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Annuities can have an important place in your Retirement Plan.

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Annuities Defined

An annuity is a financial contract between you and an insurance company.  Like a CD, it requires deposit of money up-front (known as a “premium”) that you expect to receive at a later period combined with growth.  Unlike a CD, the insurance company (contract holder) guarantees the annuity instead of the Federal Government, and money is received in retirement as a (monthly) income stream instead of on a “maturity date”.  With an annuity you may receive significantly more money than you’ve invested or much less depending on contract terms and your lifespan.  The return on several types on annuities (variable and indexed) also depends on investment growth.

Qualified Annuities

A qualified (tax deferred) annuity is simply an account where taxes have not yet been paid on the principal.  Common examples of a qualified account are IRA’s, 403(b)’s, 401(k) rollovers and various other retirement plans.

Tax deferred annuities have for years been a popular alternative for people who want high interest and tax relief for their savings.  In the last 20 years, billions of dollars have been moved into these contracts by savers seeking safety and predictability, competitive interest rates and favorable tax treatment.  One of the most important features of a tax-deferred annuity is that it allows you to compound yearly interest earnings free of current tax.  By eliminating the current tax cost of accumulation, you can build a much larger account value than with a typical interest bearing account such as a bank CD.

Tax deferred annuities are great for safely accumulating money to be used at some future date to enhance income; as long as it is understood that when you begin to withdraw money from the annuity, you must then pay taxes on your gain.  All distributions from a qualified annuity (principal, interest, and investment gains) are subject to income taxes, and you are required by the IRS to take mandatory minimum distributions at age 70 ½.

Non Qualified Annuities

A non qualified annuity is one where taxes have already been paid on the principal investment.  Deposits could come from a mature certificate of deposit, a checking or savings account, a brokerage account, or an existing non-qualified annuity.  Only the earned interest is considered taxable in a non-qualified annuity, and you will never be forced by the government to take your interest or principal out at any age.

IRA Rollover/Transfer to an Annuity

Like many Americans, you may own an IRA.  One of the most common misconceptions among IRA owners is that they must keep their IRA where it is, which is not the case.  As an owner of an IRA, you have complete control over where you invest your IRA funds.  If you are unhappy with its current rate of return or the service you are receiving from the institution where your IRA is presently held, you can transfer your IRA to another IRA qualified investment without penalty or having to pay any income tax.  This is done via an IRA Rollover or a Direct Transfer.

Annuity products are a safe and secure alternative and have interest rates that are better than most bank CDs, Savings Accounts or Money Market Funds.  Also, if your IRA is currently in a Mutual Fund and you are concerned about the risk to your principal, an Annuity is an excellent way to guarantee your principal with an opportunity for greater growth.

Immediate Payment Annuities

Annuities can be either immediate or deferred, meaning that they can immediately begin to provide income or begin at a future date, allowing the premium to grow tax-advantaged.

With Immediate Annuities (sometimes called income or payout annuities), you give an insurance company a lump sum of cash in return for regular income payments that start immediately and usually continue until you die.  They are commonly bought when you're ready to liquidate your other investments to start receiving regular monthly income.

One advantage of an immediate payment annuity is high payout.  Let’s say you invest $100,000 and request an immediate payout.  Depending on your situation and the choices you make, you might receive as much as $600 a month.  That’s better than a 7% return, which is very attractive in the current market environment.  Your income isn’t FDIC-insured, but it is backed by the insurance company you bought the annuity from, and the annuity is not subject to the ups and downs of the stock market.

There are also some disadvantages of immediate payment annuities.  One disadvantage is that an immediate annuity is irreversible once it has been purchased.  This may pose a problem should the annuitant want to change the monthly payout amount or need access to capital to deal with an emergency.

Also, the payout isn’t the return on your investment.  It’s a combination of principal and interest.  So, in the example above, while this person might be receiving a payout of 7.2%, most of it could be the investor’s own money.

Another large drawback of an immediate annuity is that it is terminated upon death of the annuitant.  This means that in the event of the annuitant's premature death, the size of the estate left to his or her heirs may be much smaller than it would have been if the immediate payment annuity had not been purchased.  For this reason an immediate annuity is not recommended for retirees who are in poor health.

In summary, an immediate payout annuity might be right for you if you mostly care about maximizing your retirement income, are in good health and don’t need access to your capital.

Deferred Annuities

Deferred Annuities have two phases: accumulation phase and payout (or annuitization) phase.  During the accumulation phase, you can add funds to your annuity contract by depositing cash, converting life insurance cash values or doing a 1035 exchange from another annuity (to name a few ways of contributing).  If you follow the annuity rules, your annuity will accumulate earnings on a tax-deferred basis until you make withdrawals.

The second (payout) phase provides a monthly income to you for as long as you choose.  Taxes are paid on the income you receive from a deferred annuity.  The amount of income that is taxed depends on whether your annuity contributions are pre-tax or after tax.  Taxes are paid on all pre-tax contributions and the accumulated growth.  See the Annuity Income section of this website for more details.

The three major types of annuities are Fixed, Variable and Indexed.


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Fixed Annuities

Fixed annuities provide a guaranteed rate of interest on your premium for a specified period of time, sometimes until you start withdrawing income.  Payments (withdrawals) begin on a specified date, they are consistent, and they continue for the period of time defined in the contract.

Fixed Annuity payments can continue for the life of the contract owner (single life annuity), life of the owner and spouse (joint lives annuity), for a specified period (period certain annuity) or for the life of the contract owner with a guaranteed minimum payout period (Life with Guaranteed term).  A single or joint lives annuity can have no payments to beneficiaries, a guaranteed number of payments (5, 10, 15 or 20 years) to beneficiaries, or payments to beneficiaries until the total amount paid to you and your beneficiaries equals the premium (installment refund paid to beneficiaries).  The dollar amount of the monthly payments (payout rate) is based on your age, gender, where you live and the contract terms.  A joint lives annuity also considers the age and gender of the spouse.

Following is an example of the three fixed annuity types for a 65 year old male living in New York with a 63 year old spouse who has $100,000 to invest:

Single Life Annuity Income Payment OptionsEstimated
Monthly Income
Annual Payout Rate
No Payments to Beneficiaries

$579

6.95%

Up to 5 Years Paid to Beneficiaries

$573

6.88%

Up to 10 Years Paid to Beneficiaries

$562

6.75%

Up to 15 Years Paid to Beneficiaries

$529

6.35%

Up to 20 Years Paid to Beneficiaries

$508

6.09%

Installment Refund Paid to Beneficiaries

$532

6.38%

   
Joint Life Annuity Income Payment OptionsEstimated
Monthly Income
Annual Payout Rate
100% to the Survivor With No Payments to Beneficiaries

$465

5.58%

100% to the Survivor with Up to 5 Years Paid to Beneficiaries

$463

5.56%

100% to the Survivor with Up to 10 Years Paid to Beneficiaries

$467

5.61%

100% to the Survivor with Up to 15 Years Paid to Beneficiaries

$466

5.59%

100% to the Survivor with Up to 20 Years Paid to Beneficiaries

$459

5.51%

100% to the Survivor with Installment Refund Paid to Beneficiaries

$463

5.56%

   
Guaranteed Income Payment OptionsEstimated
Monthly Income
Annual Payout Rate
Income for a 5-Year Period Certain Only

$1,686

20.23%

Income for a 10-Year Period Certain Only

$915

10.98%

Income for a 15-Year Period Certain Only

$674

8.09%

Income for a 20-Year Period Certain Only

$565

6.78%

Income for a 25-Year Period Certain Only

$487

5.84%

Variable & Indexed Annuities

Variable and indexed annuities are complex investment vehicles that offer considerable flexibility at the cost of higher fee structures.  In some respects variable and indexed annuities act similar to 401(k)’s and IRA’s, allowing you to invest in a range of funds that provide tax-deferred investment growth.  They can provide a variable payout rate and a “guaranteed” death benefit.  Indexed annuities have a guaranteed interest rate and protection of the principal of the fixed annuity, along with the potential to participate in market gains without exposing the principal to market risk.

Contrary to what you may be hearing in the media, variable annuities may be an excellent choice for a portion of your retirement investments.  According to John P. Huggard’s book on “Investing with Variable Annuities”, they have as many as fifty advantages over mutual funds as long term investments.  Here are some of the advantages:

  • Annuities grow tax deferred, mutual funds don’t.
  • Mutual funds can make annual taxable distributions to fund owners even where the value of their fund has gone down because mutual funds contain “embedded” gains.  Variable annuities do not present a similar embedded gain problem.  This would be exasperated if capital gain tax rates increase.
  • Variable annuities allow the annuity owner to trade or rebalance funds on a commission-free/cost-free basis.
  • There are costly tax traps associated with the buying and selling of mutual funds.  Similar tax traps do not exist for variable annuities.
  • Variable annuities can provide their owners with a guaranteed fixed-income stream for their entire lifetime.  Mutual funds cannot provide the same benefit.
  • Variable annuities provide basic as well as enhanced death benefits to the beneficiaries of the variable annuity owners.  Mutual funds do not provide any death benefits whatsoever.
  • Mutual funds are commonly part of a decedent’s estate which makes such funds available to all creditors of the estate.  Variable annuities, on the other hand, are almost always non-probate property that do not pass through a decedent’s estate and therefore are not subject to the reach of the creditors of the decedent.
  • Many variable annuities offer premium bonuses.  Mutual funds offer no similar bonuses.
  • Many variable annuities today provide a guaranteed rate of return or guaranteed protection against loss of principal.  Mutual funds do not provide the same benefit.
  • Variable annuities allow owners to control precisely how much money will be withdrawn from their variable annuity and thus allow the variable annuity owner to control taxes.  Mutual fund owners have no similar control, but are subject to involuntary mutual fund distributions each year whether they want such distributions or not.

Contributions to variable annuities are made in after-tax dollars unless you fund the annuity through rollover/transfer monies from before-tax accounts (401k’s and IRA’s).

A typical variable annuity (VA) has three stages:

Stage #1 – Contributions are received from the VA owner and are invested in various portfolios that have objectives, strategies and returns similar to mutual funds.  The portfolios grow tax deferred.

Stage #2 – In retirement the VA provides regular income for a specific number of years or for the life of the owner.  However, unlike a fixed annuity, the VA’s fund cash balance (the net of contributions and investment growth minus payouts and fees) remains available.

Stage #3 – After a certain number of years (for example 10 or 15) the VA benefit base can be used to purchase a life annuity.  Alternatively, the account value can be withdrawn (without surrender charges if held for a sufficient time period) to provide income or purchase another VA or other investment vehicle.

Recommendations

Like government savings bonds, annuities provide an opportunity to shield investment growth from the IRS until you’re ready to retire and probably in a lower tax bracket.  However, I would not suggest accumulating large assets into a deferred annuity unless you have maxed out contributions to your 401(k) and IRA accounts.  Also, I’m leery of investing in any product that anticipates your early death and maximizes the profitability of its issuing company when that occurs.  Having said this, annuities are widely used and have their place in a balance investment portfolio.

My opinion, which probably goes against the grain of conventional wisdom, is that variable and indexed annuities provide the best alternative as long as you never annuitize them.  By this I mean that the ability to take systematic withdrawals from your annuity puts you in control and gives you complete flexibility.  You can choose to forego withdrawals (depending on your age and whether it’s a qualified annuity), deplete it entirely, or transfer it to another account.  What’s left when you die passes on to your heirs.  In contrast, a fixed annuity locks you into a specific payout schedule and time period, and it ends when you (and possibly your spouse) die.