Annuities: 15 Things You Must Know to Save You Time and Money
The prospect of having some sort of guaranteed retirement income is particularly attractive in today’s uncertain financial climate. The threat of stock market volatility or outliving your savings is less of a worry if you know you’ll be receiving a check every month for the rest of your life.
Wait, won’t you have Social Security? If so, that still might not be enough to pay for all of your expenses. Furthermore, fewer than one-third (31%) of Americans are currently retiring with defined benefit pension plans.
With all of the above in mind, it shouldn’t be surprising that a TIAA survey found that 69 percent of people saving for retirement on the job ranked guaranteed income for life among their two top priorities.
But what if you aren’t fortunate enough to have guaranteed retirement income from your employer? Well, you might want to consider an annuity. Even if you do have a retirement plan, an annuity can supplement your retirement income so that you can enjoy your golden years stress-free.
But, to save you both time and money, here are 15 things you need to know before you buy an annuity.
1. How do annuities work?
With an annuity, you generally make a lump-sum payment right now. In return, this ensures you’ll receive a series of payments that begin at some point in the future. For example, you can receive monthly, quarterly, or annual payments over a regular period of time, such as for 20-years or the rest of your life. There’s also the option to receive a lump-sum payment.
Depending on what type of annuity you choose, you can also set the payments to continue for as long as your spouse lives. Annuities with certain types allow beneficiaries to inherit remaining benefits if they die before receiving all of their payments. In addition, some annuities adjust their payments according to inflation.
2. What are the most common types of annuities available?
For most people, the four types of annuities to be familiar with are;
- Deferred income annuities. Here you’ll receive a lifetime payment plan that uses money that you currently have to generate future guaranteed lifetime payments.
- Immediate annuities. The payments you receive will either last forever or for a set period of time.
- Fixed deferred annuities. Until you’re ready to begin getting payments, you’ll have a fixed annual rate of return and your premium payment guaranteed.
- Variable annuities. A long-term financial product used for retirement planning that allows investments in the markets. If the market is up, variable annuities can provide growth potential, but they can also result in a loss when the market is down.
3. How is my money invested?
You never have to worry about your investment or return if you own a fixed annuity. The payments remain the same for the duration of the contract.
That is not the case with a variable annuity. Here, your return depends mainly on your choice of investments and how they perform. In short, if your investments are performing poorly, so will your return and vice versa.
What about indexed equity annuities? Investing in a specific index, like the S&P 500, will determine your return.
4. Are annuities taxed?
Typically, annuities are tax-deferred. As a result, your earnings will grow tax-deferred until you withdraw them or convert them to payments, aka annuitization. It’s possible, however, to get a tax advantage by delaying withdrawals until you’re in a lower tax bracket, like when you’re retired.
Remember that any earnings from your contract will be taxable if you make a withdrawal. Another option would be to receive income from your contract after you annuitize it. You will be taxed on some of the payments you receive once you annuitize if your annuity contract includes earnings.
It’s also important to note that if you make a withdraw from your annuity before the age of 59 ½, there may be tax penalties — usually a 10% penalty from the IRS. However, you may qualify for an exception to the penalty rules. Any decision you make regarding an annuity should be discussed with an independent tax, legal, or financial expert.
5. It’s not all about retirement.
“Everyone thinks of annuities as income providers for retirees, but they can be a helpful tax-planning tool in your arsenal, too,” writes Kevin Nuss for Kiplinger.
“Accumulation annuities offer a tax-advantaged way to save for retirement,” he explains. “You make a deposit, and your earnings are completely tax-deferred until you withdraw them. Deferring taxes lets your savings compound faster.”
The accumulation phase of a deferred annuity involves letting your money grow for a while, and the payout phase follows. As your money accumulates, it grows tax-deferred until you withdraw it, either all at once or in installments.
It is up to you when you take income from your annuity and, thus, when you pay your taxes. The key benefit of deferred annuities is that they allow you to take control of your taxes. As a result, in retirement, you’ll likely be in a lower tax bracket when taking withdrawals.
“The longer you can defer paying income tax on your compounded interest earnings, the greater your gain will be as compared to the gain you would make with a fully taxable account,” states Nuss. “Without the drag of taxes, your money can grow faster until you need it.”
6. Are there any other tax advantages of annuities?
Understanding annuities and taxes can get complicated. For example, the money used to purchase a qualified annuity has not yet been taxed yet. On the other hand, a non-qualified annuity has been purchased with funds that have already been taxed.
The amount left over after taxes after tax-free purchases are known as the basis. Therefore, if you own a non-qualified annuity, you will not have to pay taxes twice. In any event, it is the exclusion ratio that determines how much tax you will owe. In addition, an annuity’s principal, the period it’s been in place, and the interest it’s earned are included.
However, there are also tax advantages that a lot of folks don’t take advantage of, such as;
- Tax perks for long-term care. Long-term care insurance premiums can usually be paid with interest on annuities tax-free.
- Taxes at death. No taxes are due if you leave your spouse an annuity, whether it’s qualified or non-qualified.
- Rollovers. IRA, 401(k), 403(b), and pension payouts can be converted to qualified annuities tax-free
- Deductibility. A qualified annuity contribution is deductible up to IRS limits. In addition, a qualified annuity is subject to the same deductibility limits as any other IRA, 401(k), 403(b), or another qualified plan.
- Defer RMDs with a QLAC. An QLAC is a qualified longevity annuity as long as it meets IRS requirements. Until age 85, you can defer 25% of RMDs, reducing your federal taxes. The money you withdraw from your IRA, eventually, would have to be taxed, but QLAC income is 100% taxable. A QLAC also allows you to contribute 25% of your IRAs, or $135,000 over your lifetime, whichever is less.
7. What fees are associated with annuities?
You have to pay different fees depending on the type of annuity you buy, whether it’s a fixed or a variable annuity. What factors go into determining these fees? Basically, it depends on what the intentions of the contract terms were when you signed it.
An index annuity works entirely differently. They are specifically limiting in returns in accordance with factors such as participation rates, spreads, and caps.
Whatever type of annuity you own, you can anticipate the following fees;
- Immediate annuity fees. Standard fees do not apply to immediate annuities. Nevertheless, the annuity owner may reduce the payout amount if the payout is favorable. With single premium immediate annuities, you can also expect commissions.
- Deferred annuity fees. You will see a reduction in your income distribution if the payout swings in your favor as an annuity owner. These annuities also come with commissions.
- Fixed annuity fees. These fees are paid by reducing interest rates.
- Fixed index annuity fees. With this type, fees will come in the form of annuity riders. Adding these optional features to your annuity is up to you. For example, you might increase the death benefit. Fees can easily cost up to 1.75 percent of the account value annually.
- Variable annuity fees. Variable annuities can be the most expensive in terms of annuity types. Due to the fees associated with variable products, you’ll have to pay more. Why? They aren’t insurance. Instead, they are investments.
Along with knowing the charges above, below are some of the costs associated with annuities. Again, these should never be “hidden” and clearly spelled out in your contract.
- Administrative annual fees
- Fund management
- Investment expense ratio
- Mortality and expense risk charges (M&E)
- Surrender charges
- Tax opportunity cost
8. Do all annuities have high fees?
Short answer? No.
Annuities can be bought from investment companies without paying a commission or surrender fee. Unlike traditional annuities for sale by insurance companies, these direct-sold annuities don’t involve an insurance agent. Without an agent, a commission isn’t necessary.
These are also referred to as no-load annuities.
A no-load annuity is a type of retirement investment that charges lower fees and expenses than annuities usually entail,” explains Julia Kagan for Investopedia. The monthly payments that the investor receives are based on the returns on the account, which the investor manages.”
“No-load annuities are not sold by commission-based brokers or planners because they do not pay a commission,” adds Kagan. They are sold directly by some financial institutions and insurance companies.”
What firms sell low-cost annuities? These companies include Ameritas Life, Schwab, TIAA-CREF, T. Rowe Price, Vanguard.
9. Are there contribution limits with annuities.
Unlike other retirement vehicles, mainly 401(k)s, and IRAs, annuities don’t have contribution limits. As such, you can contribute however you much each month. Just note that the insurance industry generally doesn’t recommend you invest more than 50% of your liquid assets into an annuity.
It would be best if you always ran away as fast as you can from anyone who suggests that you place most of your money into one company or product. Most of the time, they’re doing this for their own benefit and not yours.
10. How can I diversify my annuity?
As a part of your investment portfolio, annuities are important. Why? Well, annuities protect your money from market volatility, inflation, taxes, and even healthcare costs. However, do this correctly, you need to diversify your annuities by;
- Company. Say you want to invest $500k in annuities. It would be wise to spread your money across two or three companies. That would help reduce your risk specific to each company.
- Annuity type. You can also diversify between different types of annuities, so all of your eggs aren’t in one basket. A shorter-term MYGA may be paired with a longer-term index annuity, for instance.
- Crediting method. By using the crediting method, you can diversify your investment in index annuities. Using this method, you can find an index annuity that performs well regardless of the market conditions. And, by distributing it evenly, you’ll average out your return.
- Index. Investing in index annuities allows you to diversify based on the index.
- Month of purchase. When it comes to index annuities, you don’t want all your contracts to mature at once. The best way to accomplish this is by buying multiple contracts throughout the year. By doing so, you can lock in your gains at different points.
- Guarantees. You’re permitted to own guaranteed and non-guaranteed options simultaneously. And, there’s also the option of owning both a fixed and index annuity at once.
11. How much do annuities pay?
“Even in today’s low-rate environment, a 65-year-old man can buy an annuity that pays more than 6% of his initial investment annually for the rest of his life,” says Kiplinger’s Sandra Block. “That’s because your payouts are both from earnings and a return of your principal, and you pool your risk with other clients.” Generally, annuities that pay until death will have the best payouts.
Of course, payouts will vary on the following factors;
- Life vs. joint life. “If you buy an immediate annuity, you’ll get the highest annual payout if you buy a single-life version—one that stops payouts when you die, even if your spouse is still alive,” advises Block. “But if your spouse is counting on that income, it may be better to take a lower payout that will continue for his or her lifetime, too.”
- Men vs. women. Due to their shorter life expectancy, immediate annuity payments are generally higher for men.
- Older buyers vs. younger buyers. As you get older, your payout will increase because your life expectancy will be shorter.
12. Can you change your annuity?
Yes, thanks to the section 1035 exchange, you have the ability to change your annuity. But, why would you want to do this?
There are many factors to consider when choosing an annuity. You also have to pick the right type besides weighing the advantages and risks of qualified and nonqualified annuities. Following that, you must choose the contract with the highest ROI.
Obviously, you could be wrong. For example, let’s say that purchase a variable annuity that grows at 5% annually. Unfortunately, the value of your purchase drops by 3 percent each year after you purchase it. Why? Fund performance can fluctuate. As such, historical performance does not guarantee future results.
The purpose of annuities and other retirement funds is to provide long-term income. But does that mean you should hold on to a badly-performing fund to avoid early withdrawal penalties?
Thank goodness, that’s not true.
Using a Section 1035 Exchange, you can transfer funds between accounts. You can do this under special provisions in the Tax Code. Upon withdrawal, the funds are moved to another retirement account without triggering a tax event or a penalty for withdrawal.
13. How to reduce risk? Annuitize gradually.
The opportunity cost of annuities is one of the most significant drawbacks to annuities. This means in the event market interest rates rise; you’ll miss out on annuity rates once they’ve been locked in. Some people try to time their annuity purchases with interest rates because annuity rates are based in part on 10-year Treasury rates.
“If you try to time an immediate annuity purchase with interest rates, then you have to factor in the payments you’re going to miss while you’re waiting,” Stan Haithcock, also known as Stan The Annuity Man, told U.S. News. While rates will possibly rise in the future, no one can predict when. In turn, you’ll be playing the waiting game.
“The time to buy (an annuity) is when you’re ready to transfer risk,” he says. “It has to do with where you are in life,” not which direction interest rates are going or will go.
The market offers better rates than annuities, which is another argument against them. While it’s true that annuities aren’t designed to beat the market, but keep in mind that annuities don’t exist to do so.
One way to reduce opportunity costs is to annuitize gradually. For example, instead of contributing your entire $100,000 in one go, you can start with $50,000 and add the rest later, says Walter Updegrave, editor of realdealretirement.com. With this strategy, you buy yourself time to better understand the amount of annuity you actually need.
“Sometimes it’s hard to tell when you’re retiring how much income you’re going to need and how much of that income you need to be guaranteed,” he says.
14. Are annuities protected?
The FDIC does not insure annuities, but they are regulated and protected by the state. All states have nonprofit guaranty organizations that are required to join by insurance companies operating there. The guaranty association pays claims if a member company fails.
Across the 50 states, organizations provide coverage of at least $250,000 per customer, per company. In Washington D.C., however, annuites are protected up to $300,000, and in Puerto Rico, they’re protected up to $100,000.
15. Do annuities have beneficiaries?
If your annuity contract has a death benefit provision, you can designate one or more beneficiaries. The primary beneficiary will then receive payments until the remaining annuity balance is depleted or a lumpsum distribution.
You can designate anyone to a beneficiary. Moreover, inherited annuities are taxable as ordinary income. While this isn’t 100% avoidable, this blow can be softened, according to Shawn Plummer, aka The Annuity Expert.
- Spousal continuance. Survivor spouses can keep the annuity and avoid paying taxes at once.
- Bonus annuities. An inheritance can be reinvested with a premium bonus deferred annuity. A premium bonus deferred annuity offsets the taxes due.
- Enhanced Death Benefits. Owners of living annuities can now purchase an annuity with a more significant death benefit to offset their beneficiary’s future taxes upon their death.
- Joint Payout. If the survivor spouse elects a joint payout, the income will continue for the rest of the life of the living annuity owner. If the contract is a Roth IRA annuity, the payments are tax-free.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.