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Annuities are a unique financial product that, along with Social Security, employer pensions, your 401(k) plan, IRA and other assets, can enhance your retirement security. A unique financial benefit of an annuity is its ability to keep you from “outliving your assets."

What are variable annuities?

Variable annuity contracts are sold by insurance companies. Purchasers pay a premium of, for example, $10,000 for a single payment variable annuity or $50 a month for a periodic payment variable annuity. The insurance company deposits these premiums in an account which is invested in a portfolio of securities. The value of the portfolio goes up or down as the prices of its securities rise or fall.

After a specified period of time, often coinciding with the year the purchaser becomes age 65, the assets are converted into annuity payments. These payments are variable, since they depend an the periodic performance of the underlying securities.

Almost all variable annuity contracts carry sales charges, administrative charges, and asset charges. The amounts differ from one contract to another and from one insurance company to another.

Fixed annuity contracts are not considered securities and are not regulated by the SEC.

How do annuities work?

The annuity, in essence, is insurance against "living too long." In contrast, traditional life insurance guards against "dying too soon." Here is a summary of how annuities function. An investor hands over funds to an insurance company. The insurer invests the funds. At the end of the annuity’s term, the insurer pays the investor his or her investment plus the earnings. The amount paid at maturity may be a lump sum or an annuity—a set of periodic payments that are guaranteed as to amount and payment period.

The earnings that occur during the term of the annuity are tax-deferred. The investor is not taxed on them until the amounts are paid out. Because of the tax deferral, your funds have the chance to grow more quickly than they would in a taxable investment.

Should I invest in annuities?

The two reasons to use an annuity as an investment vehicle are as follows:

  1. You want to save money for a long-range goal, and/or
  2. You want a guaranteed stream of income for a certain period of time.

Annuities lend themselves 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 as an investment. It really only makes sense to put your money in an annuity if you can leave it there for at least ten years, and only when the withdrawals are scheduled to occur after age 59-1/2. This is why annuities work well mostly for retirement needs, or for education funding in cases 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 child’s name under the provisions of the Uniform Gifts to Minors Act. The child would then pay tax on the earnings when the time came for withdrawals. A major drawback to this planning technique is that the child is free to use the money for any purpose, not just education costs.

If an investment adviser recommends a tax-deferred variable annuity, should you invest it? Or would a regular taxable investment be better?

Generally, you should be aware that tax-deferred annuities very often yield less than regular investments. They have higher expenses than regular investments, and these expenses eat into your returns. (On the plus side, the annuity provides a death benefit.)

Overall, you’re probably better off going with a regular mutual fund. Tax-deferred annuities are generally only worthwhile if you are planning to leave the money in the vehicle for at least ten years, and to take it out over a long period.

Be aware that your investment counselor may be entitled to a commission on the product he or she is recommending. If so, proceed with great caution. Do not rely on the counselor’s comparison of the product’s return with taxable investments; do your own analysis.

Should a retiree purchase an immediate annuity?

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, representing a portion of principal plus interest, and guaranteed to last for life. The portion of the periodic payout that is a return of principal is excluded from taxable income.

However, there are risks. For one thing, when lock yourself into a lifetime of level payments, you aren't guarding against inflation. You are also 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. Furthermore, since the interest rate is fixed by the insurer when you buy it, you are locking into today's low rates.

You can hedge your bets by opting for a "certain period," 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 of all of the remaining principal is resumed to your beneficiaries.

There are also some plans that offer quasi-inflation adjusted payments. One company offers a guaranteed increase in payments of 10 percent at three-year intervals for the first 15 years. Payments then get an annual cost-of-living adjustment, with a 3 percent 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.

If you want a comfortable retirement income, your best bet is 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.

How do life annuities differ from life insurance?

While traditional life insurance guards against "dying too soon," an annuity, in essence, can be used as insurance against "living too long." With an annuity, 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.

What's the down side to buying an annuity?

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.

What types of annuity are available?

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).

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 .Deferred annuities are used as long-term investment vehicles by retirees and non-retirees alike. They are used in tax-deferred retirement plans and as individual tax-sheltered annuity investments. 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 period—from a month to a year, or more. Thus, the fixed annuity contract is similar to a CD or a money market fund, depending on length of the period during which interest is guaranteed. The fixed annuity is considered a low risk investment vehicle.

This guaranteed interest rate is adjusted upwards or downwards at the end of the guarantee period.

All fixed annuities also guarantee you a certain minimum rate of interest of 3 to 5 percent for the entirety of the contract.

The fixed annuity is a good annuity choice for investors with a low risk tolerance and a short-term investing time horizon. The growth that will occur will be relatively low. In times of falling interest rates, fixed annuity investors benefit, while in times of rising interest rates they do not.

The variable annuity, which is considered to carry with it higher risks than the fixed annuity—about 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.

You can switch your allocations from time to time for a small fee or sometimes for free.

The variable annuity is a good annuity choice for investors with a moderate to high risk tolerance and a long-term investing time horizon.

Tip: Today, insurers make available annuities that combine both fixed and variable features.

What are my options for collecting my annuity?

When it’s 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 monthly payment depends on...

  1. The size of the amount in your annuity contract
  2. Whether there are minimum required payments
  3. The annuitant’s life expectancy
  4. Whether payments continue after the annuitant’s death

Here are summaries of the most common forms of payment (settlement options). Once you have chosen a payment option, you cannot change your mind.

Fixed Amount gives you a fixed monthly amount—chosen 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. If you die before your annuity is exhausted, your beneficiary gets the rest.

Fixed Period 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 payments continue 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.

Life With Period Certain 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.

Installment-Refund 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.

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, monthly payments are made to the retired employee, with the same or a lesser amount to the employee's surviving spouse or other beneficiary. In this case, 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.

What's the tax on payouts from a qualified plan or IRA annuity?

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.

  1. Any nondeductible or after-tax amount you put into the plan is not subject to income tax when withdrawn

     

  2. The earnings on your investment are not taxed until withdrawal.

     

If you withdraw money before the age of 59-1/2, you may have to pay a 10% penalty on the amount withdrawn in addition to the regular income tax. One of the exceptions to the 10% penalty is for taking the annuity out in 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).

Is it a good idea to buy annuities for my IRA or qualified plan?

Though this is sometimes done, no tax advantage is gained by putting annuities in such a plan since qualified plans and IRAs as well as annuities are tax-deferred.It might be better, depending on your situation, to put other investments, such as mutual funds, in IRAs and qualified plans, and hold annuities in your individual account.

How will my annuity payouts be taxed?

The way your payouts are taxed is different for qualified and non-qualified plans. Here is a summary of the two different types of plans.

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 benefits—and penalties—that Congress saw fit to attach to such plans.

The tax benefits are:

  1. The amount you put into the plan is not subject to income tax, and/or
  2. The earnings on your investment are not taxed until withdrawal.

The tax rules say that you cannot make withdrawals before age 59-1/2 without paying an additional tax of 10% of the amount withdrawn. Further, you must begin taking withdrawals in certain minimum amounts once you reach the age of 70-1/2.

A non-qualified annuity, on the other hand, is purchased with after-tax dollars. You still get the benefit of tax deferral on the earnings.

Tax Rules

When you withdraw money from a qualified plan annuity that was funded with pre-tax dollars, you must pay income tax on the entire amount withdrawn.

Once you reach age 70-1/2, you will have to start taking withdrawals, in certain minimum amounts specified by the tax law.

With a non-qualified plan annuity that was funded with after-tax dollars, you pay tax only on the part of the withdrawal that represents 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.

What tax must my beneficiaries or heirs pay if my annuity continues after my death?

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.

How should I shop for an annuity?

Although annuities are issued by insurance companies, they may be purchased through banks, insurance agents, or stockbrokers. The "load" (commission) you will pay to the middle-man will vary from 3% to 8% of your investment. The commission reduces the return you can get on your investment.

Check Out The Insurer. Make sure that the insurance company offering it is financially sound. Annuity investments are not federally guaranteed, so the soundness of the insurance company is the only assurance you can rely on. Several services rate insurance companies.

Compare Contracts. For immediate annuities: Compare the settlement options. For each $1,000 invested, how much of a monthly payout will you get? Consider the interest rate and any penalties and charges.

For deferred annuities: Compare the rate, the length of guarantee period, and a five-year history of rates paid on the contract, not just the interest rates.

For variable annuities: Check out the past performance of the funds involved.

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.

What are the added or hidden costs in buying an annuity?

These are the most important items:

Sales Commission.Ask for details on any commissions you will be paying. What percentage is the commission? Is the commission deducted as a front-end load? If so, your investment is directly reduced by the amount of the commission. A no-load annuity contract, or at least a low-load contract, is the best choice.

Surrender Penalties. 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.

Tip: Be sure the surrender charge "clock" starts running with the date your contract begins, not with each new investment.

Other Fees and Costs.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:

  • Mortality fees of 1 to 1.35% of your account (protection for the insurer in case you live a long time)
  • Maintenance fees of $20 to $30 per year
  • Investment advisory fees of 0.3% to 1% of the assets in the annuity’s portfolios

Other Considerations. 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.

Is it better to take an annuity or a lump-sum distribution?

As in so many areas of retirement planning, that depends upon your particular needs and circumstances.

  • An annuity preserves the tax shelter for funds not yet paid out as annuity income, continuing to grow tax-free to fund future payouts.
  • A lump sum withdrawal may be preferable for those in questionable health.
  • Or consider an annuity with a "refund feature", that guarantees a fixed sum to your heirs should you die earlier than expected.

What is a joint and survivor annuity?

A joint and survivor annuity pays a certain annuity during your life and half that amount (it could be more) to your surviving spouse for life.

In almost all cases, the annual amount you will get under a joint and survivor annuity will be less than you would get under an annuity on your life alone.

Can I change from a joint and survivor annuity if it doesn't meet my needs?

Joint and survivor annuities are almost always required in pension plans, and sometimes in other plans. But you and your spouse can still agree to some other form.

Chief reasons for such agreement are so that your child or other family member can share in the income, or to take a lump sum distribution, or to take a larger annual amount over the participant’s life alone.

Source: CPA Site Solutions

Annuities—a type of insurance product— can be an effective investment vehicle, especially in providing for your retirement. This Financial Guide will help you decide whether annuity investments are right for you and how to use them in retirement planning. It also discusses the tax treatment of annuities.

 

How Annuities Work

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 you'll 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.

How Annuities Best Serve Investors

Tip: Assess the costs of an annuity relative to the alternatives. Separate purchase of life insurance and tax-deferred investments may be more cost effective.

The two primary reasons to use an annuity as an investment vehicle are:

  1. You want to save money for a long-range goal, and/or
  2. You want a guaranteed stream of income for a certain period of time.

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.

Tip: The greater the investment return, the less punishing the 10% penalty on withdrawal under age 59-1/2 will appear. If your variable annuity investments have grown substantially, you may want to consider taking some of those profits (despite the penalty, which applies only to the taxable portion of the amount withdrawn).

Annuities can also be effective in funding education costs where the annuity is held in the child’s 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.

Caution: A major drawback is that the child is free to use the money for any purpose, not just education costs.

The Various Types Of Annuities

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:

  • Single-Premium Annuities: 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.
  • Flexible-Premium Annuities: With the flexible-premium annuity, the annuity is funded with a series of payments. The first payment can be quite small.
  • Immediate Annuities: 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.
  • Deferred Annuities: 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 annuity—i.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.
  • Fixed Annuities: 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 period—from 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.
  • Variable Annuities: The variable annuity, which is considered to carry with it higher risks than the fixed annuity—about 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.

     

Tip: You can switch your allocations from time to time for a small fee or sometimes for free.

The variable annuity is a good annuity choice for investors with a moderate to high risk tolerance and a long-term investing time horizon.

Caution: Variable annuities have higher costs than similar investments that are not issued by an insurance company.

Caution: The taxable portion of variable annuity distributions is taxable at full ordinary rates, even if they are based on stock investments. They do not enjoy capital gains relief or the reduced taxation available after 2002 and before 2009 for dividends from stock investments (including mutual funds).

Tip: Today, insurers make available annuities that combine both fixed and variable features.

Tip: Before buying an annuity, contribute as much as possible to other tax-deferred options such as IRA’s and 401 (k) plans. The reason is that the fees for these plans is likely to be lower than those of an annuity and early-withdrawal fees on annuities tend to be steep.

Tip:IRA contributions are sometimes invested in flexible premium annuities—with IRA deduction, if otherwise available. You may prefer to use IRAs for non-annuity assets. Non-annuity assets gain the ability to grow tax-free when held in an IRA. The IRA regime adds no such benefit to annuity assets which grow tax-free in or outside IRAs.

Choosing A Payout Option

When it’s 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.

Caution: Once you have chosen a payment option, you cannot change your mind.

The size of your payout (settlement option) depends on:

  1. The size of the amount in your annuity contract
  2. Whether there are minimum required payments
  3. Your life expectancy (or other payout period)
  4. Whether payments continue after your death

Here are summaries of the most common forms of payout:

Fixed Amount

This type gives you a fixed monthly amount—chosen 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.

Fixed Period

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.

Installment-Refund

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.

How Payouts Are Taxed

The way your payouts are taxed differs for qualified and non-qualified annuities.

Qualified Annuity

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 benefits—and penalties—that Congress saw fit to attach to such qualified plans.

The tax benefits are:

  1. Any nondeductible or after-tax amount you put into the plan is not subject to income tax when withdrawn
  2. The earnings on your investment are not taxed until withdrawal

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).

Non-Qualified Annuity

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.

Tax on Your Beneficiaries or Heirs

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.

Tip: Ask your sales representative for a recent survey by Variable Annuity Research & Data Service. Many annuity portfolios are tracked by this service.

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.

How To Shop For An Annuity

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, Moody’s Investor Service, Standard & Poor’s 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.

  • Immediate annuities: Compare the settlement options. For each $1,000 invested, how much of a monthly payout will you get? Be sure to consider the interest rate and any penalties and charges.
  • Deferred annuities: Compare the rate, the length of guarantee period, and a five-year history of rates paid on the contract. It is important to consider all three of these factors and not to be swayed by high interest rates alone.
  • Variable annuities: Check out the past performance of the funds involved.

Tip: Ask your sales representative for a recent survey by Variable Annuity Research & Data Service. Many annuity portfolios are tracked by this service.

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.

Costs, Penalties, And Extras

Be sure to compare the following points when considering an annuity contract:

Surrender Penalties

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.

Tip: Be sure the surrender charge "clock" starts running with the date your contract begins, not with each new investment.

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:

  • Mortality fees of 1 to 1.35% of your account (protection for the insurer in case you live a long time)
  • Maintenance fees of $20 to $30 per year
  • Investment advisory fees of 0.3% to 1% of the assets in the annuity’s portfolios.

Extras

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.

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.

Risk To Retirees of Using An Immediate Annuity

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 seniors—75 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.

Source: CPA Site Solutions

You can think of a lifetime annuity as investment vehicle that functions as a personal pension plan. Sometimes referred to as “single life,” “straight life,” or “non-refund,” these are a form of immediate annuity that provides income for your entire life. The payments can be increased to cover a second person. This is called a “Joint and Survivor” annuity. While most provide income for life, some may offer the option of payments for a fixed number of years.

A lifetime annuity could serve as a retirement income supplement to Social Security checks, 401(k) retirement plans, company pension funds, etc. Lifetime annuities provide income for as long as you live - even after all the money you contributed is exhausted. They can be useful for those who want the certainty and security of establishing a regular and guaranteed income stream. If, however, you die before all the funds in your account have been used up, the payment option to your beneficiaries will be determined by the choice you made when you purchased the annuity. In some cases, no payouts will be made to your dependents or other beneficiaries. Instead, you will be getting an income that you can’t outlive.

A straight life annuity makes sense for someone who needs the most retirement income possible and does not plan to use the money invested for dependents or other beneficiaries.
 

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Fixed vs. variable annuities

In a fixed annuity, the insurance company guarantees the principal and a minimum rate of interest. In other words, as long as the insurance company is financially sound, the money you have in a fixed annuity will grow and will not drop in value. The growth of the annuity’s value and/or the benefits paid may be fixed at a dollar amount or by an interest rate, or they may grow by a specified formula.

The growth of the annuity’s value and/or the benefits paid does not depend directly or entirely on the performance of the investments the insurance company makes to support the annuity. Some fixed annuities credit a higher interest rate than the minimum, via a policy dividend that may be declared by the company’s board of directors, if the company’s actual investment, expense and mortality experience is more favorable than was expected. Fixed annuities are regulated by state insurance departments.

Money in a variable annuity is invested in a fund—like a mutual fund but one open only to investors in the insurance company’s variable life insurance and variable annuities. The fund has a particular investment objective, and the value of your money in a variable annuity—and the amount of money to be paid out to you—is determined by the investment performance (net of expenses) of that fund.

Most variable annuities are structured to offer investors many different fund alternatives. Variable annuities are regulated by state insurance departments and the federal Securities and Exchange Commission.

Types of fixed annuities

An equity-indexed annuity is a type of fixed annuity, but looks like a hybrid. It credits a minimum rate of interest, just as a fixed annuity does, but its value is also based on the performance of a specified stock index—usually computed as a fraction of that index’s total return.

A market-value-adjusted annuity is one that combines two desirable features—the ability to select and fix the time period and interest rate over which your annuity will grow, and the flexibility to withdraw money from the annuity before the end of the time period selected. This withdrawal flexibility is achieved by adjusting the annuity’s value, up or down, to reflect the change in the interest rate “market” (that is, the general level of interest rates) from the start of the selected time period to the time of withdrawal.

Other types of annuities

All of the following types of annuities are available in fixed or variable forms.

Deferred vs. immediate annuities
A deferred annuity receives premiums and investment changes for payout at a later time. The payout might be a very long time; deferred annuities for retirement can remain in the deferred stage for decades.

An immediate annuity is designed to pay an income one time-period after the immediate annuity is bought. The time period depends on how often the income is to be paid. For example, if the income is monthly, the first payment comes one month after the immediate annuity is bought.

Fixed period vs. lifetime annuities
A fixed period annuity pays an income for a specified period of time, such as ten years. The amount that is paid doesn’t depend on the age (or continued life) of the person who buys the annuity; the payments depend instead on the amount paid into the annuity, the length of the payout period, and (if it’s a fixed annuity) an interest rate that the insurance company believes it can support for the length of the pay-out period.

A lifetime annuity provides income for the remaining life of a person (called the “annuitant”). A variation of lifetime annuities continues income until the second one of two annuitants dies. No other type of financial product can promise to do this. The amount that is paid depends on the age of the annuitant (or ages, if it’s a two-life annuity), the amount paid into the annuity, and (if it’s a fixed annuity) an interest rate that the insurance company believes it can support for the length of the expected pay-out period.

With a “pure” lifetime annuity, the payments stop when the annuitant dies, even if that’s a very short time after they began. Many annuity buyers are uncomfortable at this possibility, so they add a guaranteed period—essentially a fixed period annuity—to their lifetime annuity. With this combination, if you die before the fixed period ends, the income continues to your beneficiaries until the end of that period.

Qualified vs. nonqualified annuities
A qualified annuity is one used to invest and disburse money in a tax-favored retirement plan, such as an IRA or Keogh plan or plans governed by Internal Revenue Code sections, 401(k), 403(b), or 457. Under the terms of the plan, money paid into the annuity (called “premiums” or “contributions”) is not included in taxable income for the year in which it is paid in. All other tax provisions that apply to nonqualified annuities also apply to qualified annuities.

A nonqualified annuity is one purchased separately from, or “outside of,” a tax-favored retirement plan. Investment earnings of all annuities, qualified and non-qualified, are tax-deferred until they are withdrawn; at that point they are treated as taxable income (regardless of whether they came from selling capital at a gain or from dividends).

Single premium vs. flexible premium annuities
A single premium annuity is an annuity funded by a single payment. The payment might be invested for growth for a long period of time—a single premium deferred annuity—or invested for a short time, after which payout begins—a single premium immediate annuity. Single premium annuities are often funded by rollovers or from the sale of an appreciated asset.

A flexible premium annuity is an annuity that is intended to be funded by a series of payments. Flexible premium annuities are only deferred annuities; that is, they are designed to have a significant period of payments into the annuity plus investment growth before any money is withdrawn from them.

Deferred Annuity

This type of annuity is good for long-term retirement planning for the following reasons:

  • Payments on income taxes are deferred until you withdraw the money.
  • Unlike a 401(k) or an IRA, there are no limits on your annual annuity contributions.
  • There is a death benefit. If you die before collecting on the annuity, your heirs get the amount you contributed, plus investment earnings, minus whatever cash withdrawals you made.

Immediate Annuity

This allows you to convert a lump sum of money into an annuity so that you can immediately receive income. Payments generally start about a month after you purchase the annuity. This type of annuity offers financial security in the form of income payments for the rest of your life. In other words, you cannot outlive it.

Immediate annuities allow you to:

  • Supplement your current income. If you are nearing retirement, you may consider transferring another savings or investment account into an immediate annuity. You can also move the proceeds from a deferred annuity into an immediate annuity.
  • Pay taxes only on the portion of your immediate annuity payments that is considered earnings. You are not taxed on the portion that is principal. The principal is the initial deposit made with funds that have already been taxed.

Like deferred annuities, immediate annuities can be fixed or variable. Fixed immediate annuity income payments are pegged to the amount you contribute, your age and the interest rate at the time of purchase. Those payments to you will not go up or down. Variable immediate annuity payments vary with the investments you chose.

 

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In its most general sense, an annuity is an agreement for one person or organization to pay another a stream or series of payments. Usually the term “annuity” relates to a contract between you and a life insurance company, but a charity or a trust can take the place of the insurance company.

There are many categories of annuities. They can be classified by:

  • Nature of the underlying investment – fixed or variable
  • Primary purpose – accumulation or pay-out (deferred or immediate)
  • Nature of pay-out commitment – fixed period, fixed amount, or lifetime
  • Tax status – qualified or nonqualified
  • Premium payment arrangement – single premium or flexible premium

An annuity can be classified in several of these categories at once. For example, you might buy a nonqualified single premium deferred variable annuity. For brief definitions of these categories, click here.

 

In general, annuities have the following attractive features:

Tax deferral on investment earnings
Many investments are taxed year by year, but the investment earnings—capital gains and investment income—in annuities aren’t taxable until you withdraw money. This tax deferral is also true of 401(k)s and IRAs; however, unlike these products, there are no limits on the amount you can put into an annuity. Moreover, the minimum withdrawal requirements for annuities are much more liberal than they are for 401(k)s and IRAs.

Protection from creditors
If you own an immediate annuity (that is, you are receiving money from an insurance company), generally the most that creditors can access is the payments as they’re made, since the money you gave the insurance company now belongs to the company. Some state statutes and court decisions also protect some or all of the payments from those annuities. And your money in tax-favored retirement plans, such as IRAs and 401(k)s, are generally protected, whether invested in an annuity or not.

An array of investment options, including “floors”
Many annuity companies offer a variety of investment options. You can invest in a fixed annuity which would credit a specified interest rate, similar to a bank Certificate of Deposit (CD). If you buy a variable annuity, your money can be invested in stock or bond (or other) mutual funds. In recent years, annuity companies have created various types of “floors” that limit the extent of investment decline from an increasing reference point. For example, the annuity may offer a feature that guarantees your investment will never fall below its value on its most recent policy anniversary.

Tax-free transfers among investment options
In contrast to mutual funds and other investments made with “after-tax money,” with annuities there are no tax consequences if you change how your funds are invested. This can be particularly valuable if you are using a strategy called “rebalancing,” which is recommended by many financial advisors. Under rebalancing, you shift your investments periodically to return them to the proportions that you determine represent the risk/return combination most appropriate for your situation.

Lifetime income
A lifetime immediate annuity converts an investment into a stream of payments that last as long as you do. In concept, the payments come from three “pockets”: Your investment, investment earnings and money from a pool of people in your group who do not live as long as actuarial tables forecast. It’s the pooling that’s unique to annuities, and it’s what enables annuity companies to be able to guarantee you a lifetime income.


Benefits to your heirs

There is a common misconception about annuities that goes like this: if you start an immediate lifetime annuity and die soon after that, the insurance company keeps all of your investment in the annuity. That can happen, but it doesn’t have to. To prevent it, buy a “guaranteed period” with the immediate annuity. A guaranteed period commits the insurance company to continue payments after you die to one or more beneficiaries you designate; the payments continue to the end of the stated guaranteed period—usually 10 or 20 years (measured from when you started receiving the annuity payments). Moreover, annuity benefits that pass to beneficiaries don’t go through probate and aren’t governed by your will.

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If you are in a saving-money stage of life, a deferred annuity can:

Help you meet your retirement income goals. Employer-sponsored plans such as a 401(k), 403(b) or Keogh are an important part of planning for retirement. However, contributions to these plans and to IRAs are limited, and they might not add up to enough for the retirement income you need, especially if you started saving for retirement late or had contributions interrupted—perhaps due to job changes and/or family responsibilities. Moreover, your social security and defined-benefit pension (if you have one) may provide less than you need to retire. Remember that the purchasing power of defined-benefit pension income is eroded by inflation.

Help you diversify your investment portfolio. Investment experts routinely advise that, to get the best return for a given level of risk, you should diversify your investments among a number of asset classes. Fixed annuities, in particular, offer a unique asset class—an investment that is guaranteed not to decrease and that will actually increase at a specified interest rate (and, often, potentially more). The guarantees are supported by the claims-paying ability of the insurer.

Help you manage your investment portfolio. Investment experts routinely advise that, whenever your investments in various asset classes get too far from the percentage allocations you prefer, you “rebalance” to the original formulation, by shifting funds from the classes that have grown faster to the ones that have grown more slowly. If you do this with mutual funds, you pay capital gains taxes; if you do it in a variable annuity, you don’t pay capital gains taxes. When you eventually withdraw money from the annuity (which could be many years after the rebalancing), you pay tax then at the ordinary income rate.

If you are in a need-income stage of life, an immediate annuity can:

Help protect you against outliving your assets. Social security pays retirement income for as long as you live, as do defined-benefit pension plans. But the only other source of income available that continues indefinitely is an immediate annuity.

Help protect your assets from creditors. Generally the most that creditors can access is the payments from an immediate annuity as they’re made, since the money you gave the insurance company now belongs to the company. Some state statutes and court decisions also protect some or all of the payments from those annuities.

 

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