Everything You Always Wanted to Know About Annuities But Were Afraid to Ask!

Annuities are not short-term investment strategies, and will work best for those whose goals are long-term financial security, steady income stream during retirement, and principal preservation. After the Great Depression, folks worried that stock market volatility would threaten their retirement savings and so annuities became popular. Today, pension plans are less common so many retirees believe annuities may be a good option to guarantee income and provide cash flow.

There’s little about annuities that’s simple. Annuities and the rules under which they operate can be complicated. It’s important to understand the different types and how they work, and a lot to consider before making a decision.

THREE KEY POINTS

1. Immediate annuities pay income right away, while deferred annuities pay it at some future date.
2. Annuities provide tax-deferred investment growth, but you have to pay income taxes on the money when you withdraw it.
3. Most annuities penalize investors for early withdrawals, and may have high fees

Overview of Annuities

An annuity is a contract between the annuitant (contract holder) and an insurance company. For your contributions or premiums, the insurer agrees to pay out a certain amount of money for a specified period. Many think of annuities as a kind of retirement-income insurance, guaranteeing them a regular income stream after they’ve left the workforce.

The primary benefits of buying an annuity include principal protection, guaranteed lifetime income and the option to leave money to your beneficiaries. Some annuities may also be optimized to help pay for long-term care.

Most annuities also offer tax advantages. The investment earnings grow tax-free until you begin to withdraw income. This feature can be attractive to retirement savers, who can contribute to a deferred annuity for many years and take advantage of tax-free compounding in their investments with guaranteed cash flows paid out in the future.

Annuities typically have provisions that penalize investors if they withdraw funds early. Also, tax rules generally encourage investors to postpone withdrawals until they reach a minimum age. However, most annuities allow investors to make withdrawals for qualified purposes without penalty, and some annuity contracts have provision for withdrawals of up to 10% – 15% for any purpose per year without penalty.

Annuities can provide more tax-sheltered ways to save for retirement if you’ve already maxed out your 401(k) and individual retirement account, or IRA. Since annuities have no contribution limits, you can save to your heart’s content.

Qualified annuities are funded with pre-tax dollars, and non-qualified annuities with post-tax dollars.

How an Annuity Works

Annuities basically transfer risk from the owner (annuitant) to the insurance company, and you pay the company premiums to bear this risk. Premiums can be a single lump sum or a series of payments, depending on the type of annuity. You don’t pay annuity premiums indefinitely. Eventually, you stop paying the annuity and the annuity starts paying you.

Annuities can be structured to trigger payments, 1) for a fixed number of years to you or your heirs, 2) for your lifetime until you and your spouse have passed away, or 3) a combination of both lifetime income with a guaranteed “period certain” payout. Number 3 pays you income for life, but if you die during a specified time frame (the period certain years), the annuity will pay your beneficiary the remainder of your payments for the contractual period chosen when you set up the annuity. Lifetime income streams are based on the recipient’s life expectancy, with smaller payments received over longer periods. So the younger you are when you start receiving income, the longer your life expectancy is, or the longer the period certain term is, the smaller your payments will be.

Payments can be monthly, quarterly, annual or even a lump sum. They can start immediately or they can be postponed for years, even decades.

How Annuities and Life insurance Differ

Life insurance and annuities are both issued by insurance companies, but they serve opposite purposes. Life insurance provides lump sum fiscal benefits to loved ones after you die, while annuities are designed to provide a lifetime of guaranteed income stream as a benefit while you are still living. An annuity protects against the financial risk of living a very long life, while life insurance provides for beneficiaries in the event of a death. Both products are often marketed as tax-deferred alternatives to traditional stock and bond investments. They each also have high expenses that can blunt investment returns.

Main Types of Annuities

There are two main types of annuities: deferred and immediate. Deferred annuities provide a stream of income later, while immediate annuities provide income now. The type of annuity you purchase determines your future annuity payments:

1. Immediate annuity: an annuity that is annuitized, meaning converted to an income stream for the buyer, (almost) immediately. Although it’s annuitized immediately, it doesn’t start paying income right away. You make a single lump sum payment to the insurance company and it begins paying you income one annuity period after purchase, which can be 30 days to one year later. The period is based on how often you elect to receive income payments. If you choose monthly payments, your first immediate annuity payment will come one month after you buy it.
2. Deferred annuity: an annuity that begins paying income at a future date determined by the owner. Deferred annuities provide tax-advantaged saving and lifetime income. With a deferred annuity, you begin receiving payments years or decades in the future while your premiums grow tax-deferred inside the annuity. Beneficial to supplement IRAs and employer retirement plan contributions because most annuities have no IRS contribution limits.

Within the deferred and immediate categories are fixed and variable annuities:

• Fixed annuities pay a guaranteed minimum rate of return and provides a fixed series of payments under conditions determined when you buy the annuity. Because your rate of return is guaranteed, the insurance company bears all of the investment risk with fixed annuities.
• Variable annuities depend on performance and the eventual return is based on underlying investments in mutual funds.
• Fixed indexed annuity: an annuity that has a minimum guaranteed rate of return with total returns based on an underlying index like the S&P 500. These annuities claim to blend the secured returns of fixed annuities with the potential stock market upside of variable annuities. Marketed as the best of both worlds with the potential for upside but no downside, they are complicated products with limited potential and protection.

Penalties May Apply

Annuities have surrender charges if you withdraw your money early. Surrender periods vary from two years to 10 or more, and the corresponding charges typically decline with time. However, most companies give you access to at least the interest, with many allowing you access after 12 months to either 10% of your original premium deposited or 10% of your account value.

Just like with IRAs and 401(k)s, earnings withdrawn before age 59½ may be subject to a 10% federal tax penalty. Likewise, annuity income is taxed as ordinary income the year it’s received.

Investment Risk

Not all annuities guarantee a fixed rate of return. With a variable annuity, your premiums are invested in a variety of subaccounts, similar to mutual funds. The annuity’s rate of return is based on the performance of these subaccounts. The insurance company does not guarantee variable annuity rates, so you bear the investment risk. You have the opportunity for higher returns here than in a fixed annuity, but be wary because markets are volatile. A variable annuity gives you some control and the ability to participate in the stock market and still enjoy the tax-deferred, income benefits of annuities. But you might be better off holding low cost mutual funds instead of incurring the high fees of variable annuities.

Taxes and Annuities

Annuities are tax-deferred, so you don’t pay taxes on the money while it’s in the annuity. Like a 401(k) or IRA, you only pay taxes on the money when you withdraw it.

If you fund your annuity with pretax dollars, called a “qualified annuity,” then everything you withdraw will be taxed at your ordinary income rates. If, however, you used after-tax dollars to fund your annuity, called a “nonqualified annuity,” you won’t be taxed on the portion of your withdrawal that represents a return of your original principal. Only your earnings will be taxed in a nonqualified annuity.

Annuity Fees and Commissions

Many annuities have no annual fees, but variable annuities do. Most all annuities have commissions built in to the policy so you won’t see the costs taken out each year (ask BEFORE buying). The simpler the annuity, the lower the commission, and the longer the surrender period or more complex the annuity, the higher the commission.

Contract Riders and Additional Benefits

Riders can be used to enhance an annuity’s income, legacy or long-term care provisions. They generally come with a fee and reduce the current income you receive. Living riders provide benefits while the annuitant is alive, while death benefit riders protect beneficiary benefits. For example, an income rider attached to a deferred annuity enables you to turn on your lifetime income stream whenever you want instead of the age you specified when you signed the contract. Income riders often have a guaranteed growth rate during the deferral years, called the roll-up rate. Once you start receiving income, the rate stops growing. With the death benefit rider, if you die before the annuity has returned all of your premium payments, the insurance company will pay your estate or beneficiary the difference.

Premiums and Death

Don’t think for a minute that if you die early, the insurance company keeps your money. Whether you live long or not, annuities are about guaranteed protection. But guarantees are never absolute, so when you buy a retirement annuity, consider the financial strength of the insurer. Stick to insurers that are highly-rated by A.M. Best, Moody’s, Fitch and Standard & Poor’s. States have guaranty associations that cover an insurer’s annuity obligation to a state-determined coverage level limit. While coverage levels vary, most states cover at least $250,000 in present value of annuity benefits. To reduce risk, you could spread your annuity funds among different insurers and keep the amount you have with any one insurer below your state’s coverage limits.

Annuitize Gradually to Reduce Risk

A risk of annuities is opportunity cost. Once you lock in an annuity rate, the market interest rates may rise. Since annuity rates are partly based on 10-year Treasury rates, you could try to time the annuity purchase with interest rates, but then factor in the payments you’re going to miss while you’re waiting. Buy the annuity when you’re ready to transfer risk, you may be waiting a long time for interest rates to rise. One way to mitigate the risk of opportunity cost is by annuitizing gradually. Rather than putting in your full $100,000 as a lump sum, you could start with $50,000 and add the rest later.

Annuities Aren’t for Everyone

Not worried about running out of income? You and Bill gates may not need an annuity. If you’re healthy and you want a stream of income you can’t outlive, or you want to provide security for your spouse or heirs, an annuity may be the right choice. Just don’t put all of your eggs in one basket. Have enough non-annuity money accessible to cover unanticipated expenses and some of your living expenses. If you decide to buy an annuity, do so through a financial advisor – this isn’t recommended as a do-it-yourself task. Make sure you understand exactly what you’re getting, particularly all of the insurance charges, fees and conditions.

• You can lose money in a Variable Annuity because they are investment-based retirement plans. You are investing in stocks, bonds, mutual funds, etc. If the investment performance is negative, you will lose money.
• You can lose money in an Index-Linked Annuity (not to be confused with fixed index annuities) but with limitations. Most contracts have a buffer or floor that limits an individual’s loss each year.
• You cannot lose money in Fixed Annuities, these do not participate in any index or market performance but offer a fixed interest rate similar to a CD.
• You cannot lose money in Fixed Index Annuities which allow owners to grow their retirement savings based on the positive movement of a particular stock or bond index while protecting against a stock market crash. Conversely, if the index performance is negative, the annuity’s value will stay at the same value of the previous year (minus fees).
• You cannot lose money in Income Annuities. Immediate and Deferred Income Annuities are income annuities that do not participate in any accumulation but rather a conversion of money into a stream of paychecks, either now or in the future.

Chart of Pros & Cons of Annuity Types

	Fixed Annuities Provide a fixed interest rate on your investment for a set period	Variable Annuities Provide growth potential of the market through sub-accounts
Immediate Annuities Pay a lump sum and receive guaranteed income right away	Type 1: Immediate Fixed Pros: Receive income right away, simplicity of not needing to monitor investment, know exactly how much money you’ll receive in payout Cons: Payments can end upon the death of the annuitant; may not keep pace with inflation; trading liquidity for guaranteed income	Type 2: Immediate Variable Pros: Guaranteed lifetime income right away, opportunity to benefit from the market, death benefit for beneficiaries Cons: Less common and can be more expensive than other retirement options; monthly payments may fluctuate based on the market
Deferred Annuities Pay a lump sum or income premiums to receive guaranteed income at a set future date	Type 3: Deferred Fixed Pros: Easier to understand; principal protection; payment timing flexibility; tax-deferred growth during accumulation phase; No annual contribution limits; Not impacted by market volatility Cons: Subject to early-withdrawal penalties; may not keep pace with inflation	Type 4: Deferred Variable Pros: Tax-deferred growth during accumulation phase; potential to benefit from the upside of the market Cons: Subject to early-withdrawal penalties; assets subject to market fluctuation

 

Reach Out To Us: The next generation of retirees are living longer, and also approaching retirement with a renewed sense of purpose. So, what does that mean about how we should plan for retirement? With more life to look forward to and more passions to pursue, it’s essential that we build a nest egg that lasts a lifetime. Life insurance and annuities both allow individuals to invest on a tax-deferred basis.

Annuities can help you protect what matters, are highly customizable, and provide guaranteed income later on, so you may be able to take a more aggressive investing strategy with your other assets. Talk to your TFGFA financial advisor about the benefits of annuities as part of your retirement plan as well as what a traditional portfolio of stocks and bonds can contribute to your financial future as well. Questions? We have answers! Contact us at 561-209-1120.

 

TFG Financial Advisors, LLC is a registered investment advisor.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any securities, and past performance is not indicative of future results.  Investments involve risk and are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here.