If you’re a regular reader of the financial media, you’ve probably seen headlines or pop-up ads about annuities. Sometimes, the message is that if you don’t have an annuity, you’re missing out on the greatest retirement funding idea since the invention of currency. On the other hand, the message might be that you should never purchase an annuity if you value your financial health.
Obviously, both assessments can’t be true. While it is true that annuities, if misunderstood, can create challenges, it is also the case that in certain instances, annuities can be a very useful tool in your overall financial strategy. Let’s take a look at some annuity basics and consider a few examples for how various types of annuities might be incorporated into someone’s financial plan.
What it is: At its most basic, an annuity is simply an agreement to provide a specified amount of income each year for a certain period of time—typically, the rest of the recipient’s life. In financial terms, annuities are contracts issued by life insurance companies, and they come in several different types.
Immediate annuity. An immediate annuity is a contract that begins paying annual income when a lump-sum amount is deposited according to the terms of the contract. The insurance company guarantees a specified amount of income to be paid annually for the rest of the life of the recipient (the annuitant). The annuitant may choose one of several different payout methods, including:
- Life—guarantees payments for the life of the annuitant.
- Life with period certain—guarantees payments for the life of the annuitant, but with a minimum amount that must be paid out based on a guaranteed term, such as ten years, even if the annuitant dies before the guaranteed term is complete.
- Joint life and survivorship—guarantees payments for the life of the annuitant, with payments also guaranteed for the life of a surviving beneficiary, such as a spouse.
And there are other variations, depending on the specifics of the annuity contract. The option chosen by the annuitant will affect the actuarial calculations of the insurance company and, thus, the amount of the income generated by the annuity. Typically, once the payments begin, they may not be altered except as required by the terms of the chosen payout option.
Deferred annuity. As the name implies, a deferred annuity does not begin paying immediately, but rather accumulates over a period of time before the payouts start. Funds in an annuity accumulate on a tax-deferred basis, meaning that the earnings accrued by the annuity are not taxed until they are withdrawn. A deferred annuity may be funded either in a lump sum or by periodic deposits during the accumulation period. The contract will specify how long the funds must be left on deposit before withdrawals can begin, but most deferred annuities require a minimum accumulation period of 6–10 years, depending on the terms of the contract. You can withdraw funds before the end of this period, but the company will typically impose a penalty in the form of a surrender charge. Also, funds withdrawn from a deferred annuity before age 59 ½ are usually subject to a 10% tax penalty, much like funds withdrawn from an IRA before reaching 59 ½.
Next, let’s consider the different types of deferred annuities: fixed annuities, variable annuities, and indexed annuities. These three types are differentiated by the way value accrues during the accumulation phase, ranging from a fixed rate of interest guaranteed by the insurance company (fixed annuities) to a variable, non-guaranteed rate provided by various types of investments intended to generate growth (with variable annuities) or tied to the performance of a specific financial index (index annuities).
An important basic fact to keep in mind with annuities is that they are issued by insurance companies. Any guarantees are provided by the issuing company, not the government. In other words, it is vital to learn about the financial condition of the insurance company that is offering your annuity. Most insurers will provide their A. M. Best rating and also their rating with Standard & Poor’s, Moody’s, or another recognized rating agency.
Why would someone want an annuity? Here are a few suggestions.
Unlimited tax deferral. Unlike IRAs, 401(k)s, and other retirement accounts, annuities have no limit on the amount of after-tax funds you can deposit into them. For persons seeking to defer taxes on more of their assets, deferred annuities can provide a good solution.
Contractual guarantees. While not backed by the US government or any other taxing entity, annuities often come with a number of guarantees provided by the issuing insurer. Depending on the specifics of the contract, these guarantees may provide downside protection in volatile markets, guaranteed income levels, or other features that may be helpful as part of overall portfolio risk management.
Indefinite tax deferral. Annuities that are not purchased as IRAs or other tax-advantaged retirement accounts have no RMDs; the contract owner may choose to leave the funds on deposit as long as wished. Upon the owner’s death, the funds can be paid to a beneficiary, such as a grandchild, a charity, or a spouse.
Funds pass outside probate. Because annuity contracts have beneficiaries, funds paid upon the death of the annuitant are not subject to the delays of probate.
If you are considering annuities as part of your financial planning, Mathis Wealth Management has the expertise and knowledge to help you choose the type of annuity best suited to your purposes. To find out more with no obligation, please contact us.
All guarantees are based on the financial strength and claims paying ability of the issuing insurance company. This is meant for educational purposes only. Information presented should not be construed as specific investment, tax or legal advice, or a recommendation to take a particular course of action.
