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Annuities:
A Retirement Planning Tool to Consider
When
it comes to deferring taxes, people normally think of retirement
accounts like 401(k)s, Keoghs, SEPs, and IRAs. But there's another
way to defer taxes on your investment earnings until you reach retirement
age: by purchasing an annuity.
What
is an Annuity? An annuity is a contract between a purchaser and
an insurance company. All tax-deferred annuities have two phases:
an accumulation phase and a distribution or payout phase. During
the accumulation phase, your money potentially grows on a tax-deferred
basis. In the distribution or "annuitization" phase, funds
are paid out in installments over a period of time. Earnings that
are generated in your annuity account are then taxed as ordinary
income as they are paid out. Withdrawals taken prior to age 59 ½
may be subject to an additional 10% IRS penalty tax.
Immediate
annuities differ from other annuities in that the distribution phase
begins "immediately," meaning payments start right away.
In most cases, the payout option that best suits the buyer's financial
needs is selected upon purchase.
Purchase
Options Depending on your investment objectives and risk tolerance,
you can purchase either a fixed annuity or a variable annuity. A
fixed annuity is somewhat comparable to a certificate of deposit
in that it offers a guaranteed rate of return for a specified period
of time. Also, a fixed annuity may include an early withdrawal penalty
and surrender charges if not held until the contract matures. However,
the tax-deferred status of the earnings generated in a fixed annuity
account clearly distinguishes it from a CD. CD interest is taxed
yearly. Penalties for cashing a CD before maturity vary by institution.
In addition, bank CDs are FDIC insured and offer a fixed rate of
return. The fixed annuity guarantees are provided by the claims
paying ability of the issuing insurance company.
The
other type of annuity product is a variable annuity. A variable
annuity is an investment vehicle specially designed for your long-term
investment needs and offers multiple investment options. It is considered
a hybrid product, regulated by both the state securities and insurance
divisions. As such, a variable annuity is a contract between a purchaser
and an insurance company and broker-dealer.1
Typically,
the investor can choose among several investment options (stock,
bond and/or money market sub-accounts). Money may be transferred
into and out of the various investment options without incurring
taxes. This makes it possible to respond to changes in your investment
objectives and risk tolerance. Although a variable annuity offers
the potential for higher rates of return than a fixed annuity, it
is subject to market fluctuations and carries the greater risk inherent
in fund investments so that when redeemed, the value may be less
than the original amount invested. Like fixed annuities, variable
annuities are also subject to early withdrawal penalties and taxes
upon distribution and surrender charges if not held until the contracted
maturity date. Variable annuities can offer tax deferral, lifetime
income and death benefits. Variable annuities have riders that may
be available at an additional cost.
Purchasing
a single-premium annuity is done in a lump sum -- an attractive
option for the well-heeled individual who wants to begin experiencing
the benefits of tax-deferred accumulation as quickly as possible.
Alternatively, a flexible-premium annuity can be chosen if you prefer
making payments in a series of installments, or in a less systematic
way.
Distribution
or Payout Phase Distributions from a deferred annuity can take place
in two ways. You can either annuitize (enter the payout phase),
or you can take withdrawals from the contract during the accumulation
phase of your tax-deferred annuity contract.
Keep
in mind, some important restrictions apply to withdrawals from annuities.
During the accumulation phase of your contract, many products will
permit you to withdraw up to a certain percentage of your account
balance -- usually 10% for a fixed annuity and 15% for a variable
annuity -- without incurring surrender charges or penalties. However,
keep in mind that taxes will be applied to the earnings amount withdrawn.
There
are also IRS penalties for early withdrawal that parallel those
of other tax-advantaged retirement vehicles. Except in cases of
extreme hardship, such as death or disability (as defined by the
IRS), withdrawals from an annuity taken before the age of 59-1/2
(and in the absence of a contract that has already entered the distribution
phase under a lifetime payment arrangement) may trigger an additional
10% Federal penalty tax on the earnings that are withdrawn. The
moral: plan carefully when setting up your annuity and fund it with
money that you're fairly certain you're not going to need until
your contract calls for you to begin receiving payments after you
reach age 59-1/2.
During
the "payout" phase, you can withdraw your money in a variety
of ways. A lifetime annuity guarantees you a certain level of income
for the rest of your life -- however long or short that might be.
This guarantee is backed by the claims-paying ability of the issuing
insurance company. This option appeals to people who are worried
about outliving their assets. Like anyone else on a fixed income,
though, purchasers of lifetime annuities will find that inflation
may reduce their purchasing power. You may want to consider delaying
the start of lifetime annuity payments for as long as possible.
Annuity
payments also can be set up over a certain period, where the payments
will continue for that specified period regardless of whether you
live or die. In the event of your death, they will be paid to your
beneficiary for the remainder of the period.
Annuities
offer many advantages, including flexibility in payments, payout
options and, above all, the benefits of potentially accumulating
tax-deferred earnings. A qualified financial advisor can help you
determine whether an annuity is consistent with your financial objectives.
1Variable annuities are offered by prospectus. An investor should
carefully consider the investment objectives, risks, charges and
expenses of the variable annuity and the underlying fund options
before investing. To obtain a prospectus that contains this and
other information call your financial services representative for
a free prospectus. Read the prospectus and underlying fund prospectus
carefully before you invest or send money.
About
the Author
David Chazin is a fee-based financial planner with Sagemark Consulting.
His practice focuses on providing his clients with a comprehensive
solution to their financial needs. He delivers objective, strategic,
and prudent advice designed to help his clients accumulate, retain
and transfer wealth. This typically involves developing a customized,
fully comprehensive financial plan identifying issues that need
to be addressed and outlining stepswww.PlannerConnect.com
