Fixed Annuities for Dummies
Fixed annuities are a contract between an investor and an insurance company. They provide a contractual way for an investor to ensure that he or she receives guaranteed income for life. Other investment products, such as stocks that pay dividends, can also supply income. But, they are not guaranteed. Fixed annuities guarantee an investor will have a stream of income for as long as he or she lives.
What Are Deferred Fixed Annuities
Like all deferred annuities, deferred fixed annuities have two distinct phases. The first is called the accumulation phase. During the accumulation phase, which can be as short as a couple of years or as long as many decades, the owner of the annuity makes deposits according to the contract. These deposits are called the premium. If a deferred fixed annuity is part of an employer sponsored defined contribution plan, the deposits can be deducted from a paycheck. Payments can also be made directly to a life insurance company if the investor has purchased the annuity outside of his or her employment.
Premiums contributed to deferred annuities grow tax-deferred. They can be made with either pre-tax or post-tax dollars. Pre-tax dollars are those dollars that are contributed to qualified account, such as a 401(k). Post-tax dollars are dollars that have been taxed in the year in which they were earned. A Roth IRA, which is a type of retirement savings account, is funded with post-tax dollars. Whether a deferred fixed annuity is purchased with pre-tax or post-tax dollars, it will grow much faster than an account with taxable earnings.
When the annuity owner, who is called the annuitant, requests that distributions begin, the annuity is “annuitized”. Distributions can be paid out monthly, quarterly or annually, depending on how the annuitant structures the contract. Annuitants must think about their distribution schedule carefully, as once it is selected, it cannot be changed. Insurance companies will also usually let an annuitant select the length of time for the distributions. Guaranteed payouts can be taken for life or for a set number of years. This selection will affect the amount of each payout.
Under current federal tax law, a deferred fixed annuity owner cannot start taking distributions before he or she is age 59 ½ without incurring a 10% penalty. Distributions must begin by age 70 ½.
What Are Immediate Fixed Annuities
Immediate fixed annuities are funded with one single premium. The lump-sum is typically made with money that is from a savings account, an inheritance or the after-tax profits from a property or real estate investment. As so many people are living longer today, a large percentage of immediate fixed annuities are being funded with distributions from qualified retirement accounts. The payouts made by the life insurance company begin immediately, usually within 12 months of the start date of the contract.
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Are There Risks Associated with Fixed Annuities
The return on a fixed annuity is always fixed. While it might change from year to year, it will not change because of stock market or currency fluctuations. This can be very helpful for those on a tight budget, as they will know exactly the amount of each payout. While the rate paid on a fixed annuity will vary, most insurance companies will pay a rate of between 2% and 5% of the total principal. However, this amount may not be enough to offset a cost of living increase. Inflation is one of the most significant threats to retirement savings and can very easily reduce the purchasing power of any savings account.
A COLA (cost of living adjustment) rider provides a solution for investors who want to make sure that inflation does not cut into future purchasing power. A cost of living adjustment rider increases the price of the annuity, but it can increase the amount of money that is paid out each year.
One other risk factor associated with fixed annuities is premature death. If the annuitant dies before he or she has received the amount he or she paid in, the insurance company keeps the balance. To offset this negative, however, most insurance companies now provide for a guarantee of the premium, less charges and fees. For example, if an annuitant owns an annuity in the amount of $250,000 and dies after having only received $25,000, the named beneficiary will receive the remaining $225,000. Alternately, there is an option called “period certain”. If an annuitant opts for a period of 30 years but dies during year 12, a beneficiary will receive payouts for the remaining 18 years.
Who is Best Suited for Fixed Annuities
Retired investors seeking guaranteed income for life or for a defined period of time are advised to consider fixed annuities. Retirees who depend on dividends for a majority of their income may also want to look into fixed immediate annuities. Dividends, while beneficial, are not guaranteed to be paid and can be cancelled at any time should a corporation need to conserve cash.
Retired investors may also fear that they will live longer than they have saved for. Immediate fixed annuities can provide financial stability and security. The payouts are guaranteed for as long an annuitant lives, regardless of the amount of the premium. Even if the total amount of the payouts exceeds the amount of the premium, the insurance company is obligated by contract law to make the payouts. For people in good health with few liquid assets, a fixed annuity can make a huge difference in the standard of living.
Fixed annuity investors should always ensure they have enough cash on hand for emergencies. As stated earlier, an annuity is a contract. It cannot be cancelled except under the most extreme circumstances. Once the contract is in place, the only way an investor can receive his or her money is through the distributions. Keeping enough cash in a savings or checking account to cover car repairs, out-of-pocket medical expenses and other emergency expenses is prudent.
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