Annuity: Not a Bad Word

The term ‘annuity’ has really come to have a bad reputation. The truth is that annuities have an important place as a component of the financial plans for many families. Unfortunately, over the years these types of accounts have often been misrepresented and misused by poorly qualified and untrained financial professionals. Every situation requires special consideration, but in many cases a family can benefit tremendously by utilizing certain tax advantages and income features that annuities can provide. Let’s examine some of the facts about annuities and some examples of situations where this type of account will make sense and otherwise.

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Breaking Down the Annuity Contract

To begin, let’s define annuities in the simplest terms and how they are viewed by the U.S. Government, specifically the IRS. An annuity is, simply put, an account with an insurance company that provides some form of ‘insurance’ on future income. Of course there is more to it than that, and we’ll touch on these details throughout this article.

It should be stated that annuities have evolved immensely since their invention centuries ago, and now there are literally hundreds of bells and whistles available for modern annuity holders. Nonetheless, ALL annuity accounts have a few things in common: each has an accumulation phase, an annuitization phase, and a tax deferred status in the eyes of the IRS. What does that mean? Here is each piece defined:

  • Accumulation Phase – This is the time where an account accumulates (more accurately: changes) value from gains, losses, and deposits.
  • Annuitization Phase – This is the time where funds are withdrawn from the annuity in equal or proportional payments for a designated period of time (ex. 5 years, 15 years, life, joint life)
  • Tax Deferred – This means that taxes on earnings will not be paid until those dollars are withdrawn at a later date (they are deferred to that date).

Now we need to examine each part of an annuity in more detail, beginning with the accumulation phase. Ultimately, there are two simple choices for the type of annuity that will accumulate in value: Fixed Annuity and Variable Annuity. The names are well suited and reflect the type of investment the insurance company will make on your behalf (they will simply be the custodian of your money).

The fixed annuity will invest in fixed rate return vehicles of which the most common is bonds. Fixed indicates that the duration and rate of return will not change. Variable annuities will include investments that will vary or change, though the portfolio within this account can range from aggressive (more equity investments with more fluctuation in daily value) to conservative (more, but not all, fixed investments and less fluctuation). With both types of accounts, the plan for the annuity is to have it grow through investment returns and deposits over time so it can be withdrawn later in life.

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Annuitization: Reaping What You’ve Sown

At some point in time you will want to get money from the annuity. In most cases this will begin the annuitization phase. Though the annuity holder can make lump sum withdraws and even entirely close and remove all funds, the intended purpose of an annuity is to take systematic (or annuitized) payments over a period of time. Similar to a pension, there are many choices for withdrawing the funds.

Period Certain will give payments divided over a specific number of years, for example ten years of equal monthly payments. Lifetime payments will provide equal payments for the rest of life, whether that is one year or fifty years. Joint Life payments will provide equal payments for the duration of one life and then continue on to the end of a second life (spouse for example).

This is the reason insurance companies are involved – an annuity can provide ‘insurance’ on the income. When you choose lifetime payments of any type, the insurance company uses actuaries to calculate the risk they can take with you based on your age and account value. This form of managing income and insuring it with an annuity can bring peace of mind and security to persons on fixed incomes or wanting a reliable future income for others. There are dozens of variations on the payout methods for annuities, just keep in mind that different methods will provide different payment amounts.

Benefits of Annuities

Now we can get into some of the additional benefits of annuities. Tax deferral is a big benefit in many cases where an annuity makes sense for an investor. Here is why tax deferral may help: typically tax rates are highest when a person is young, working, and putting money away for later. During this time income is at its highest and having taxable interest will only elevate your tax rate.

Putting the money into a tax deferred account will allow you to ‘defer’ or put off those taxes to a later year when it is likely your tax rate will be less, such as during retirement. The magic age for tax deferral for both annuities and IRA’s is 59 ½ after which money withdrawn will not be subjected to a 10% penalty from the IRS. One major and potentially helpful difference as compared to an IRA is that annuities don’t force withdrawals at the age of 70 ½.

When Annuities Work

Who can benefit from an annuity? Let’s examine a family that could benefit from an annuity and some simple examples where annuities don’t make sense. Let’s first consider a married couple that is five or ten years away from retirement. They have done a good job of saving and want to sustain their lifestyle, leaving extra money to their three children.

They will have a pension and social security income after they retire, but that falls about $1000 per month short of what they expect their lifestyle to cost.  In this circumstance it would make sense to consider taking a portion of their invested assets and allocate it into an annuity that will grow until their exact retirement date and then provide them a joint life annuity payment of $1000 per month.

Now they have locked in the income they will both need to live the way they want when they retire, giving them peace of mind now and the freedom to invest the other assets for their kids. Who should avoid annuities? Younger folks with more than 15 years until retirement and anyone that will or might need access to the funds to be invested – consider a different investment if this is you.

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