Annuities: Answering your questions about annuities

Two types of annuities. The two types of annuities are fixed and variable. With a fixed annuity, you can expect a guaranteed rate of return for a specified time. With variable annuities, where the underlying investments are in stocks and bonds, you have the potential for a greater return on your investment, coupled with higher risk of loss including loss of your original investment.

Two payout options. When you purchase an annuity, you will need to decide how you want the proceeds paid to you. An immediate annuity will begin payments to you within 12 months of purchase. With a deferred annuity, you will receive payments at a later date.

This article will help you understand more about the types of annuities you can purchase and how to determine which specific annuity might satisfy your needs.

You have the choice of buying a fixed annuity or a variable annuity. Fixed annuities are generally considered to be more conservative. Variable annuities, having the potential for gain and losses, have a higher risk.

Fixed Annuities

Fixed annuities earn a guaranteed rate of interest for a specific time period, such as one, three, or five years. Once the time period is over, a new guaranteed interest rate is set for the next period. A fixed annuity guarantee is subject to the financial strength and claims-paying ability of the insurance company that issues the annuity.

Variable Annuities

Variable annuities typically offer a range of funding options from which you may choose. These funding options may include portfolios comprised of stocks, bonds, and money market instruments. The account value of variable annuities can go up or down based on market fluctuations. Your purchase payments and earnings 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 fixed annuity returns. If they don’t perform well, you may lose not only any earnings you’ve made, but even some of your purchase payments.

Some variable annuities offer, in addition to a range of funding options, a fixed account option that guarantees both principal and interest, much like a fixed annuity. A fixed account option can give you the security of allocating some of your purchase payment more conservatively while still taking advantage of market potential.

Variable annuities also allow you to transfer money from one funding option 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 federal income taxes on any earnings you have accumulated at the time of transfer. Income tax free transfer means you can re-allocate money to suit changing investment goals (e.g., due to life events) without worrying about a current income tax burden on such a transfer because the tax burden is generally deferred until the taxable portion is distributed from the contract.

Fixed and Variable Annuity Charges/Fees

If you withdraw money from an annuity, there may be a surrender fee (or withdrawal charge). Usually surrender charges are applied to all purchase payments you make and reduce to zero over time. Therefore,if you save over the longer term, no surrender charges would apply.

Additionally, if you choose to surrender your contract early, the insurance company will recoup expenses (taxes, commission, and operational overhead), that could not be realized because you did not leave your money on deposit long enough. Many surrender charges start between 7% and 9% in the first year of a deposit, go to 0% within 7–9 years, and may provide for a free corridor (e.g., 10% of Account Value) where surrender charges do not apply. Some annuities have surrender charges that are longer and higher than that and you should examine all features of the contract carefully. Also a market value adjustment may apply that may be positive or negative.

Surrender fees are usually highest if you take out money in the first few years of an annuity contract. Withdrawals and income payments from annuities are subject to ordinary income taxes. Distributions of taxable amounts are subject to ordinary income taxes and, if made before age 59½, may be subject to a 10% federal income tax penalty. The calculation of the taxable portion of a distribution may differ depending on the type of contract (e.g., qualified or nonqualified) and whether you are taking withdrawals or receiving income payments.

Fixed annuity contract expenses are taken into consideration when the company declares the periodic interest rate or determines the payment amount.

Variable annuities usually have more features, therefore, more complex and higher fees than fixed annuities. For example, variable annuity fees may include an annual contract charge (referred to as a “separate account” charge) that covers the risks that the insurance company undertakes in administering the contract and providing a basic death benefit.

In addition, a variable annuity, like most other investments, has fees for the management and operating expenses of the funding options in which your money is invested. These charges pay for everything from the fund manager’s salary to brokerage commissions.

For a variable annuity, important information including investment objectives, risks, charges, and expenses will be explained in the prospectus. This and other information is described in detail in the variable annuity product prospectus. Read it carefully before you invest or send money and be sure you understand exactly what your expenses will be. The prospectus is available from your registered representative.

You can put money into a deferred annuity with a single payment or flexible payments, but immediate annuities are usually purchased with a single payment. As the names imply, you get money sooner from an immediate annuity and you delay getting money from a deferred annuity.

If you want retirement income beyond what you will receive from Social Security or your pension plan, a deferred annuity may be what you’re looking for. They are particularly effective if you have many years until retirement. Your money has the potential to grow, tax-deferred. That means you pay no income taxes on investment earnings until you begin to withdraw your money.²

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. Consult a professional financial advisor for assistance in making this determination.

A nonqualified deferred annuity is not a vehicle for money you may need for current expenses. If you withdraw income before age 59½, a 10% federal income tax penalty typically applies to the taxable portion of the withdrawal, in addition to ordinary income tax. What’s more, your insurer may impose its own early withdrawal penalty, also known as surrender fees, if you cash in all or part of your deferred annuity within a specified period. These fees often cease seven to nine years after your date of purchase. There is often a separate surrender fee for each payment. A new payment may have a 7– 9 percent fee if you take out the new payment 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 percent) annually without surrender charges but ordinary income taxes (and a 10% tax penalty if you are under age 59½) may still apply. In general, partial withdrawals from nonqualified annuity contracts are treated as coming first from the earnings in the contract (and, thus, subject to ordinary income tax), and only when all the earnings have been exhausted are the withdrawals treated as a nontaxable return of your after-tax investment in the contract.

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. How do the fees and charges of your existing contract compare with the proposed new contract? If you decide to exchange one annuity for another, you usually should request and complete the appropriate forms provided by your insurance company to enable the transaction to 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—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, too. Some of the earnings are included in your income annuity payments (based on an exclusion ratio) and are taxable; meanwhile, tax-deferred earnings can continue to accumulate on the remaining purchase payments and earnings that have not yet been distributed. Choosing the alternative of receiving distributions as periodic income payments after retirement may further reduce your income tax liability, if you are in a lower income tax bracket in later years. Some annuities also provide you with an option called systematic withdrawal to have a set amount, determined by you, automatically withdrawn and deposited directly in your bank account at regularly scheduled intervals, such as monthly. Note, however, these systematic withdrawals are generally treated as partial withdrawals (not income annuity payments) and taxed according to the rules that apply to partial withdrawals (and not income annuity payments). You have many options for receiving your money, each with its own tax ramifications. Consult your tax professional or financial advisor to tailor a plan for your particular needs.

² Tax laws and regulations are subject to change. Unlike a nonqualified deferred annuity purchased with after-tax dollars, an IRA or other qualified plan receives tax deferral under the non-annuity provisions of the Internal Revenue Code. Therefore, there is no additional tax benefit to purchasing a deferred annuity to fund an IRA.

Good reasons to consider a deferred annuity as part of your financial retirement plan:

• You postpone paying income taxes on any earnings until you withdraw money, typically during retirement, when you may be in a lower income tax bracket. In general, all earnings can grow income tax-deferred. Of course, IRAs already receive the benefit of tax deferral, so there is no additional tax benefit to purchasing a deferred annuity.

• There is no tax law restriction on how much money you can contribute. Unlike Individual Retirement Accounts (IRAs), federal tax law does not restrict the amount of after-tax money you can contribute to a deferred annuity. You can, however, use a deferred annuity to fund your traditional or Roth IRA, in which case you would be subject to federal tax law limits that apply to IRAs (including Roth IRAs).

• You can provide death benefits to your beneficiaries. Death benefits for annuities vary according to contract. If you die prematurely, your annuity can offer a death benefit to your beneficiaries without the costs and delays of probate. Typically, your beneficiaries will receive your account value and many variable annuities will guarantee at least what you have contributed (less withdrawals). A spouse can step in as the new owner of the annuity and the tax deferral continues until the taxable amount is withdrawn. A nonspousal beneficiary who inherits an annuity before distribution begins can request a lump sum distribution or delay receipt for up to 5 years or, if the designated beneficiary is a natural person and the terms of the applicable annuity contract permit, the nonspousal beneficiary may be able to receive distributions of his/her inherited interest in the annuity contract over his/her life or life expectancy.

• You can choose to protect either your purchase payments or the income your annuity will provide with additional guarantees called “living benefits.” There are three basic types of living benefits that may be available in a variable annuity,each with a distinct objective. The actual guarantees offered and corresponding additional fees will vary by contract. When choosing a living benefit, it’s important to weigh the costs against the benefit. Your financial representative can provide you information to help you decide if a living benefit is right for you.

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 through a retirement plan or other savings vehicle.

To purchase an immediate annuity, you make a one-time payment, and distributions must begin within a year, but typically begin within a month. Immediate annuities can be fixed or variable, just like deferred annuities. Unlike deferred annuities, you typically do not have access to your purchase payment once it is paid to the insurance company. However, in return for your purchase payment, you are guaranteed to receive an income stream, like that described earlier under 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. Variable immediate annuities are designed to provide income that can increase over time to help you keep pace with inflation. Bear in mind that income payments may go up or down based upon market fluctuations with a variable immediate annuity.

Your purchase payment to an immediate annuity are not generally readily accessible. If you need more income than the immediate annuity provides, you can keep some of your retirement funds in a liquid account, such as a savings account or money market fund. Also, if you choose an income for life option your income payments may be less than your original purchase payment. Fortunately, annuities generally offer several guaranteed payout options for your heirs and benficiaries, including guarantee periods and refund features. For more information, see the Payout Options with Guarantees section below.

When selecting the funding options for a variable immediate annuity, keep inflation in mind. You want investments that will keep pace with inflation. Variable immediate 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 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.

Among the reasons to consider an immediate annuity are the following:

• An immediate annuity is a financial vehicle that can provide guaranteed income for life. When you are ready to retire, and look at what your expenses will be, you’ll notice that some of them will last a lifetime. If your Social Security retirement benefits and company pension aren’t enough to pay for these expenses, an income annuity can provide income to close a “guaranteed income gap.”

• The income payments you receive can supplement your other income sources, such as Social Security and pension payments, which may not provide enough income by themselves.

• You choose how often to receive your income payments whether monthly, quarterly, semiannually or annually.

• You pay income taxes only as you receive your payments. When you receive income payments, you will be taxed on the portion of the payments that is earnings. The portion that is purchase payments, which represents your initial deposit made with money that had already been taxed, is not taxable.

• You can put a system in place to help lessen your financial worries or help you recover from the effects of market volatility. Financial management can be a burden in your retirement years. Because you don’t know how long you’ll live, it’s hard to be sure your resources will last as long as you need them. If you withdraw too much of your nest egg, your future income can suffer or you may run out of money entirely. If you are too thrifty when it comes to spending your nest egg, you might not be able to maintain your current lifestyle. Fixed immediate annuities can help you determine your periodic income as they guarantee a fixed rate and fixed payments. Your payments will not be affected by the ups and downs of the financial markets. Variable immediate annuities will offer income payments, although they will vary according to the performance of the selected subaccounts.

• You want to help maximize your retirement income.

• You’re concerned about running out of money in the later years of life. Some income annuities provide a type of “longevity insurance,” meaning that you’ll receive a guaranteed income stream at a certain age, such as age 85. These annuities help you plan your retirement income for a set number of years.

You can choose from a number of payout options for receiving income from an annuity. 

• Lifetime Income for You. You can opt for income, guaranteed by the insurance company, for the rest of your life. Payments cease upon your death. This is called a straight life option.

• Lifetime Income with a Guaranteed Period. You will receive income for life, guaranteed by the insurance company. If you die before the guarantee period is over, your beneficiaries will receive the remaining number of payments. This type of annuity option is often called a “life annuity with period certain.”

• Lifetime Income for Two. You can opt for income guaranteed for the rest of your life and the life of another person, such as your spouse. Guaranteed income for two people is known as a joint and survivor option, which guarantees that income payments will continue for the life of the primary owner and a second person. The insurance company issuing the annuity makes the guarantee.³

All guarantees are subject to the financial strength and claims-paying ability of the issuing company.

³ For qualified retirement plans and IRAs, if income annuity payments are payable over the joint lives (or a period certain not exceeding the joint life expectancy) of you and a nonspousal beneficiary, the federal tax rules may require that the payments be made over a shorter period or that payments to your beneficiary be reduced after your death.

All guarantees are subject to the financial strength and claims-paying ability of the issuing company.

What Are My Retirement Goals?

If you decide an annuity is an appropriate investment for you, you’ll need to answer four questions to determine the kind of annuity best suited to your needs.

How secure do you want the annuity to be?

• I want the returns from my annuity to be at a guaranteed predetermined interest rate: Fixed annuity, or

• I want a return that varies with the success of the investments made for me by the insurance company: Variable annuity.

How do you want to pay for the annuity?

• I want to make a single, lump sum payment for my annuity:Single premium annuity, or

• I want to make ongoing payments at intervals: Flexible payment annuity.

When do you want to begin getting returns (payout) on your money?

• I want to begin receiving the income from my annuity right away, or start the income at a certain age in the future: Immediate annuity, or

• I want to begin receiving the income at some future date (e.g., at retirement): Deferred annuity.

How do you want deferred proceeds to be paid out?

• I want payments for the rest of my life: Straight life option, or

• I want payments for life and for the rest of my spouse’s life: Joint and survivor option, or

• I want payments for life, but if I die before collecting all the premiums I paid, I want my beneficiary to collect the remaining money: Life annuity with refund feature option.

For example, after receiving an inheritance, you could decide to invest a lump sum of money right away, and receive a specified interest rate beginning now for the next five years. In that situation, you might want to buy an immediate fixed annuity and pay for it with a single premium.

Before you buy an annuity, consider the following:
The money contributed to a nonqualified annuity may be in post-tax dollars. When you contribute after-tax savings to an annuity, you can put as much money in 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 qualified retirement plan, such as your IRA, SEP, 401(k) or 403(b). Also note that annuities may fund a qualified retirement plan, such as an IRA, SEP, 401(k) or 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 72. Failure to do so will result in a tax penalty of 50 percent of the amount of the shortfall. Additionally, once money is in your 401(k) or 403(b) plan, you generally cannot make withdrawals before age 59½ except for special circumstances, such as severance from employment, death or disability. If you meet an exception, withdrawals of taxable amounts are subject to ordinary income taxes and may be subject to a 10 percent federal tax penalty for pre-59½ withdrawals.

Expenses can vary. Make sure that the annuity contracts you consider have competitive fees. Independent rating services such as Morningstar and Lipper Analytical Services publish reports that compare variable annuity fees. 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 when distributed. If your ordinary income tax rate at retirement is higher than the applicable long-term capital gains rate for certain investments, you would actually pay higher taxes. You do, however, gain a tax deferral on earnings. With some other investments, you could be subject to ordinary income taxes as well as capital gains taxes annually, even if you have not cashed in the investment, which can reduce the value of your earnings.

If you’ve decided that an annuity makes sense for you, here are several key questions to ask yourself before signing up:

• Have you done some comparison shopping and considered all of your options? Because annuities are long-term savings vehicles, you’ll want to make sure the company you pick will be around at least as long as you will. And, as you learned in the previous discussion, different annuities offer a wide range of choices, prices, features and flexibility.
  

• Does the rate on a fixed annuity look too good to be true? You want a competitive interest rate at renewal time. If the company is offering bonus rates (a higher interest rate for a set period of time) make sure the underlying interest rate is financially attractive, considering any additional contract costs or early surrender fees. Once the bonus rate term expires, you have no guarantee going forward that renewal rates will be competitive.

• What are the annuity’s surrender fees and how long are they in place? If the surrender fee is a high (typical fees are around 6 to 7 percent and decline over a period of approximately 5–7 years), you could find yourself locked into a contract from which it will be costly to escape.
  

• What is the track record of the funding options offered in a variable annuity? Don’t be swayed by last month’s top performer. Look for strong returns over a three-to-five-year period or more. Newspapers such as Barron’s and the Wall Street Journal publish rankings of various funding options on a regular basis. The history of various funding options also can be found in Morningstar and Lipper Analytical Services publications. Remember, past performance is not a guarantee of future results.
  

• Does a variable annuity offer multiple funding options in case you change your investment strategy a few years down the road? Look for a range of funds to diversify your retirement savings as your needs change.
  

• Will your ordinary income tax rate be greater than the applicable capital gains rate when you begin to take distributions (possibly at retirement)? If so, you may pay more in taxes by choosing annuities over another investment that would be taxed at the capital gains rate. Keep in mind, however, that your money in an annuity is accumulating on a tax-deferred basis. By selecting an annuity, you can avoid paying yearly ordinary income tax on the earnings while your money can compound and grow.
  

• What is the insurance company’s rating? While anyone who is properly licensed to sell insurance products (e.g., banks, brokers, agents) can sell annuities, the insurance company issues the annuity contract. So, you’ll want to consider the company’s rating when considering annuity product guarantees. Is it financially strong, with a good claims-paying record? While this is most important for fixed annuities, it is relevant to any guarantees (e.g., death benefit) in a variable annuity as well. Checking up on an insurance company is easy at your local library or on the Internet, or you can contact your state’s Department of Insurance. A.M. Best, Standard & Poor’s and Moody’s all rate the financial strength of insurance company general accounts. Morningstar and VARDs evaluate and report information on variable contracts only. Variable annuities are rated by independent sources such as Lipper Analytical Services, VARDs and Morningstar. It’s a good idea to choose an annuity from a company that gets high marks from at least two independent rating sources.

References

Getting Started in Annuities by Gordon Williamson
Published by John Wiley & Sons $19.95 (paperback)
ISBN# 0471-283037

Standard & Poor’s Guide to Saving for Retirement
by Virginia B. Morris and Kenneth Morris (Lightbulb Press)
Published by McGraw-Hill. . . . . . . . . . . . . . $15.95 (paperback)
ISBN: 193-356903-4

Web Sites

www.aarp.org
Provides information on annuities and other topics related to financial planning for retirement.

www.sec.gov/investor/pubs/varannty.htm
The Securities and Exchange Commission’s (SEC) online pamphlet, Variable Annuities: What You Should Know, offers information about all aspects of variable annuities.