details.
Unlike indexed annuities that are tied to a market index, variable annuities provide a return that’s based on the performance of a portfolio of mutual funds that you, as the annuitant, have selected. The insurance company may also guarantee a certain minimum income stream if the contract includes a guaranteed minimum income benefit (GMIB) option.
Unlike fixed and indexed annuities, a variable annuity is considered a security under federal law and is subject to regulation by the Securities and Exchange Commission (SEC) and FINRA. Potential investors must also receive a prospectus.
When you buy an annuity, you’re gambling that you’ll live long enough to get your money’s worth—or, ideally, more than that.
Tax Benefits of Annuities
Annuities offer several tax benefits. In general, during the accumulation phase of an annuity contract, your earnings grow tax-deferred. You pay taxes only when you start taking withdrawals from the annuity. Withdrawals are taxed at the same tax rate as your ordinary income.
If you fund an annuity through an individual retirement account (IRA) or another tax-advantaged retirement plan, you may also be entitled to a tax deduction for your contribution. This is known as a qualified annuity.
Taking Distributions from Annuities
Once you decide to start the distribution phase of your annuity, you inform your insurance company. The insurer’s actuaries then determine your periodic payment amount by means of a mathematical model.
The primary factors that go into the calculation are the current dollar value of the account, your current age (the longer you wait before taking an income, the greater your monthly payments will be), the expected future inflation-adjusted returns from the account’s assets, and your life expectancy based on industry-standard life-expectancy tables. Finally, the spousal provisions included in the contract are factored into the equation. Most annuitants choose to receive monthly payments for the rest of their lives and their spouse’s lives, in case their spouse outlives them.
If you live for a long time after you start taking distributions, the total value you receive from your annuity contract could be significantly higher than what you paid into it. However, should you die relatively soon, you may not get your money’s worth.
Annuities can have many other provisions, such as a guaranteed number of payment years, otherwise known as a period certain annuity. Under that provision, if you (and your spouse, if applicable) die before the guaranteed payment period is over, the insurer pays the remaining funds to your heirs.
As you can see, annuities are a complex investment option which must be closely analyzed before implementing into a retirement/financial plan. There are many types, costs, and uses that must be assessed before choosing tis investment vehicle. You will hear of financial companies who use annuities predominantly and you will hear financial companies who do not offer them at all. Remember, financial/retirement planning should be individualized and any part of the plan should b chosen based on its benefits and individual suitability.
Fixed and Variable Annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxed as ordinary income upon withdrawal. Guarantees are based on the claims-paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS tax penalty and surrender charges may apply. Variable annuities are subject to market risk and may lose value.