Annuities and Annuity Plans

You can purchase an annuity in two ways:

Make one lump-sum payment to purchase a single-premium annuity. If you want to contribute more money at a later date, you will have to purchase another annuity.

Make ongoing contributions to a flexible-payment annuity. You can contribute money at regular or even irregular intervals anytime you want.

There are two basic types of annuities you can buy-fixed and variable.

Fixed Annuities

Fixed annuities earn a guaranteed rate of interest for a specific time period, such as one, three or five years. Once the guarantee period is over, a new interest rate is set for the next period. This guarantee of both interest and principal makes fixed annuities somewhat similar to Certificates of Deposit (CDs) purchased from a bank. Unlike a typical CD, however, an annuity is not backed by the Federal Deposit Insurance Corporation (FDIC); its security is directly related to the financial health of the insurance company that issues the annuity.

Variable Annuities

Variable annuities typically offer a range of investment or funding options. These funding options may include stocks, bonds and money market instruments. The return on variable annuities can go up or down. Your principal and the return you earn are not guaranteed; they depend on the performance of the underlying investment options. If the funding options you choose for your annuity perform well, they may exceed the inflation rate or fixed annuity returns. If they don't, you may lose not only prior earnings, but even some of your principal.

Some variable annuities offer, in addition to a range of investment options, a fixed account option that guarantees both principal and interest, much like a fixed annuity. This gives you the option of dividing your money between the low-risk fixed option and higher-risk vehicles such as stocks, all under the umbrella of just one annuity. Many variable annuities offer asset allocation programs to help you decide where to invest your assets based on your circumstances.

Variable annuities also allow you to transfer money from one account to another without triggering a taxable event. In other words, if you transfer money to a different funding option within your variable annuity, you will not have to pay taxes on any earnings you have made. Tax-free switching lets you re-allocate money to suit changing market conditions, without worrying about the taxes.

Deferred Annuities

Deferred annuities can be a great way to accumulate money for retirement, if you want retirement income beyond what you will receive from Social Security or your pension plan. They are particularly effective if you have many years before retirement. Your money grows tax deferred, which means you pay no taxes on earnings until you begin to withdraw your money.

If the tax-deferred aspect of a deferred annuity is important to you, make sure the expenses do not outweigh the tax benefits. This can be a tough judgment call, but a good guideline is that if the expense charges are more than 1.5% greater than a comparable financial vehicle and your time horizon is less than 10 years, a deferred annuity may not be the option for you. Consult a tax advisor for assistance in making this determination.

A deferred annuity is not a vehicle for money you may need for current expenses. If you withdraw income before age 59 1/2, the IRS will usually apply a 10% penalty in addition to ordinary income tax, similar to the penalty for early IRA withdrawals. What's more, your insurer may impose its own early withdrawal penalty, known as surrender fees, if you cash in your deferred annuity (surrender it) within a specified period. These fees, similar to withdrawal penalties on a CD, usually cease seven years after your date of purchase. Often there is a separate surrender fee for each payment. So, a new payment may have a 7% fee if you take the new payment out right away, while a 10-year-old payment may have no surrender fee. The fee will usually decrease and be eliminated over time. Keep in mind, however, you can often withdraw small amounts (e.g., 10%) annually without any penalty from your insurer, but the IRS penalty may still apply. The IRS views all withdrawals as income, which are taxable, until all income has been paid out.

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If you switch annuities, you may also incur withdrawal charges from your current annuity. If a salesperson advises you to change annuities despite the fact that you will be penalized, make sure you know the reason. Do the benefits of the new annuity . such as a higher interest rate, better investment choices or greater flexibility . offset the withdrawal charges? Be sure the salesperson isn't benefiting from the switch at your expense. If you decide to exchange one annuity for another, be sure to request and complete the appropriate forms provided by your insurance company to ensure that the transaction will be treated as a tax-free exchange under the federal income tax law (Section 1035 of the Internal Revenue Code).

Withdrawing Money from a Deferred Annuity

When you're ready to start withdrawing money from your deferred annuity, you will need to choose how to receive your money. You can take it all out in a lump sum, take it as needed, or receive it in a steady stream of periodic payments . so-called "annuitizing." If you annuitize, you can receive a stream of income that is guaranteed to continue for the rest of your life, no matter how long you live. And, the tax liability can be spread out for the rest of your life too. Some of the earnings are included in each payment and are taxable, meanwhile, any earnings continue to accumulate tax-deferred on the remaining principal and earnings that have not yet been distributed. So, receiving distributions as periodic payments after retirement may further reduce your income tax liability, if you are in a lower tax bracket. Some annuities also provide you with an option to have a set amount, determined by you, automatically withdrawn and deposited directly in your checking account during a regularly scheduled period, such as monthly. You have many options on how you receive your money, each with its own tax ramifications. Consult your tax or financial advisor to tailor a plan for your particular needs.

Immediate Annuities

Immediate annuities can provide dependable financial security: a stream of income payments guaranteed to continue for the rest of your life or for a period you select. If you are about to retire, an immediate annuity may be a good place to put a large lump sum of money accumulated for retirement through another savings or investment vehicle. You also can convert your deferred annuity into an immediate annuity to start receiving income.

To purchase an immediate annuity, you make a one-time payment, and distributions typically begin within a month. Immediate annuities can be fixed or variable, just like deferred annuities. The income payments you receive from fixed immediate annuities are based on the amount you contribute, your age and the interest rate environment at the time of purchase. The payments to you will not change. The payments from variable immediate annuities fluctuate based on the performance of the investment options you choose. Although payments may go up or down, variable annuities are designed to provide income that can rise over time to help you keep pace with inflation.

The principal in an immediate annuity is not readily accessible. If you need more money than the income provided by the immediate annuity, you can minimize this drawback by keeping some of your retirement funds in a liquid account, such as a savings account or money market fund. There also is a chance you may lose some of your principal. If you choose an income for life option with no refund guarantee, and you should die before your principal is all paid out, the balance of your principal and any earnings will go to the insurance company rather than to your heirs. Fortunately, annuities offer several guaranteed payout options. For more information see Options with Guarantees.

When selecting the investment options for your immediate annuity, keep inflation in mind. You want investments that will keep pace with inflation. Variable annuities can let you participate in stock market growth, historically shown to be one of the best ways to combat inflation over the long term. However, the downside is that payments can drop if the market drops. Not only is this unnerving, but obviously it will make it harder for you to budget. If you still want the potential for higher payments, consider dividing your retirement savings between fixed and variable options to provide fixed payments, as well as growth potential.

Before You Buy an Annuity Consider the Following:

The money contributed to an annuity may be in post-tax dollars. When you contribute after-tax savings to an annuity, you can put in as much money as you like. Before you put after-tax savings into an annuity, it may be advisable for you to put the maximum pre-tax amount into a retirement plan such as your IRA, SEP, 401(k) or 403(b). Also note that annuities may fund an IRA, SEP, 401(k), 403(b). When an annuity is used to fund these vehicles there are contribution limits that apply, and federal tax laws generally require that you begin taking minimum distributions by April 1 of the calendar year following the year in which you reach age 70 1/2. Failure to do so will result in a tax penalty of 50% of the amount of the shortfall.

Expenses can vary. Make sure that the annuity contracts you consider have competitive fees. Independent rating services such as Morningstar and Lipper Analytical Services both publish reports that compare variable annuity fees. Your local library may have copies. While cheaper doesn't necessarily mean better, if a contract is too expensive it could offset gains from the tax-deferred status.

All earnings from annuities are taxed as ordinary income.* If your ordinary income rate at retirement is higher than the current capital gains rate for other investments, you would actually pay higher taxes. You do, however, have a tax deferral on any earnings. With some other investments, you could be subject to ordinary income as well as capital gains taxes annually, even if you have not cashed in the investment, which can reduce the value of your earnings.

This website provides only a general overview of estate planning. You should consult an attorney, or perhaps a CPA or tax advisor for additional guidance.

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