If you have a 401k or a Roth IRA, you probably feel like you’re doing all you can to prepare yourself financially for retirement, don’t you? This may be the case, but you could also benefit from integrating an annuity into your savings plan.
So how do you know if you need an annuity?
Let’s take a look at the basics of these unique used vehicles, how they work, and more importantly, if you would benefit from owning one.
What is an annuity?
An annuity, by definition, is simply an agreement to make a series of payments of a certain amount of money to a specific party over a predetermined period of time. Annuities also refer to a commercial insurance contract offered by a life insurance company.
Purpose of annuities
Annuities are designed to insure the policyholder against retirement risk – that is, the survival of their income. Older investors who have no more money to support themselves face a terrible dilemma. Therefore, annuities were created to mitigate this risk.
These contracts are guaranteed to pay at least a certain minimum amount periodically to the beneficiary until death, even if the total payments exceed the amount paid on the contract plus accrued interest or income. Because of this type of protection and the fact that you cannot withdraw funds without penalty before the age of 59.5, annuities are inherently considered to be retirement savings vehicles.
History of annuities
Annuities have existed in one form or another since the Roman Empire. The citizens of the time bought annual contracts from the emperor. They would pay a lump sum to the Roman government in exchange for an annual payment for the rest of their lives. European governments also offered a series of payments to investors in exchange for a lump sum investment now as a way to finance their wars in the 17th century.
Annuities arrived in the United States in the 18th century as a means of supporting church ministers. A Pennsylvania life insurance company was the first insurance company to market commercial annuity contracts to the public in 1912. Fixed annuities grew in popularity over time and became a mainstay of conservative investors. Although the first variable annuity was created in 1952, it did not become mainstream until the 1980s, and they were followed by indexed contracts in the 1990s.
Basic characteristics of annuities
Although there are many types of annuities, all annuity contracts are similar in several ways.
- They stand out as the only commercially available investment vehicle that thrives on a tax-deferred basis without having to be placed in some type of IRA, qualified pension plan or the like.
- Unless the contract is held in an IRA or Qualified Pension Plan, there is no limit to the amount of money that can be invested and contributions are not deductible. (Of course, most annuity holders have property limits on how much they’ll accept, but this typically hovers around $ 5 million.)
- Most annuity contracts also contain a decreasing ransom fee schedule that eventually disappears after a set period of time, such as 5 or 10 years. For example, a 10-year fixed annuity contract may impose an early withdrawal penalty of 7% for amounts withdrawn in the first year of the contract, a penalty of 6% for amounts withdrawn in the second year, and so on until the ransom fee schedule. expired. Variable and indexed annuities generally charge a similar fee for early withdrawals. However, many contracts will allow the investor to withdraw 10-20% of the capital each year without penalty in order to alleviate this restriction as long as the investor is at least 59 and a half years old.
Purchase of annuities
Annuity contracts can be purchased inside or outside of an IRA or Qualified Plan. In both cases, a check is issued to the bearer of the annuity. They can also be purchased through Exchange 1035, where an expiring contract on a previous annuity policy, life insurance policy, or endowment policy is transferred tax-free to an annuity policy with your preferred company. . As with life insurance, any type of life insurance with a cash value, such as multi-risk, universal or variable universal insurance, can also be surrendered for an annuity.
How annuities work
Because these products were originally designed, the contract owner made a lump sum payment or series of payments on the contract and then started receiving payments at retirement. Annuity payments are used to purchase units of accumulation within the contract, which, as the name suggests, are accumulated in the contract until the payments are due to the beneficiary.
Then a one-time event known as annualization takes place. This event marks the conversion of capitalization units into annuity units, which annuity contracts can pay out to beneficiaries in different ways. Either way, the policy owner essentially exchanges the dollar amount of their annuity for a series of guaranteed payments. This means that they forgo access to the larger lump sum to receive guaranteed income for life. Beneficiaries can choose from several types of payment options, including:
- The righteous life. The contract will pay the beneficiary an amount calculated actuarially based solely on their life expectancy. This amount will be paid even if the total payment exceeds the amount paid plus interest or other income. However, payments cease after the death of the beneficiary, even if an amount less than the value of the contract is repaid. In theory, the insurance company keeps the value of the contract even if the beneficiary dies after receiving a single payment.
- Life with a certain period. The contract will be paid for life or for a certain period, for example 10 or 20 years. This prevents the possibility described above from occurring. If the beneficiary dies shortly after the start of payments, the insurance company must pay the beneficiary the value of certain payments for the period, either as a series of payments or as a lump sum.
- Common life. As with normal life, joint annuities will continue to pay as long as one of the two beneficiaries is alive.
- Common life with certain period. Combine the given pay period with the common life expectancy.
Or, without annualization, policyholders can withdraw money in the following ways:
- Systematic withdrawal. A simple payment of a fixed dollar amount or a percentage of the contract value that is paid annually, either monthly, quarterly or annually.
- Lump sum. As the name suggests, the lump sum is a one-time payment of the total contract value. This payment can be considered as a distribution or carried over to another annuity contract.
Taxation of annuities
As mentioned above, all money placed in an annuity contract grows tax-deferred until retirement, provided the beneficiary is at least 59 and a half years old. Otherwise, a 10% penalty will apply at the time of withdrawal, just like with an early distribution from an IRA or qualified plan.
All distributions, whether early or normal, are also taxed as ordinary income for the beneficiary and are reported on Form 1099-R. The exclusion index is used to calculate the taxation of annuity payments. This formula assigns a proportional amount of each payment made as the principal tax-free return.
For example, if an investor places $ 100,000 in an annuity and the annuity reaches $ 400,000 and then receives monthly payments of $ 500, then $ 125 of each payment will be considered a return of capital and therefore tax exempt. . . The $ 125, or 25% of $ 500, arises from the fact that the initial principal, $ 100,000, constitutes 25% of the present value of the contract, $ 400,000.
However, annuities are not subject to Employee Retirement Income Security Act (ERISA) regulations unless they are placed in an IRA or qualifying plan.
Other benefits of annuities
While their favorable tax status is one of their greatest advantages, annuities also offer other unique advantages. Annuity contracts are exempt from legalization; that is, after the death of the contract holder, the value of the contract will pass to the beneficiary without going through legalization.
Annuity contracts are also exempt from creditors in many cases, although the exact rules in this regard vary somewhat from state to state. Texas is a state that unconditionally renounces these creditors’ contracts; O.J. Simpson lived on the money he had in annuities after the civil lawsuit against him in 1994 (but before his most recent incarceration).
Types of annuities
There are three main types of annuities: fixed, indexed and variable.
- Fixed income annuities pay a guaranteed interest rate like a CD or a bond.
- Equity-indexed annuities promise a portion of any growth in the stock market while securing capital.
- Variable annuities contain sub-accounts of mutual funds that invest in stocks, bonds, real estate, and commodities like precious metals and energy. Unlike the other two types of annuities, the principal is not guaranteed in variable annuities, which means that these annuities can lose value.
Annuities can also be classified as immediate or deferred.
- Payout annuities begin to pay out income to the beneficiary as soon as the contract is purchased
- Deferred pensions do not begin to be paid until later.
The three types of annuities can belong to one of these categories; A fixed annuity can be immediate or deferred, just like an indexed or variable contract.
Do you need an annuity?
The broader answer to this question is that anyone who wants to save more for retirement than what is allowed in their IRA or company pension plan should consider an annuity as an additional funding vehicle.
There are also a few other reasons why those whose employers offer annuity contracts as part of their retirement plans should consider them. For example, annuities can be used as tax shelters by the wealthy and as sources of guaranteed income for downpours.
That said, the restrictions inherent in annuities may make them inappropriate for some investors.
- Fees and expenses. In variable annuities, the investor pays mortality and expense (M&E) fees, sub-account fees and ancillary fees which are selected when opening the account. Because these fees can reduce some income, variable annuities are often not suitable for young investors who are less likely to need insurance benefits.
- Money blocked. When you invest in an annuity, you agree to keep your money there until the surrender period expires and you are at least 59 and a half years old. The insurance company will charge a surrender fee for withdrawing more than the allowed percentage during the surrender period, and the IRS will take 10% if you withdraw before 59 1/2. Make sure you have an emergency savings fund (without penalty) if you decide to invest in an annuity.
- Financial guarantee. Annuities are not FDIC insured, which means they are not federally guaranteed like bank CDs. The promise to guarantee an investor’s capital is only valid through the financial strength of the insurance company. Potential investors should research the financial condition of an insurance company with an independent rating agency such as www.weissratings.com before investing.
- Taxes. When earnings are withdrawn from an annuity, they are taxed as ordinary income and do not benefit from the reduced rate of long-term capital gains.
- Commissions. Unfortunately, even kind-hearted finance professionals can be swayed by their clients’ interest in a large commission. Annuities offer some of the largest in the industry. An investor should trust their financial advisor and weigh the pros, cons and other options before investing.
- Annualization. This is both a bonus and a scam. While the annuity can guarantee a lifelong income stream, it comes at the cost of irrevocably handing over the highest account value to the insurance company.
How should annuities be used in an investment or retirement portfolio?
There is no single correct answer to this question. Not only the investor’s age, time horizon, tolerance for investment risk and other goals must be weighed, but the specific type of annuity in question must also be taken into account.
Certain types of investors may be better off with only guaranteed fixed annuities, while others should look to the growth potential of a variable contract. There is also no recommended investment portfolio allocation percentage for these vehicles, as some investors can get along with every penny of their savings locked in these vehicles, while others should limit their contracts. at a small percentage of the value. .
The proper use and allocation of these products can only be done effectively on a case-by-case basis. There is no one size fits all. Make sure you take enough time to weigh the pros and cons with a trusted financial advisor.
Annuities, like retirement accounts, are a form of insurance that ensures that you receive a steady flow of money long after your working years have ended. Annuities have many benefits and provide secure retirement savings to millions of Americans every year.
If you want more information or want to know if an annuity is right for you, talk to your financial advisor. The more financially prepared you are for retirement, the happier your golden years will be.
What do you think of annuities? What percentage of his portfolio do you think they should be?