Annuities: Understanding Purpose and Functionality
Purchasing an annuity is much like buying a car, with so many makes, models and options it’s important to understand your choices. It’s equally important you understand what features will be used, determine how long they will be needed, and how they fit overall into your financial plan. While it can be debated whether anyone can own “too much” car, it is easier to determine if one owns too little or too many benefit riders with an annuity.
Q: What is an Annuity?
A: The annuity is actually a contract with an insurance company where you are purchasing an insurance policy so it’s important to understand the “basics” and the choices you have before you settle on one.
Annuities are incorporated in many financial plans for multiple reasons. Often people use annuities for the tax-deferral appeal while building additional wealth outside of IRAs or company retirement plans. Others choose annuities to meet their essential income needs in retirement by utilizing the various guarantee benefit riders. And some are uncomfortable being in the market and prefer to seek other avenues to address inflation concerns and growth opportunities.
In the estate planning arena, sometimes assets are gifted to non-profit entities in the form of charitable annuity contracts where they can benefit from the gift and you can receive a tax benefit and enjoy an income stream for the rest of your own lifetime. Remember there are tax considerations when making these choices but upon death the asset passes tax-free to the entity. There are various kinds of charitable type trusts for this type of gifting and an estate planning attorney along with your tax and financial advisor will be beneficial in selecting the right type of annuity for your gifting.
Often the concerns associated with annuities center around fees, the deferral of taxes, the absence of a step-up in the cost basis and the utilization of annuities within IRA’s or 401(k)’s accounts where tax deferral is not the objective.
Q: So What, When, and How Should Annuities Be Used?
A: This brief introduction is provided merely as a guide to empower you with information for an option you may not have considered and begin your discussion with your financial advisor. Let’s get started!
Most Common Types of Annuities: (Most popular cars)
Single Premium Immediate Annuities: Insurance product- Offers an immediate stream of income for life - or for a specified time period. Guarantees are a promise of the insurance company.
Single Premium Deferred Annuity: Insurance product - Can be either a fixed annuity or variable annuity, see features of each below.
Variable Annuities: Insurance/Securities product- Offers tax deferral on investment growth; market driven investment selections (known as sub-accounts); additional associated fees for portfolio management choices; a guaranteed death benefit and optional living benefit riders available.
Fixed Rate Annuities: Insurance product- Can be a fixed rate income annuity or a deferred annuity with a fixed rate of return for a specified period. With some products, after the specified rate period, a fixed rate annuity may drop to a minimum guaranteed rate. For those who tend to be more risk adverse, shifting the investment risk to the insurance company while being guaranteed a specified rate could make more sense.
Indexed Annuity: Insurance product- the Insurance Company offers a minimum guaranteed return with possible additional returns based on the performance of the stock market index, which this annuity is associated with. This type of annuity has complex features, i.e. participation rates and cap rates and may or may not outpace inflation.
Options and Features: (Car Enhancements)
The most common upgrades sought after with annuities are:
- Lifetime Income Benefit
- Joint Lifetime Income Benefit
- Increasing Death Benefit Option
- Daily, Quarterly, Annual Contract Step up Features
- Generational Benefit Features
Remember, these optional features also come with an additional costs. Just like buying a car, you choose the manufacturer then choose the optional features you are interested in. Unfortunately, sometimes you’re forced to have features you may not need or want, so be careful when choosing.
Note: Generally, once an annuity has been purchased a “cost basis” is established. Any proceeds coming out are taxed as ordinary income until contract value is reduced to original cost basis and then taxes may be incurred only on the gains. There is one carrier who has obtained a patent on the distribution phase of the annuity that allows taxes on a pro-rated basis, thus reducing the overall tax hit while maintaining control over the annuity.
Exception: If a single premium immediate income annuity is purchased, this means a lump sum payment is used to purchase the annuity with the intent of beginning an immediate income stream. The income stream will begin within the first year and the payments which are received are considered a partial return of premium and not fully taxable.
Consult with your tax advisor and carefully review an annuity contract to understand features before buying. Most annuities have a “Free-Look Period” which allows the purchaser the right to cancel the contract for a period of days after purchase.
With so many choices to consider, we are here to assist you in making appropriate decisions regarding your financial plan and to design an appropriate income portfolio to match your needs, including the possibility of annuities.
Let us help you take the stress out of finance and put the fun back into living. Contact us today for your free initial consultation.
Investment decisions must be made on your own individual needs and risk tolerance. Past performance may not be indicative of future results.
Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.