When you buy an annuity, or retirement savings contract, from an insurance company no taxes are due on any earnings the annuity produces until you begin to receive income under the terms of your contract. There are no federal limits on the amount you can put into the annuity each year as there are with IRAs or employer sponsored retirement plans. That means you can build a substantial nest egg for your long-term needs. However, putting money into this type of annuity doesn’t reduce your salary or income tax the way contributing to traditional 401(k)s and similar plans do.
You can invest in a single premium annuity with a lump-sum purchase, or build your annuity account by adding money regularly over a period of time. During this accumulation phase, while the money is invested and you are not withdrawing, you pay no taxes on earnings in the account.
DEFERRED ANNUITIES
With a deferred annuity, you get the benefit of tax-deferred compounding, at either a fixed or variable rate. When you’re ready to begin withdrawals, the way you’ll collect is spelled out in the terms of your contract. Usually it’s in regular monthly installments, but it may be in a fixed number of lump-sum payments. The part of your payout that comes from earnings is taxed at your regular tax rate.
OR
IMMEDIATE ANNUITIES
You buy an immediate annuity with a single payment and begin the payout period right away, or within the first year. The amount of each payment is set by the terms of your contract if you choose a fixed annuity, but changes if you have a variable annuity. Because an annuity provides income on a regular schedule, usually after you retire, these plans resemble employer sponsored pensions in certain ways. You can also buy an immediate annuity to provide a lifetime stream of income for another person.
You get income from your deferred annuity during the payout period, usually beginning after you retire but sometimes much later. If you’re 59½ or older when payments begin, you owe income tax on your earnings at the same rate you pay on regular income. If you’re younger than 59½, you may have to pay an additional 10% of the income as an early withdrawal tax penalty.
INSTALLMENT PAYOUTS
You can choose regular monthly payments for as long as you live or for a set period of time, such as 10 or 20 years.
OR
LUMP-SUM PAYOUT
You can use the money to buy another annuity or for any purpose you choose. You may lose money if your plan imposes a penalty for lump-sum withdrawal.
ANNUITY PAYOUTS
The most common payout options for both deferred and immediate annuities are:
- Single life, which pays you income each month as long as you live. When you die, the payments stop.
- Life, or period certain, which covers your lifetime or a set number of years, whichever is longer. Your heirs get the balance if you die before the term is up.
- Joint and several, which makes payments for your lifetime and the lifetime of your beneficiary.
Remember, though that your receiving guaranteed payments depends on the claims-paying ability of the issuer.
FIXED OR VARIABLE?
Both deferred and immediate annuities are available in two forms: those that pay a fixed rate of interest for the life of the annuity and those that pay a variable rate.
When you buy a fixed annuity contract, the insurance company that issues it guarantees earnings at a fixed rate of return during the build-up period and a guaranteed income for life if you annuitize, which means converting your annuity into a stream of regular income. The company invests your principal and takes responsibility for earning enough income to meet its obligations to you.
With a variable annuity, you decide how your money will be allocated among a specific menu of subaccounts offered by the issuer. Subaccounts are pooled investments, as mutual funds are, with varying investment objectives and strategies.
Variable annuities give you the chance to choose how your contribution is invested and potentially make more than you could with a fixed rate. However, the contract makes no payment promises, so you could also end up earning less if the markets are weak or you choose poorly performing investments.
CHECKLIST FOR ANNUITY INVESTORS
- Consider deferred annuities only if you’re investing for the long term, as assets need time to accumulate. Withdrawals before age 59½ face a 10% penalty in addition to the regular income tax.
- Investigate the reputation of the company offering the annuity to be sure it’s financially sound.
- Compare surrender periods. Most annuities have surrender charges in the first seven years. You can avoid annuities with lifetime surrender charges.
- Look beyond the initial rate if buying a fixed-rate annuity. Approach unusually high rates with caution.
- Look for maximum flexibility on getting your money out. You can avoid annuities that don’t offer a lump sum or give you a lower interest rate if you take one.
- Research the fees an annuity charges. There are alternatives to paying more than 2% annually.
- Compare costs. Some annuities cost more than others offering a similar income stream.
WEIGHING THE ISSUES
Immediate annuities provide the security of a regular income for people who are uncomfortable managing their investments. But they have some potential drawbacks:
- If you choose a single life annuity and die within a few years, the company keeps the balance of your money and your heirs get nothing
- Your annuity income from a fixed-rate contract may not keep pace with inflation
- You may not be able to withdraw a lump sum in an emergency
- Collecting income from the annuity assumes that the issuing company will be able to meet its financial obligations to you
LOOKING AT THE BOTTOM LINE
Annuities are popular retirement planning products, but they also have critics who argue that other investments give you more for your money. It pays to look at both sides:
Pluses
- Tax-deferred compounding
- No government caps on contributions
- Guaranteed income stream with fixed-rate contract subject to claims-paying ability of issuer
- Expanding number of investment choices in variable-rate plans, many with lower fees and no surrender charges
Minuses
- Some variable annuity contracts have high fees and other expenses
- Some annuities impose stiff surrender charges
- Payouts on variable-rate plans may be less than anticipated if rates drop or investments don’t perform as expected
- Taxes on earnings are due at regular income-tax rates, not the long-term capital gains rate