Annuities

Related Terms: Retirement Planning; Life Insurance

An annuity is an interest-bearing financial contract that combines the tax-deferred savings and investment properties of retirement accounts with the guaranteed-income aspects of insurance. Annuities can be described as the flip side of life insurance. Life insurance is designed to provide financial protection against dying too soon. Annuities provide a hedge against outliving your retirement savings. While life insurance plans are designed to create principal, an annuity is designed to liquidate principal that has been created, usually in the form of regular payments over a number of years.

Annuities can be purchased from insurance providers, banks, mutual fund companies, stockbrokers, and other financial institutions. They come in several different forms, including immediate and deferred annuities, and fixed and variable annuities. Each form has different properties and involves different costs. Although the money placed in an annuity is first subject to taxation at the same rate as ordinary income, it is then invested and allowed to grow tax-deferred until it is withdrawn. Distribution is flexible and can take the form of a lump sum, a systematic payout over a specified period, or a guaranteed income spread over the remainder of a person's life. In most cases annuities are a long-term investment vehicle, since the costs involved make it necessary to hold an annuity for a number of years in order to reap financial benefits. Because of their flexibility, annuities can be a good choice for small business owners in planning for their own retirement or in providing an extra reward or incentive for valued employees.

TYPES OF ANNUITIES

There are several different types of annuities available, each with different properties and costs that should be taken into consideration as business owners put together their retirement investment portfolio. The two basic forms that annuities take are immediate and deferred.

An immediate annuity, as the name suggests, begins providing payouts at once. Payouts may continue either for a specific period or for life, depending on the contract terms. Immediate annuities—which are generally purchased with a one-time deposit, with a minimum of around $10,000—are not very common. They tend to appeal to people who wish to roll over a lump-sum amount from a pension or inheritance and begin drawing income from it. The immediate annuity would be preferable to a regular bank account because the principal grows more quickly through investment and because the amount and duration of payouts are guaranteed by contract. Immediate annuities are also known by the name income annuities. What is important to remember when considering an immediate annuity is that "at the end of the day, you've got to remember what you're buying is insurance, not an investment vehicle like a stock or mutual fund," explains Rob Nestor in an article by Murray Coleman in Investor's Business Daily.

Deferred annuities delay payouts until a specific future date. The principal amount is invested and allowed to grow tax-deferred over time. More common than immediate annuities, deferred annuities appeal to people who want a tax-deferred investment vehicle in order to save for retirement.

There are also two basic types of deferred annuity: fixed and variable. Fixed annuities provide a guaranteed interest rate over a certain period, usually between one and five years. In this way, fixed annuities are comparable to certificates of deposit (CDs) and bonds, with the main benefit that the sponsor guarantees the return of the principal. Fixed annuities generally offer a slightly higher interest rate than CDs and bonds, while the risk is also slightly higher. In addition, like other types of annuities, the principal is allowed to grow tax-deferred until it is withdrawn.

The more popular of the deferred annuity types is the variable annuity which offers an interest rate that changes based on the value of the underlying investment. Purchasers of variable annuities can usually choose from a range of stock, bond, and money market funds for investment purposes in order to diversify their portfolios and manage risk. Some of these funds are created and managed specifically for the annuity, while others are similar to those that may be purchased directly from mutual fund companies. The minimum investment usually ranges from $500 to $5,000, depending on the sponsor, and the investments (or subaccounts) usually feature varying levels of risk, from aggressive growth to conservative fixed income. In most cases, the annuity principal can be transferred from one investment to another without being subject to taxation. Variable annuities are subject to market fluctuations, however, and investors also must accept a slight risk of losing their principal if the sponsor company encounters financial difficulties.

FEATURES OF ANNUITIES

Variable annuities have a number of features that differentiate them from common retirement accounts, such as 401(k)s and IRAs, and from common equity investments, such as mutual funds. One of the main points of differentiation involves tax deferral. Unlike 401(k)s or IRAs, variable annuities are funded with after-tax money—meaning that contributions are subject to taxation at the same rate as ordinary income prior to being placed in the annuity. In contrast, individuals are allowed to make contributions to the other types of retirement accounts using pre-tax dollars. That is why financial specialists usually instruct people to first maximize their contributions to 401(k) plans and IRAs before considering annuities. On the plus side, there is no limit on the amount that an individual may contribute to a variable annuity, while contributions to the other types of accounts are limited by the federal government. Unlike the dividends and capital gains that accrue to mutual funds, however, which are taxable in the year they are received, the money invested in annuities is allowed to grow tax free until it is withdrawn.

Another feature that differentiates variable annuities from other types of financial products is the death benefit. Most annuity contracts include a clause guaranteeing that the investor's heirs will receive either the full amount of principal invested or the current market value of the contract, whichever is greater, in the event that the investor dies before receiving full distribution of the assets. However, any earnings are taxable for the heirs.

Another benefit of variable annuities is that they offer greater withdrawal flexibility than other retirement accounts. Investors are able to customize the distribution of their assets in a number of ways, ranging from a lump-sum payment to a guaranteed lifetime income. Some limitations, however, do apply. For example, the federal government imposes a 10 percent penalty on withdrawals taken by anyone before they reach the age of 59 1/2 years. But contributors to variable annuities are not required to begin taking distributions until age 85, whereas contributors to IRAs and 401(k)s are required to begin taking distributions by age 70 1/2.

 1 | 2  NEXT