Annuities

Annuity contracts offer investors a safe means of saving for retirement with a low but reliable return. There are two basic choices. The first is to take your savings and make a lump sum payment for an annuity contract. You do this at retirement and the insurance company makes steady payments until the annuity is exhausted or until you die. In general, if you pass away before the annuity is used up, the residual can go to your spouse or estate but this needs to be spelled out in the contract.

The second choice is to make payments over the years into the annuity and defer payments to you until a later date, such as your retirement. Like the first choice, you receive payments until the annuity is used up or you pass away in which case the residual money typically goes to your estate.

In each case, you can choose when to start taking payments, either immediately or at a later date. When you go looking for an annuity, you will be told this a tax-deferred investment vehicle. The money you put it gains interest, so you receive more in the end than what you put in. However, your taxes are due on receipt of payments when you are retired and in a lower tax bracket. (Similar to an IRA or 401k)

Types of Annuities

There are three types of annuities. These are fixed, variable, and indexed. Fixed and variable are the most common. Indexed annuities are a hybrid and also called equity-indexed annuities or fixed-index annuities. Variable annuities are considered securities and subject to regulation by the Financial Industry Regulatory Authority.

Depending on who you purchase an annuity from, you may pay a commission as high as 7% as well as administrative fees. There are commonly surrender charges, mortality charges, and “expense risk” charges as well.

Fixed Annuities

A fixed annuity is an insurance product. You put in your money and receive a guaranteed rate of return. This return is based on your life expectancy, age, and the current interest rate. Other factors may also come into play, depending on who you are dealing with.

Variable Annuities

Although a variable annuity has insurance features attached, it is an investment product. You will choose from a wide range of investment choices including mutual funds. In this case, your payments will depend on how well the investment vehicle does over the years. And, this is why variable annuities are regulated as securities.

Indexed Annuities

You may like the idea of a variable annuity because of the potential of a better return than for a fixed annuity. But, then you worry that the investment (and your retirement savings) could be wiped out. Indexed annuities provide a guaranteed minimum interest rate return on your annuity capital as well as a higher rate which is typically market index-linked.

In regard to annuities pros and cons, indexed annuities may be the best option. But, they come in all shapes and sizes so they can be difficult to understand. And, when you are investing your retirement savings in something, you need to understand it!

Annuity Taxation

A common approach to retirement savings using an annuity is to use one in your IRA. When you do that, the IRA rules apply. This is “pre-tax” money so taxes on the initial investment, as well as earnings, are due upon withdrawal. Like with other IRAs, you are taking the money in your retirement years so your tax rate will be lower. Unfortunately, annuity payments are subject to normal taxes and not taxed as capital gains. The good side will be your low tax rate at the time.

If you put previously taxed money into your annuity, only the income from the annuity is taxable upon withdrawal.

It is a good idea to run this by your tax preparer before choosing an annuity and before withdrawing money.

Annuity Exclusion Ratio

Here is where an annuity may or may not work to your benefit but also gets complicated. Because an annuity is in total or in part an insurance vehicle, the exclusion ratio applies. For example, you put $50,000 into an annuity. You receive $5,000 a year for ten years (simply getting your money back) and this money is not taxed. When you start receiving payments the next year, this is considered income and is taxable. Again, discuss this with your tax preparer.

Annuities Pros and Cons

If what you want for retirement is a totally safe investment vehicle that will not crash with the stock market or real estate, a fixed annuity is a good choice. You can put it in the same class as a bank CD, US Treasury or AAA corporate bond. The only concern is the health of the insurance company.

If you want to stay in this kind of investment but get a better return, then things get a little murky. You will start seeing rather high fees and commissions and will get tied into investment vehicles like mutual funds that have commonly not done as well as the S&P 500 in recent years.

The fact is that you don’t need to go with just one investment approach in your earning years or in retirement. Rather, you could choose the totally safe route of CDs, bonds, or fixed annuities for a part of your investment portfolio. Then, other passive investment options include ETFs which have a much lower carrying cost than mutual funds.