Annuities aren’t for everyone, but for many people they can play a role in a well-designed and balanced financial plan. They offer tax-deferred growth potential, guarantees to your principal and interest, and the ability to assure income for life.
Types of Annuities
There are three types of annuities: fixed, fixed index, and variable. In fixed and index annuities, your principal is not at risk. These normally pay an income stream which is a combination of return of principal plus an interest factor described in the contract. A variable annuity, however, is linked directly to the stock market and the principal is at risk. A more detailed discussion of fixed, index and variable annuities is provided in Column 2.
Each type of annuity can be purchased either by periodic premium payments over many years, or with a single premium. Periodic annuities are designed for long-term planning, much like IRAs, 401(k)s and other retirement plans. They tend to be purchased by younger people who are beginning their retirement savings. On the other hand, single premium annuities are usually purchased by those with money available from savings, property sales, inheritance, IRAs, CDs or other lump sums. The lottery, pension plans and structured settlements are really annuities.
There are immediate annuities, and then there are deferred annuities. Most immediate annuities are purchased with a single premium. For example, someone who takes his 401(k) with him upon retirement from his company, or has an IRA that has accumulated, will have a lump sum available to purchase a single premium annuity. Let’s say this person will have Social Security benefits either immediately or in the near future, or even a pension. His Social Security or pension will provide lifelong income, but the combined monthly payments might not be enough for him. An immediate annuity may be just what he needs to get his income stream to a comfortable level.
Although in this example the IRA could be left in mutual funds, there is always the risk of the stock market going down, and of outliving the periodic withdrawals taken from the IRA. For example, if you have $100,000 in mutual funds that earn 5 percent growth and you are taking $8,000 per year ($667 per month), there will be nothing left after 21 years. Instead, investing in a $100,000 immediate annuity would provide a similar monthly income that could not be outlived.
A deferred annuity, on the other hand, does not start paying you immediately. Instead, the income payments start at a later date (after accumulation phase). In the example above, if the person put his $100,000 into a deferred annuity and let it grow for five or 10 years before starting monthly income payments, the lifetime monthly payments would be larger (based on the original $100,000 plus the accumulated gain). The later you start lifetime income payments, the larger the monthly payments will be. In most deferred annuities, you can elect to start taking income whenever you want.
Accumulation Phase and Payment Phase
Most annuities have an accumulation phase and payment phase. In all annuities that have an accumulation phase, the premiums paid into the annuity grow tax deferred until income starts. Tax deferral is a major advantage over instruments where taxes are paid yearly on gains, such as interest and dividends.
Fixed and indexed annuities did not decline in value during the recent market downturn. These annuities are insurance products, not security products, and are designed to protect you against loss of principal. Of course, variable annuities (a combination of securities and insurance) are also available if they fit within your risk tolerance and are otherwise suitable. Annuities offer:
• Peace of mind (set it and forgot it)
• Annuity earnings grow tax free until withdrawn (tax-deferred growth)
• No risk to principal (fixed and index annuities, but not variable annuities)
• No capital calls, margin calls, etc
• Disciplined investment
• Flexible premium payment choices
• Unlimited opportunity to save for retirement
• Only annuities provide the opportunity to assure income for you (or you and your spouse) for the rest of your life no matter how long you live.
• Unlike IRAs and retirement plans, there are no required minimum distributions after 70½ for annuities purchased with non-qualified funds
• For old-style annuities that have not yet been annuitized, and new-style protected withdrawal value annuities, the beneficiary you name receives the death benefit without delay, expense or probate.
• For those who would like their growth linked indirectly to the stock market (index annuity), or directly (variable annuity), there are several index choices available in index annuities and many sub-account choices available in variable annuities.
• Diversification is available by investing in several different kinds of annuities with different insurance companies.
• Fixed annuity guarantees a fixed interest rate for a specific period of time.
• There are many choices for payouts.
• Annuities are exempt from creditor claims.
• Many annuities with a guaranteed withdrawal benefit provide for automatic doubling of monthly life income payments if you are disabled.
• Annuities may not be counted as assets when qualifying for Medicaid.
• Protected withdrawal benefit riders allow you to hedge against poor stock market returns by including an automatic annual increase to your protected withdrawal account value no matter how badly the stock market performs.
• During accumulation, the interest or gain accruing on an annuity is not counted as income for determining taxability of your Social Security benefits.
• If you have insomnia, reading your annuity contract in the evening is a great substitute for sleeping pills.
• Annuities pay a conservative interest rate on the amount invested.
• Annuities are long-term investments; you must be patient.
• Annuities can be considered illiquid investments.
• In the early years of an annuity, surrender charges apply if you want to cash in your annuity and get your money back.
• Until the surrender charge period expires, most annuities will allow you to withdraw only 10 percent per year without penalty.
• Unlike bank CDs, annuities are not guaranteed by the FDIC.
• Gains on some investments are taxed at long-term capital gains tax rates if you own them for more than a year, but payment gains in an annuity are always taxed as ordinary income.
• Diversification in variable annuities cannot eliminate the risk of investment loss.
• Guarantees are based on the insurance company’s ability to pay.
• Early withdrawal may cause a loss of principal due to surrender charges.
• Purchasers may experience fees and expenses, including surrender charges, market value adjustments, rider premiums, etc., which may effect contract values.
• Investing IRA funds in an annuity provides no additional tax-deferred growth.
• There may be fees and expenses that are not applicable to other investments.
• If you can buy a house or condo and double your money by flipping it in a couple of years, maybe an ordinary annuity is not your best investment choice.
This article is for information purposes only and does not constitute legal advice.
Jeff Riddell is a Sarasota, Florida attorney with Riddell Law Group (rlglawfirm.com). He has published numerous articles on real estate transactions and most recently authored a book titled “21st Century Real Estate Investing.” He can be reached at (877) 455-2628.