Fixed Tax Deferred Annuities
Fixed tax-deferred annuities are those on which a guaranteed amount of interest is paid regardless of market conditions and taxes are not paid on the earnings until distributions are paid out or the annuity is surrendered.
If an annuity is fixed, it means that the insurance company that issued the contract guarantees to pay a fixed amount of interest on the principal and its compounded value each quarter or year. The interest is credited according the schedule outlined in the contract, and does not change based on the current rate of interest established by the Federal Reserve or fluctuations in the equity, bond or credit markets.
The underlying investments of fixed annuities are United States Treasury Bonds, Bills and Notes, and very highly rated corporate bonds. This differs from variable annuities, which have as their underlying investments equities and riskier bonds. The amount of interest paid on variable annuities will vary based on the performance of these investments.
What Types of Fixed Tax-Deferred Annuities are Available
Investors interested in fixed tax-deferred annuities can choose between two types: Guaranteed Return Annuities (GRA) and Market Value Adjustment Annuities (MVAA).
Guaranteed Return Annuities
With a Guaranteed Return annuity, the investor is provided with a guarantee the he or she can never receive less than 100% of his or her investment back if the annuity is surrendered. Neither fluctuations in interest rates nor surrender penalties will impact the principle if the annuity is surrendered before its maturity date. For example, if an investor were to purchase a GRA for $50,000, he or she would be guaranteed to receive $50,000 in return if the surrender date is before the maturity date. Note that the GRA does not guarantee the interest that is credited to the account. It only guarantees the principal.
While the guarantee of principal is important to some investors, especially those who may have to surrender the annuity before it matures, the rate of interest paid on a Guaranteed Return annuity is very low. The insurance company must pay lower rates because it cannot assume the same amount of risk when investing the principal. A GRA is not a very highly recommended tax-deferred annuity, as there are very few situations under which an investor would need to guarantee the surrender value of the principal.
Market Value Adjustment Annuities
A Market Value adjustment annuity pays a higher rate of interest than a GRA because it does not guarantee the principal if the annuity is surrendered. This type of fixed tax-deferred annuity is structured much like a bond. The higher rate that is paid by the insurance company reduces the risk of interest rates rising after the annuity is purchased. In other words, the annuitant is rewarded for taking more risk.
The amount of money he or she uses to purchase the annuity could earn a higher interest rate in a different investment. Typically, the guaranteed interest rate matches the surrender term. If the surrender charge expires in year 10, then the interest rate is guaranteed through year 10.
It's important to note that technically, all fixed annuities are considered to be tax-deferred because none of the earnings are taxed until distributions begin. Even if the annuity is an immediate annuity purchased with after-tax dollars, only the earnings that are paid out as part of the distribution are taxed. The earnings that remain in the account are not taxed. If the fixed annuity is part of a qualified account, meaning that it has been purchased with pre-tax dollars as part of a retirement savings plan, it also is not taxable until the contract is annuitized and payouts begin after age 59 ½.
Choosing Fixed Tax-Deferred Annuities for Retirement Savings
In general, fixed tax-deferred annuities are not as well suited for retirement savings, especially for younger investors. While the interest rate paid by the insurance company is guaranteed, it is generally much lower than an investor could earn on other investments. Younger investors in particular are almost always better off with investments that have the potential for greater growth.
A fixed annuity can make sense for an older investor nearing retirement age or one who has already retired, provided he or she has additional assets that are growing faster than the rate of inflation. In this case, the retired investor could purchase the annuity as a way to protect his or her money from extreme market fluctuations.
Which Life Insurance Companies Sell Fixed Tax-Deferred Annuities
Almost all life insurance companies sell fixed tax-deferred annuities. But they are typically sold through another division or subsidiary of the company. Life insurance companies are required by law to keep certain assets separate from others. This prevents a catastrophic event in one division from disrupting business in other divisions. For example, the money that needs to be available to pay claims in the form of death benefits is kept separate from money that is invested in equities to pay annuity distributions.
When reviewing the fixed tax-deferred annuities offered by different insurance companies it's extremely important to review each company's financial strength and credit rating as issued by one of the leading credit rating agencies: A.M. Best, Fitch, Moody's Investor Services and Standard and Poor's. The ratings issued by these companies reflect the financial stability of the insurance company and its ability to meet its financial obligations.
Each of the four ratings agencies uses a proprietary system to arrive at a rating. However, each more than likely looks at an insurance company's history of on-time claim payment, it's ability to raise capital in uncertain economic environments, the amount of cash reserves and the balance sheet as it relates to stocks and bonds owned.
The highest credit rating issued by A.M. Best is A++ Superior. The highest rating awarded by Fitch, Moody's and Standard and Poor's is AAA Extremely Strong. Even though these ratings are different, they mean essentially the same thing: The insurance company's ability to meet its financial obligations is unlikely to be affected by adverse market conditions.
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