Planning for Retirement
Too many people are financially unprepared for retirement. Are you one of them? Don't worry . . . it's never too late to start saving. Use the checklist on the left to plot your strategy.

Know Where Your Retirement Income Comes From
 

People get retirement income from three sources. How solid is your retirement three-legged stool?

The traditional retirement income “stool”—Social Security, employer pensions, and personal savings—is getting shaky. Accelerate your personal savings to keep your future in balance.

Most people have three possible sources of retirement income:

  • Savings and investments
  • Pension payments (retirement benefits provided by your employer)
  • Social Security

The income that will have to be provided through savings and investments (which you can plan for) can be determined only after you have estimated the income you can expect from Social Security and from any pension plans (over which you have little control).

Social Security

The amount of Social Security benefits you will receive depends on how long you worked, the age at which you begin receiving benefits, and your total earnings.

If you wait until age 65, the current full retirement age, to begin receiving benefits, your monthly retirement benefit will be larger than if you elect to receive benefits beginning at age 62. The full retirement age is due to increase beginning in the year 2003, and will increase gradually to age 67 by the year 2027.

Social Security benefits may be subject to income tax. The basic rule is that if your adjusted gross income plus tax-exempt interest plus half of your Social Security benefits are more than $25,000 for an individual or more than $32,000 for a couple, then some portion of your Social Security benefit will be subject to income tax. The amount that is subject to tax increases as the level of adjusted gross income goes up.

Retirement Plans

Estimate how much you can expect to receive from a traditional pension plan or other retirement plan. If you are covered by a traditional pension plan and you are vested, ask your employer for a projection of what you can expect to receive if you continue working until retirement age or under other circumstances—e.g., if you terminate before retirement age. You may already have received such an estimate.

If you are covered by a 401(k) plan, a profit-sharing plan, a Keogh plan, or a Simplified Employee Pension, make an estimate of the lump sum that will be available to you at retirement age. You may be able to get help with this estimate from your employer.

Tip: If you are in the military or formerly served in the military, contact the relevant branch of service to find out about retirement benefits.

CPA Site Solutions

Estimate your Social Security Benefits

For most people, Social Security is a key component of retirement income.

For planning purposes, it’s essential to know how much to expect from Social Security and when those payments will start.

Eligibility for Retirement Benefits

When you work and pay Social Security taxes (referred to as FICA on some pay stubs), you earn Social Security credits. Most people earn four credits per year. The number of credits you need to get retirement benefits depends on your date of birth. If you were born in 1929 or later, you need 40 credits (10 years of work). People born before 1929 need fewer than 40 credits (39 credits if born in 1928, 38 credits if born in 1927, etc.).

If you stop working before you have enough credits to qualify for benefits, your credits will remain on your Social Security record. If you return to work later on, you can then add credits so that you may qualify. No retirement benefits can be paid until you have the required number of credits.

If you are like most people, however, you will earn many more credits than you need to qualify for Social Security. While these extra credits do not increase your Social Security benefit, the income you earn while working will increase your benefit.

Amount of your retirement benefits

Your benefit amount is based on your earnings averaged over most of your working career. Higher lifetime earnings result in higher benefits. If you have some years of no earnings or low earnings, your benefit amount may be lower than if you had worked steadily.

Your benefit amount is also affected by your age at the time you start receiving benefits. If you start your retirement benefits at age 62 (the earliest possible retirement age), your benefit will be lower than if you wait until a later age.

Full Retirement

Persons in the Social Security system who retire at "full retirement age" receive the full retirement benefit. Your full retirement age depends on when you were born.

Because of longer life expectancies, the full retirement age increased from age 65 and increases gradual steps until it reaches age 67.

Early Retirement

You can start your Social Security benefits as early as age 62, but your benefit amount will be less than your full retirement benefit. If you take early retirement, your benefits will be reduced based on the number of months you will receive checks before you reach full retirement age. The reduction is 5/9 of one percent for every month before full retirement age. If your full retirement age is 66 (for example, one born in 1945 and retiring in 2007 at age 62), the reduction for starting your Social Security at 62 is about 27%.

Delayed Retirement

If you decide to continue working full-time beyond your full retirement age, you will increase your Social Security benefit in two ways:

  • You will be adding a year of earnings to your Social Security record. (As stated earlier, higher lifetime earnings results in higher benefits.)
  • Your benefit will increase by a certain percentage for each additional year you work. These increases will be added in automatically from the time you reach your full retirement age until you either start taking your benefits or reach age 70. The percentage varies depending on your year of birth. The chart below shows the increase that will apply to you.

    Year of Birth Yearly Rate of Increase
    1917-1924 3%
    1925-1926 3.5%
    1927-1928 4%
    1929-1930 4.5%
    1931-1932 5%
    1933-1934 5.5%
    1935-1936 6%
    1937-1938 6.5%
    1939-1940 7%
    1941-1942 7.5%
    1943 or later 8%

Example: If you were born in 1943 or later, your benefit will increase by 8% (2/3 of one percent per month) for each year you delay signing up for Social Security beyond your full retirement age.

Choosing Your Retirement Date

If you plan to start your retirement benefits at age 62, contact Social Security in advance to determine the best retirement month to claim your benefits. In some cases, your choice of a retirement month could mean additional benefits for you and your family.

If You plan to start collecting your Social Security when you turn 62, you should apply for benefits three months before the date you want your benefits to start. Because the rules are complicated, you should discuss your plans with a Social Security claims representative in the year before the year you plan to retire.

Benefits For Widows/Widowers

Many people do not realize that widows and widowers can begin receiving Social Security benefits at age 60 (or age 50 if disabled) on the deceased spouse’s account. If you are receiving widows/widowers (including divorced widows/widowers) benefits, you can switch to your own retirement benefits (assuming you are eligible and your retirement rate is higher than your widow/widower's rate) as early as age 62.

In many cases, a widow or widower can begin receiving one benefit at a reduced rate and then switch to the other benefit at an unreduced rate at age 65. Since the rules vary depending on the situation, talk to a Social Security representative about the options available to you.

© CPA Site Solutions

Utilize your Employer Retirement Benefits

Employer-provided plans are a key retirement-savings tool. Are you using them fully?

Employer-sponsored qualified retirement plans such as 401(k)s are powerful retirement savings vehicles.

If your employer offers such a plan and you're not participating in it, you should be. After you enroll, try to contribute the maximum allowable amount.

Understand your employer-sponsored plan

Before you can take advantage of your employer's plan, you need to understand how these plans work. Read everything you can about the plan and talk to your employer's benefits officer. You can also talk to a financial planner, a tax advisor, and other professionals.

Recognize the key features that many employer-sponsored plans share:

  • Your employer automatically deducts your contributions from your paycheck. You may never even miss the money--out of sight, out of mind.
  • You decide what portion of your salary to contribute, up to the legal limit. And you can usually change your contribution amount on certain dates during the year.
  • With 401(k), 403(b), 457(b), SARSEPs, and SIMPLE plans, you contribute to the plan on a pretax basis. Your contributions come off the top of your salary before your employer withholds income taxes.
  • Your 401(k) or 403(b) plan may let you make after-tax Roth contributions--there's no up-front tax benefit but qualified distributions are entirely tax free.
  • Your employer may match all or part of your contribution up to a certain level. You typically become vested in these employer dollars through years of service with the company.
  • Your funds grow tax deferreded in the plan. You don't pay taxes on investment earnings until you withdraw your money from the plan.
  • You'll pay income taxes and possibly an early withdrawal penalty if you withdraw your money from the plan.
  • You may be able to borrow a portion of your vested balance (up to $50,000) at a reasonable interest rate.
  • Your creditors cannot reach your plan funds to satisfy your debts.

Contribute as much as possible

The more you can save for retirement, the better your chances of retiring comfortably. If you can, max out your contribution up to the legal limit. If you need to free up money to do that, try to cut certain expenses.

Why put your retirement dollars in your employer's plan instead of somewhere else? One reason is that your pretax contributions to your

This means you save money in taxes when you contribute to the plan--a big advantage if you're in a high tax bracket. For example, if you earn $100,000 a year and contribute $10,000 to a 401(k) plan, you'll pay income taxes on $90,000 instead of $100,000.

Another reason is the power of tax-deferred growth. Your investment earnings compound year after year and aren't taxable as long as they remain in the plan.

Over the long term, this gives you the opportunity to build an impressive sum in your employer's plan. You should end up with a much larger balance than somebody who invests the same amount in taxable investments at the same rate of return.

For example, you participate in your employer's tax-deferred plan (Account A). You also have a taxable investment account (Account B). Each account earns 8 percent per year. You're in the 28 percent tax bracket and contribute $10,000 to each account at the end of every year. You pay the yearly income taxes on Account B's earnings using funds from that same account.

At the end of 30 years, Account A is worth $1,132,832, while Account B is worth only $757,970. That's a difference of over $370,000! (Note: This example is for illustrative purposes only and does not represent a specific investment.)

Capture the full employer match

If you can't max out your 401(k) or other plan, you should at least try to contribute up to the limit your employer will match. Employer contributions are basically free money once you're vested in them (check with your employer to find out when vesting happens).

By capturing the full benefit of your employer's match, you'll be surprised how much faster your balance grows. If you don't take advantage of your employer's generosity, you could be passing up a significant return on your money.

For example, you earn $30,000 a year and work for an employer that has a matching 401(k) plan. The match is 50 cents on the dollar up to 6 percent of your salary. Each year, you contribute 6 percent of your salary ($1,800) to the plan and receive a matching contribution of $900 from your employer.

Evaluate your investment choices carefully

Most employer-sponsored plans give you a selection of mutual funds or other investments to choose from. Make your choices carefully. The right investment mix for your employer's plan could be one of your keys to a comfortable retirement. That's because over the long term, varying rates of return can make a big difference in the size of your balance.

Research the investments available to you. How have they performed over the long term? Have they held their own during down markets? How much risk will they expose you to? Which ones are best suited for long-term goals like retirement?

ou may also want to get advice from a financial professional (either your own, or one provided through your plan). He or she can help you pick the right investments based on your personal goals, your attitude toward risk, how long you have until retirement, and other factors.

Your financial professional can also help you coordinate your plan investments with your overall investment portfolio.

Finally, you may be able to change your investment allocations or move money between the plan's investments on specific dates during the year (e.g., at the start of every month or every quarter).

Know your options when you leave your employer

When you leave your job, your vested balance in your former employer's retirement plan is yours to keep. You have several options at that point, including:

  • Taking a lump-sum distribution. This is often a bad idea, because you'll pay income taxes and possibly a penalty on the amount you withdraw. Plus, you're giving up continued tax-deferred growth.
  • Leaving your funds in the old plan, growing tax deferred (your old plan may not permit this if your balance is less than $5,000). This may be a good idea if you're happy with the plan's investments or you need time to decide what to do with your money.
  • Rolling your funds over to an IRA or a new employer's plan if the plan accepts rollovers. This is often a smart move because there will be no income taxes or penalties if you do the rollover properly (your old plan will withhold 20 percent for income taxes if you receive the funds before rolling them over). Plus, your funds will keep growing tax deferred in the IRA or new plan.

© 2003 Forefield, Inc.

Establish Your Retirement Goals
 

Think you know how much retirement income you’ll need? Think again.

Your retirement could last for decades. Will your nest egg keep pace?

Once you have determined how much income you will need at retirement, you can figure out how much you will need to put away to have a big enough nest egg to fund your desired income level.

A general guideline is that you will want to have at least 70% of whatever income stream you have before retirement. If you have any special needs or desires—e.g., a desire to travel extensively—the percentage should be adjusted upward. The 70% figure is not a substitute for a thorough analysis of your income needs after retirement, but is only a guideline.

Here are some suggestions for estimating how much of an income stream you will want to have coming in after retirement:

Figure Your Current Annual Expenses. The first step in trying to figure out what your annual expenses will be after retirement is to figure what your expenses are now. Take a year’s worth of checkbook, credit card, and savings account records, and add up what you paid for insurance, mortgage, food, household expenses, and so on.

Figure Out How Your Expenses Will Differ After Retirement. After you retire, your expenses will generally be a lot lower than they are while you are working. To help determine how much lower, here are some questions you might ask yourself :

  • Will your mortgage be paid off?
  • Will you still be paying for commuting expenses?
  • How much will you pay for health insurance?
  • Will you increase or decrease your life insurance coverage?
  • How much will you pay for travel expenses? (Do you want to travel after you retire, either on vacation or to visit relatives? Will you be commuting between a winter or summer home?)
  • Will you be spending more on hobbies after retirement?
  • Will your children be financially independent by the time you retire or will you have to factor in some sort of support for them?
  • Will your income tax bills be the same, lower, or higher?

The answers to these questions will help you determine your estimated annual expenses after retirement. Then subtract from this estimate the anticipated annual income from already-viable sources. (Do not subtract the lump-sum payments you expect to receive—e.g., lump sum payments from 401(k) plans, which will be discussed later). The difference is the annual shortfall that will have to be financed by the nest egg you will need to accumulate.

How do you determine how much you need to save each year to accumulate a nest egg of that size by retirement age? You can do this by using the table below (which, assumes an after-tax return of 5% per year). Just multiply the required nest egg by the Savings Multiplier for the number of years until retirement.

Example: You are 40 years old and want to retire at age 65. You determine that you need a nest egg of $350,000 to fund your annual shortfall. To find out how much you must save each year to have that $350,000 nest egg by the time you are 65, multiply $350,000 by the 25-year savings multiplier (2.1%). You will need to save $7,350 (2.1% times $350,000) a year for 25 years.

Subtract from this nest egg any lump sums that you expect to receive at retirement. To project the value at retirement of a present asset (retirement account, savings, investments, etc.), multiply the current value of this asset by the Growth Multiplier for the number of years until retirement.

Example: You already have $75,000 in a 401(k) plan. To find out what that amount will grow to in 25 years, multiply it by the growth multiplier for 25 years. This $75,000 will grow to $254,250 (339% times $75,000) by the time you retire. Subtract this $254,250 from the $350,000 needed in the previous example. This amount ($95,750) is the amount you must accumulate by age 65 to meet the income shortfall. Multiply this $95,750 by the 25-year savings multiplier (2.1%). You now know that, after taking the projected lump sum into consideration, you will still need to save $2,010.75 per year to accumulate $95,750.

Years Until Retirement Savings Multiplier Growth Multiplier
5 18.1% 128%
10 8.0% 163%
15 4.6 208
20 3.0 265
25 2.1 339
30 1.5% 432%

Choose Your Investment Vehicles
 

How much risk is too much? Only you can answer that question.

If you have a lot of time to prepare for retirement, generally, more of your savings should be invested in vehicles with a higher growth potential. If you are very close to or at retirement, you may wish to put the bulk of your savings into low-risk investments.

However, your tolerance for risk, your income level, your other sources of retirement income, and your unique needs will lead you toward the investments that fit you best.

You have several options for savings for your retirement. How do you know what to do? Here’s one common approach:

First, contribute enough to your employer-sponsored plan to earn the maximum match.

Often, your employer will match your contributions up to a certain limit. Take advantage of the maximum amount of employer money by contributing the highest amount you are allowed to contribute. The advantages of this strategy include the employer match being “free” money to you and the match grows tax-deferred until you withdraw it (ideally when you use it during retirement). The disadvantage is that you might forfeit all or much of the employer match amount (and the earnings on them) if you do not work for that employer for a certain amount of time.

Second, contribute as much money to your employer-sponsored plan as you can afford.

You usually can contribute money to your employer-sponsored plan even beyond the amount that qualifies for the company match. Although you will not earn “free” employer money, your contributions are often contributed pre-tax, meaning you do not pay taxes on your contribution until you use it. This allows you to pay fewer taxes now and you have a higher dollar amount with which to earn tax-deferred earnings. The systematic payments from your paycheck are also less noticeable to you, so you are more apt to continue contributing. The disadvantage may be the choice of investment options you have.

Third, use IRAs to accumulate long-term savings.

If you have maximized your employer-sponsored retirement plan, you can still contribute money to a retirement vehicle that provides tax advantages. Individual Retirement Accounts, or IRAs, are available through a wide variety of companies, including many banks and financial companies. Depending on your other tax-free retirement activities, contributions to your IRA may or may not be tax deductible, but the earnings in a qualified IRA are always tax-deferred. Beginning in 2008, individuals can contribute up to $5,000 per year, (married couples $10,000 per year) to your IRA. If you are over age 50, you might also qualify to make an additional $1,000 per year in “catch-up” contributions.

Other options if you still want to save.

f the first three options do not get you to your projected goal, you have several other options from which to choose. Annuities and some life insurance policies can provide a savings vehicle and offer unique tax advantages as well. You might be interested in investing in stocks, bonds, or mutual funds. You also might be eligible for a salary continuation plan or nonqualified deferred compensation plan through your employer. Each of these options has certain tax implications that you will want to examine more closely before you use them in your retirement investment strategy.

© Forefield, Inc.

Determine Your Investment Strategy
 

What’s worse than not investing for retirement? Investing without a plan.

Once you know how much you want to have and when you want it, you have many different options to get you there. Some have tax advantages while others require you to pay taxes now.

Very briefly stated, here are the various retirement-savings investments and their pros and cons.

Tax-Deferred Retirement Vehicles

Each year, maximize your deposits in a 401(k) plan, an IRA, a Keogh plan, or some other form of tax-deferred savings. Because this money grows tax-deferred, returns will be greater. Further, if the amount you put in is deductible, you are reducing your income tax base.

Lowest Risk Investments

Money market funds, CDs, and Treasury bills are the most conservative investments. However, of the three, only the Treasury bills offer a rate that will keep up with inflation. For the average individual saving for retirement, it is recommended that these vehicles make up only a portion of investments.

Bonds

Bonds provide a fixed rate of income for a certain period. The income from bonds is higher than income from Treasury bills.

Bonds fluctuate in value depending on interest rates, and are thus riskier than the lowest risk investments. If bonds are used as a conservative investment, it is a good idea to use those of a shorter term, to minimize the fluctuation in value that might occur.

Stocks

Although common stock is riskier than any other investment yet discussed, it offers greater return potential.

Mutual Funds

Mutual funds are an excellent retirement savings vehicle. By balancing a mutual fund portfolio to minimize risk and maximize growth, a higher return can be achieved than with safer investments.

© CPA Site Solutions

Understand Your IRA Options

IRA’s have been around for years. Is it time for you to have one?

An individual retirement arrangement (IRA) is a personal savings plan that offers specific tax benefits. IRAs are one of the most powerful retirement savings tools available to you.

Even if you're contributing to a 401(k) or other plan at work, you should also consider investing in an IRA.

What types of IRAs are available?

The two major types of IRAs are traditional IRAs and Roth IRAs. Both allow you to contribute as much as $4,000 in 2006 and 2007. You must have at least as much taxable compensation as the amount of your IRA contribution. But if you are married filing jointly, your spouse can also contribute to an IRA, even if he or she does not have taxable compensation. The law also allows taxpayers age 50 and older to make additional "catch-up" contributions. These folks can contribute up to $5,000 in 2006 and 2007.

Both traditional and Roth IRAs feature tax-sheltered growth of earnings. And both give you a wide range of investment choices. However, there are important differences between these two types of IRAs. You must understand these differences before you can choose the type of IRA that's best for you.

Note: If you were affected by Hurricanes Katrina, Rita, or Wilma, or if you are a reservist called to active duty after September 11, 2001 and before December 21, 2007, special rules may apply to you.

Learn the rules for traditional IRAs.

Practically anyone can open and contribute to a traditional IRA. The only requirements are that you must have taxable compensation and be under age 70½. You can contribute the maximum allowed each year as long as your taxable compensation for the year is at least that amount. If your taxable compensation for the year is below the maximum contribution allowed, you can contribute only up to the amount that you earned.

Your contributions to a traditional IRA may be tax deductible on your federal income tax return. This is important because tax-deductible (pretax) contributions lower your taxable income for the year, saving you money in taxes. If neither you nor your spouse is covered by a 401(k) or other employer-sponsored plan, you can generally deduct the full amount of your annual contribution. If one of you is covered by such a plan, your ability to deduct your contributions depends on your annual income (modified adjusted gross income, or MAGI) and your income tax filing status. You may qualify for a full deduction, a partial deduction, or no deduction at all.

What happens when you start taking money from your traditional IRA? Any portion of a distribution that represents deductible contributions is subject to income tax because those contributions were not taxed when you made them. Any portion that represents investment earnings is also subject to income tax because those earnings were not previously taxed either. Only the portion that represents nondeductible, after-tax contributions (if any) is not subject to income tax. In addition to income tax, you may have to pay a 10 percent early withdrawal penalty if you're under age 59½, unless you meet one of the exceptions.

If you wish to defer taxes, you can leave your funds in the traditional IRA, but only until April 1 of the year following the year you reach age 70½. That's when you have to take your first required minimum distribution from the IRA. After that, you must take a distribution by the end of every calendar year until you die or your funds are exhausted. The annual distribution amounts are based on a standard life expectancy table. You can always withdraw more than you're required to in any year. However, if you withdraw less, you'll be hit with a 50 percent penalty on the difference between the required minimum and the amount you actually withdrew.

Learn the rules for Roth IRAs.

Not everyone can set up a Roth IRA. Even if you can, you may not qualify to take full advantage of it. The first requirement is that you must have taxable compensation. If your taxable compensation for the year is at least $4,000 (for 2006 and 2007), you may be able to contribute the full $4,000. But it gets more complicated. Your ability to contribute to a Roth IRA in any year depends on your MAGI and your income tax filing status. Your allowable contribution may be less than the maximum possible, or nothing at all.

Your contributions to a Roth IRA are not tax deductible. You can invest only after-tax dollars in a Roth IRA. The good news is that if you meet certain conditions, your withdrawals from a Roth IRA will be completely income tax free, including both contributions and investment earnings. To be eligible for these qualifying distributions, you must meet a five-year holding period requirement. In addition, one of the following must apply:

  • You have reached age 59½ by the time of the withdrawal
  • The withdrawal is made because of disability
  • The withdrawal (of up to $10,000) is made to pay first-time home-buyer expenses
  • The withdrawal is made by your beneficiary or estate after your death

Qualifying distributions will also avoid the 10 percent early withdrawal penalty. This ability to withdraw your funds with no taxes or penalties is a key strength of the Roth IRA. And remember, even non qualifying distributions will be taxed (and possibly penalized) only on the investment earnings portion of the distribution, and then only to the extent that your distribution exceeds the total amount of all contributions that you have made.

Another advantage of the Roth IRA is that there are no required distributions after age 70½ or at any time during your life. You can put off taking distributions until you really need the income. Or, you can leave the entire balance to your beneficiary without ever taking a single distribution. Also, as long as you have taxable compensation and qualify, you can keep contributing to a Roth IRA after age 70½.

Choose the right IRA for you.

Assuming you qualify to use both, which type of IRA is best for you? Sometimes the choice is easy. The Roth IRA will probably be a more effective tool if you don't qualify for tax-deductible contributions to a traditional IRA. However, if you can deduct your traditional IRA contributions, the choice is more difficult. The Roth IRA may very well make more sense if you want to minimize taxes during retirement and preserve assets for your beneficiaries. But a traditional deductible IRA may be a better tool if you want to lower your yearly tax bill while you're still working (and probably in a higher tax bracket than you'll be in after you retire). A financial professional or tax advisor can help you pick the right type of IRA for you.

Note: You can have both a traditional IRA and a Roth IRA, but your total annual contribution to all of the IRAs that you own cannot be more than $4,000 for 2006 and 2007 ($5,000 in 2006 and 2007, if age 50 or older).

Know your options for transferring your funds.

You can move funds from an IRA to the same type of IRA with a different institution (e.g., traditional to traditional, Roth to Roth). No taxes or penalty will be imposed if you arrange for the old IRA trustee to transfer your funds directly to the new IRA trustee. The other option is to have your funds distributed to you first and then roll them over to the new IRA trustee yourself. You'll still avoid taxes and penalty as long as you complete the rollover within 60 days from the date you receive the funds.

You may also be able to convert funds from a traditional IRA to a Roth IRA if your MAGI for the year is $100,000 or less (the $100,000 income limit will be eliminated for tax years after 2009). This decision is complicated, however, so be sure to consult a tax advisor. He or she can help you weigh the benefits of shifting funds against the tax consequences and other drawbacks.

Note: The IRS has the authority to waive the 60-day rule for rollovers under certain limited circumstances, such as proven hardship.

© 2003 Forefield, Inc.

Analyze Annuity Options
 

Annuities provide guaranteed income for life. See whether they’re for you.

Annuities may help you meet your retirement goals. But before you buy one, learn how they work, what types are available, and which might be suitable for your needs.

How Annuities Work

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

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.

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.

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

How Payouts Are Taxed

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 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.

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.

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.

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.

© CPA Site Solutions