Annuities...
How They Work and When You Should Use Them...
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.
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Request-PA Insurance Services represents all types of
Annuities from 50 companies.
How Annuities Work
How Annuities Best Serve Investors
The Various Types Of Annuities
Choosing A Payout Option
How Payouts Are Taxed
How To Shop For An Annuity
Costs, Penalties, And Extras
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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.
The two primary reasons to use an annuity as an investment vehicle are:
- You want to save money for a long-range goal, and/or
- 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.
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TIP: The greater the investment return, the less
punishing the 10% penalty on withdrawal under age 59-1/2 will appear. Your variable
annuity investments have grown with late 1990s stock prices, you may want to consider
taking some of those profits (despite the penalty, which applies only to the taxable
portion of the amount withdrawn).
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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.
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CAUTION: A major drawback is that the child is free
to use the money for any purpose, not just education costs. |
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Request-PA Insurance Services represents all types of Annuities from 50 companies.
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.
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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.
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CAUTION: Variable annuities have higher costs than
similar investments that are not issued by an insurance company. |
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TIP: Today, insurers make available annuities that combine both
fixed and variable features. |
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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.
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TIP: Contributions may be tax-deductible (traditional
IRAs) or tax deferred (401(k)s).
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.
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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.
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CAUTION: Once you have chosen a payment option, you
cannot change your mind. |
The size of your payout (settlement option) depends on:
- The size of the amount in your annuity contract,
- Whether there are minimum required payments,
- Your life expectancy (or other payout period), and
- 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.
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:
- Any nondeductible or after-tax amount you put into the plan is not subject to income tax
when withdrawn, and
- 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.
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.
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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.
Be sure to compare the following points when considering an annuity contract:
Sales Commission
Ask for details on any commissions you will be paying. What percentage is the
commission? Anything above 3-5% should be unacceptable. Is the commission deducted as a
front-end load? If so, your investment, as noted above, 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. Charges that go beyond seven years, or that exceed
the above amounts, should not be acceptable.
Other 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, and
- 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.
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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.
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Services represents all types of Annuities from 50 companies.
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