Annuities

Your Guide to Annuities

Note: This website may contain information that could carry legal, accounting, or tax implications. None of the information is intended to provide legal, accounting, or tax advice. Please consider consulting a competent attorney, tax advisor, or accountant for this information. Any references using the word “guarantee” are based on the claims paying ability of the insurance company providing the annuity.

Annuities are contracts issued through an insurance provider. These investment products allow investors to defer tax on capital gains and interest. Through annuities, investors have the option to set up a guaranteed income for life. Most annuitants, or people who will benefit form an annuity, use them to provide an income during their retirement.

Investors are drawn to annuities because of the option to grow their money on a tax-deferred basis. Annuities have two basic parts, known as phases: the accumulation phase followed by the distribution phase. The annuitant does not have to enter the distribution phase and relinquish control of the annuity’s cash value, because these investments come with options that provide access to your funds without giving up control.

Understanding the Accumulation Phase

Investors looking to invest through annuities should consider the following factors:

• Funds grow tax deferred during the accumulation phase, but this does not mean they are free from taxes. Unless the annuity is purchased through a qualified retirement program, including 457, IRA, 401(k), or TSA plans, to name a few, the annuitant will pay income taxes on the growth when the money is paid out. For annuities that are in a qualified retirement plan, the income taxes are paid when the money is withdrawn through the retirement plan.
• Withdrawing money from the annuity before the age of 59 ½ is considered “premature distribution.” The IRS charges a 10 percent penalty for this action.
• Annuities have surrender charges for early withdrawals. However, many offer partial withdrawal options without this fee.
• Investors can purchase annuities in many methods. The single premium charges a one-time payment, whereas the flexible premium allows periodic payments on a regular basis as defined in the contract.
• Annuities can vary in the timing of the payments. Deferred annuities have deferred income payments. Immediate annuities begin making payments as soon as the annuity is purchased and placed into effect.
• If the annuitant prematurely passes away during the accumulation phase, the funds in the annuity will be transferred to the beneficiary named in the annuitant’s contract, which allows the investment to avoid probate costs.
• Variable products, like some annuities, have mortality and expense charges that other investments may not carry. They also have administrative fees not common with other investments.
• Indexed and fixed annuities come with a safety of principal and earnings.

There are three different types of annuities, which are as follows:

• Fixed Annuities
• Indexed Annuities
• Variable Annuities

Fixed Annuities

For fixed annuities, insurance carriers will:

• Declare a current interest rate for a set period of time. When this time expires, the insurance company will establish a new rate. The new rate can be higher or lower than the original one.
• Guarantee the principal.
• Guarantee a minimum interest rate, as stated in the annuity contract. The interest rate cannot fall below this minimum.

Indexed Annuities

Indexed annuities are linked to the equity market, using measures like the S&P 500. These annuities have fixed minimum rate guarantees, which means the interest rate can grow, but it cannot fall below the minimum rate due to market movement. If the market grows, the interest rate on the indexed annuity will also grow. This gives the owner the opportunity to enjoy the upside potential of equities without the risk of significant investment loss.

Indexed annuities have many differences in design from one product to the next. However, all will fall into one of three basic categories: Annual Reset, Point-to-Point, and Annual High-Water Mark with Look-Back.

• Annual Reset: This design resets the account to the starting index point each year. This structure is also called the Annual Ratchet Design. This design credits interest each year and compounds annually.
• Point-to-Point: The point-to-point design follows the change of the index from the beginning to the end of the term.
• Annual High-Water Mark with Look-Back: This design is a variation of the point-to-point design. It measures the interest rate from the start of the term to the highest anniversary value over the term of the annuity.

Variable Annuities

Variable annuities have either fixed or variable accounts in which to invest your money:

• Fixed Accounts: Fixed accounts have interest rates and principal guaranteed through the insurance company. Interest rates may be guaranteed for just one year or for a longer period of time.
• Variable Accounts: These accounts place the investment risk on the shoulders of the annuity owner. The policy’s interest rate will vary directly with the market, which means the owner can lose principal and prior earnings if the market drops significantly. The owner is able to select the investment vehicles tied to the annuity. These carry a guarantee that if the owner dies, the beneficiary will receive at least the amount of premiums paid minus any withdrawals made, even if the policy value is lower.

Withdrawals

• Annuity owners can make withdrawals at any time. If they choose to withdraw before the age of 59 ½, the IRS charges a 10 percent penalty. Also, withdrawals are subject to surrender charges, as outlined in the contract. Many annuities allow for 10 percent withdrawal each year free of charges.
• Owners can pre-authorize systematic periodic withdrawal plans for their annuities. Under this plan, the owner instructs the insurance company to withdraw a certain percent or dollar amount from the annuity on a regular basis, such as every month, quarter, or year.

The Distribution Phase

During the distribution phase, the owner has two options to access the earnings and principal in the annuity. Either the owner can withdraw the money through a lump sum or systematic withdrawal plan, or he or she can annuitize.

Annuitization

Annuitizing the funds refers to purchasing an annuity payout plan. For fixed or indexed annuities, the owner will receive a monthly income each month until death. This income amount is guaranteed and cannot change. In variable annuities, this same fixed income is available, or the owner can transfer all the funds to sub-accounts to annuitize the funds in that way. In this scenario, the separate accounts produce a variable income, which changes based on how well the sub-accounts perform.

Annuity Payout Plans

• Life Only – Life only payout plans pay for the duration of the owner’s life, then cease upon his or her death. The annuitant cannot outlive the payments, and the payment amount is determined at the time of purchase based on the age and gender of the annuitant.
• Life with 10 Years Certain – In this structure, payments are made for at least 10 years, whether or not the annuitant lives for this entire time. If the annuitant dies during this time, the payments will be made to a beneficiary. If the annuitant lives past the 10 years, the payments will continue for his or her lifetime. This structure has lower monthly payments than the “life only” structure.
• Life with 20 Years Certain – Similar to the Life with 10 Years Certain, this structure guarantees payments for 20 full years. If the annuitant dies during this period, the payments go to a beneficiary. If the annuitant lives past the 10 years, the payments will continue for his or her lifetime. This structure has lower monthly payments than the “Life Only” and “Life with 10 Years Certain” structures.

Alternative

There is another way to access funds from your annuity contract without giving up control of your principal as you do in annuitization. Many companies now offer riders you can purchase with your contract for a reasonable cost. These riders allow you to accumulate money in what is known as an “income account.” This is not typically a death benefit and it is separate from the principle. You can use this rider to create a flow of income that you will not outlive, while allowing the principal to continue to grow, an option you do not have if you annuitize. There are a few companies that allow your beneficiary the opportunity to take this higher value as a death benefit, but the beneficiary must do so over a period of years, rather than as a lump sum payment.