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Annuities are money contracts between you
and an insurance company. You contribute a sum of money to your contract, and the
insurance company provides income payments according to the type of annuity you purchase.
This security comes at a price, however.
Traditionally, annuities have higher costs than other retirement vehicles. The trick to
buying annuities is knowing your income and investment objectives, and your annuity's tax
and estate-planning implications.
The three main types of annuities are fixed, variable, and
immediate. But the annuity product line is broad, rounded out by several other options,
including charitable gift annuities, split and joint annuities, and some 403(b) plans
known as tax-sheltered annuities, which are the granddaddy of tax-sheltered retirement
plans.
Since investors can use annuities in a variety of different
ways, and because they have a few considerable drawbacks, it is essential for would-be
buyers to understand the ins and outs of opting for an annuity. For those seeking the
peace of mind of a guaranteed income stream, they can be a very useful tool.
Annuities take different forms, but common features include
unlimited contributions when purchased outside employer-sponsored retirement plans,
flexible distributions, and lifetime income. They also bear interest and offer
tax-deferred gains.
The Umbrella Analogy
Created with the distinct purpose in mind of helping
shelter your money from taxes, an annuity offers guaranteed income that a person cannot
outlive.
Annuities offer deferred income tax on gains from an
interest-bearing account, just like other retirement-saving investments, such as 401(k)s
and IRAs, but can be used for more than retirement income. Annuities can be set up to
provide income for any set period of time the investor chooses.
"Annuities have been around for long time … and
were used as tax shelters in the early 80s by professional athletes who knew they wouldn't
be playing in ten years and would need some income at 35," explains Larry Beltramo, a
certified financial planner with Regency Securities in Irvine, Calif.
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"The fixed annuity is usually for
the more conservative investor who wants to supplement their retirement income and lower
their income tax rate after age 59ý."
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| —Larry
Beltramo, certified financial planner with Regency Securities in Irvine, Calif. |
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Beltramo said that annuities were first used by high
net-worth individuals before the tax law changed to make the minimum age for distribution
59ý. This change put annuities on the same playing field with other retirement vehicles,
and it was then that consumers began scrutinizing annuities' cost.
"People will complain about costs ... but still buy
them for their guaranteed income and interest. Despite higher costs, than say, a municipal
fund, the tax-deferred status of annuities makes them popular," Beltramo added.
So how are annuities different from other retirement-saving
plans? The answer depends on the type of annuity.
You Are the "Owner"
Anyone who buys an annuity is called a contract
"owner." There are three main types of annuities investors can own.
A fixed annuity pays a fixed amount to the owner for
the life of the contract. The contract money is held in the insurance company's fixed
account, also called the "guaranteed" account. This makes fixed annuities very
secure, and, since account returns are determined by a locked-in interest rate, very
predictable. And, if the annuity is structured properly, the death-benefit proceeds pass
to the owner's named beneficiary.
Fixed-annuity owners are "ultra conservative,"
says Beltramo. "This investment is a little more aggressive than a CD (certificate of
deposit) and since it is longer term, with tax benefits, would be used for supplementing
retirement income or lowering a high-income tax rate after age 59ý."
A variable annuity gives the contract owner these
benefits, as well as deferring taxation on any capital gains. Variable annuities have the
potential of higher returns than the interest rate locked in with a fixed annuity,
depending on market performance.
The insurance company offers a range of portfolios for
variable annuities, from conservative to aggressive. Contract owners design a portfolio
that matches their risk/return profile, and the account can potentially gain from stocks,
bonds, or other securities — with tax-deferred status.
Variable annuities also have a fixed-account option, which
provides that a portion of the portfolio be held in the insurance company's
"guaranteed" account — offering some asset-allocation stability. Again, if
the contract owner dies, this annuity can be set up so that the beneficiary receives the
portfolio's current value. However, if the contract owner dies during the pay-out phase of
a "life-span" or life-variable annuity, the insurance company will keep the
remaining account balance.
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If you need one of the various options
provided with annuities, which aren't provided with other retirement plans, the annuity's
extra cost may be worth it to you.
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Both fixed and variable annuities can offer stability or
long-term gains, and can be structured with the income payment plan that suits the owner.
When the distribution schedule is set up, owners can choose either a single payment or
payments over a fixed number of years. And, you don't have to be a contract owner to
receive income. Systematic income payments can be guaranteed for the rest of the owner's,
and/or their spouse's, life.
What if the annuity owner needs payments right now? This
investor might choose an immediate annuity.
Purchased with either a single, lump-sum payment or a
payment schedule, immediate annuities are structured to begin paying out within 12 months.
In contrast, payout schedules on fixed and variable annuities can begin five, 10, or 20
years after being purchased, and payments can be received monthly, quarterly,
semi-annually, or annually.
According to Beltramo, the annuity you select depends
heavily on your income and tax-deferral needs.
"The fixed annuity is usually for the more
conservative investor who wants to supplement their retirement income and lower their
income tax rate after age 59ý. The variable-annuity investor is usually a younger
retiree, age 50 or younger, who is maxing out their 401(k) but needs income because they
have already retired," said Beltramo.
The Money Contract
If you buy an annuity with after-tax money, the interest
grows tax deferred. Taxes are paid on the interest gained at withdrawal.
You can, if you want the security of never running short of
retirement money and a fixed interest rate, roll your 401(k), Keogh, or IRA money into an
annuity, thereby "purchasing" it with pre-tax dollars.
This approach has disadvantages. Interest rates aside, you
are essentially trading one tax-deferred account for another. The catch is that with an
annuity you will almost certainly pay higher maintenance fees than with a 401(k) or an
IRA.
However, if you need one of the various options provided
with annuities, which aren't provided with other retirement plans, the annuity's extra
cost may be worth it to you.
Recent figures from Lipper Analytical state that the
average costs for a variable annuity run about 0.6% above the cost of most mutual funds,
but just as there are now "no-load" (no sales charge) mutual funds, consumers
can find "no-load" annuities.
Additionally, annuity buyers should be aware of all types
of sales charges, including contingent deferred sales charges, which are surrender costs
that are paid out over the first several years of an annuity contract.
Most insurance companies charge this surrender fee, which
averages at about 5.5% of the contract value, but the term "contingent deferred sales
charge" means that this surrender fee is phased out after you've been in the annuity
for a set number of years.
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"The variable-annuity investor is
usually a younger retiree, age 50 or younger, who is maxing out their 401(k) but needs
income because they have already retired."
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| —Larry
Beltramo, certified financial planner with Regency Securities in Irvine, Calif. |
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If you do want to cash out early, the IRS will take 10% of
the contract value, thereby lowering your lump-sum distribution. And, it's important to
remember the other tax implications of annuities — that retirement-plan contributions
(401(k), 403(b), and Keogh plans) aren't tax deductible.
Other potential tax implications include the possibility of
a "state premium tax" that is imposed upon the accumulated value of the annuity
policy or the purchase payments. Not all states have this tax, so to be aware of all
potential costs of your annuity, check with the company issuing your annuity for the
current tax status of the policy.
Any other factors that could impact payouts, either early
or down the road?
Life expectancy will determine the size of your
distributions if you elect to take payments, as opposed to a lump sum, from your variable
annuity. Also, higher fees could mean it takes longer for this type of investment to pay
off, and there are yearly contract charges, usually around $25.00. Every annuity charge
makes this product less profitable, for the time being. Therefore, annuities, in general,
may be better suited to being held for the long term.
Annuities Online, a Cornerstone Financial Products
publication, illustrates the long-term compounding potential of annuities:
Shopping Tips
After reviewing all the potential factors, including fees,
tax implications, and time horizon, you can decide which annuity is best for your
situation. Some of the options listed below may help you further tailor your annuity to
fit your needs.
With a split annuity your original principal is
restored at the end of the guaranteed period. The split-annuity owner then begins the
contract over, at current interest rates.
Joint annuities make payments to an owner and a
co-owner. And, you can make a gift of annuities with a charitable gift annuity.
Cash donations that fund this annuity entitle the person making the gift to claim a
charitable income tax deduction, and, you can elect to defer the annuity's income or
choose to have your gift's payments begin immediately.
The income options available in annuities include
"life span" which is the term for setting up income payments for the remainder
of the owner's life. There are also five-, 10-, or 20-year "certain" options,
for payments made for a certain time period. And, investors can also choose either a
single- or joint-life annuity, depending on whether they want a co-owner on the annuity.
These options, among other features, for instance, a systematic
withdrawal plan, can be applied to fixed, variable, and immediate annuities.
Beltramo makes these recommendations when shopping for any
type of annuity:
"Ask yourself, what is the company going to offer you?
What is your life expectancy, and what are your needs? There are higher payments for
single life and 10- or 20-year certain, and lower payments for life span. The individual
purchasing an annuity should look at what the interest rate is, and what deal the company
will give them on costs, because those rates are for the life of the annuity,"
advises Beltramo.
If you know what you want from your money today, as well as
in the future, a crystal ball is not necessary when buying annuities.
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