An Explanation of Fixed Annuities
As usually happens after steep market declines followed by periods of uncertainty, money takes a flight to safety where it moves into secure and stable investments. The problem is that the flight is taken only after the damage is already done. Then, when it is certain that it’s safe to come out, money slowly makes its way back into the recovering market, but only after most of the gains have been already been realized. Such is reason why small investors have had a difficult time achieving long term, consistent returns on their investments. It’s also the reason why an investment in a fixed annuity in 2001 would have outperformed an investment in the S&P 500 index over a ten year period.
While one cannot forecast future stock performance, the predictability, stability and security of a fix annuity is always certain. With a new light shining on these dull and stodgy (code for “safe and secure”) savings vehicles, it’s a good time to reexamine fixed annuities and their significance in securing your financial future.
How a Fixed Annuity Works
As opposed to an immediate annuity which immediately converts a sum of money into a stream of income, a fixed annuity has an accumulation component allows an investor to defers the income into the future. The idea is to allow for a sufficient amount of funds to accumulate before it is annuitized into income.
Like immediate annuities, fixed annuities are considered, under current tax law, to be a life insurance contract which confers upon them the same favorable tax treatment. So, the first unique characteristic that differentiates a fixed annuity from other fixed yield vehicles is tax deferral. The interest earned on the accumulation inside an annuity is not currently taxed which allows for faster accumulation.
Most fixed annuities offer an initial fixed yield that is guaranteed for a set period of time, at least one year. The yield is then adjusted to reflect the current investment experience of the life insurer. The interest rates credited by the life insurer are based on the yields generated on its own investment portfolio. Historically, the average yields on fixed annuity contracts have exceeded average CD yields.
The tax advantage of fixed annuities should be underscored for the significant difference it can make in the growth of money over time. If a person, with a combined tax bracket of 40%, invested $30,000 in a fixed annuity for a period of 25 years at an average rate of 4% his investment would grow to $80,000 (before taxes). This is compared to the same investment in a taxable CD with an equivalent yield that grows to $54,000.
Since the contract creates a long term obligation on the part of the life insurer to guarantee principal and offer a minimum rate of growth, it does require that investor commit to a long holding period. Although fixed annuities allow for the withdrawal of funds, the provisions are restrictive and fees will be charged for doing so.
Most contracts allow for a withdrawal of 10% of the accumulated value in a given year. A withdrawal fee or surrender fee is charged by the life insurer according to a schedule set by the life insurer. Typically the fee starts as high as 10% in the first year and then declines annually until it reaches 0% , after which there is no longer a charge to withdraw 10%. Because fixed annuities enjoy the same favorable tax treatment as qualified retirement plans, the IRS will apply a 10% penalty on withdrawals made prior to age 59 ½.
As long as your principal is in the custody of the life insurer, its safety is guaranteed and backed by the underlying assets of the insurer. Life insurers must meet stringent tests for financial strength and credit worthiness. Those that rate the highest (A++ by A.M. Best, AAA by S & P) are considered rock solid.
At some point there will need to be decision made as to the distribution of the accumulated funds. Tax considerations and planning strategies should guide the decisions. If held until age 59 1/2 , the funds may be withdrawn in part or whole without penalty. The interest portion will be taxed as ordinary income, so a complete surrender may not be advisable. The fixed annuity could also be annuitized, or converted into an immediate annuity, in order to create a guaranteed stream of income.
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How to Determine if a Fixed Annuity is Right For You
Fixed annuities are not for everyone and the decision to invest in one should be based on a thorough analysis of your current financial situation, long term goals, priorities, time horizon, liquidity needs, and tolerance for risk. Essentially, a fixed annuity is considered to be a retirement vehicle although it can be applied to other long term goals as well. It is also geared towards a person who cannot tolerate any risk or has a sufficient allocation of funds in growth investments and is seeking to add stability to his retirement plan.
A younger person with other, more immediate needs, such as funding a college education for his children, or purchasing a home, may not want to allocate savings to a long term vehicle such as a fixed annuity. If there are funds available for retirement savings, a younger person should first contribute to a tax deductible, qualified retirement account such as a 401(k) or an IRA.
In a situation where, an older person, in his 40’s or 50’s, has excess funds for savings and has maxed out contributions to his qualified plans, the fixed annuity becomes a viable way increase his retirement savings. Plus, if his qualified retirement accounts are allocated to higher risk growth investments, the fixed annuity will add stability to the overall performance of his retirement savings.
Fixed annuities, when considered as part of a complete financial plan, can play an instrumental role in adding security, stability and predictability to an investment portfolio that has any exposure to fluctuating or uncertain markets. There time has come, again.
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