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Dissecting how annuities work,
whether you should buy one, and what kind to buy is no easy task.
Here's how you can cut through the complexity of annuities to
determine whether they are the right long-term product for you.
An annuity is a retirement-planning
tool that has two phases: the accumulation phase and the annuitization
phase. In the accumulation phase, you give money to an insurance
or investment company over a period of time or in a lump sum,
and it earns a rate of return. In the annuitization phase, you
begin to withdraw regular payments (such as monthly or annually)
from your contract until you die.
An annuity has a death benefit,
although it is not like one found in a life insurance policy.
If you die before you annuitize, your beneficiary will receive
either the current value of your annuity or the amount you have
paid into it, whichever is greater. For example, if you die when
your investments are performing poorly and your account value
is less than what you have paid in, your beneficiary would receive
the amount you paid in.
Once you begin to receive monthly
payments, you no longer have a death benefit on your contract.
For example, if you annuitize at age 65 and die at age 67, the
insurance company keeps your money in your contract. However,
you can buy "term certain" annuities, which guarantee
that either you or your beneficiary will receive payments for
a certain period of time, such as 10 to 15 years. For example,
if you died three years after you began receiving payments from
a 10-year term certain annuity, your beneficiary would still
receive payments for the next seven years.
The money in your annuity grows
tax-deferred, meaning that the money is not taxable until you
begin to receive payments from your annuity. Once you receive
payments, your gains are taxed at your ordinary income tax rate.
If you die before you annuitize, your beneficiary pays taxes
on the death benefit. In either case, the person who receives
the money (the annuity holder or your beneficiary) is taxed at
his or her ordinary income tax rate.
The ideal annuity buyer is 55
or older. Annuities are less attractive to younger investors
because there is a 10 percent penalty tax if you withdraw money
from your annuity before age 59½ for reasons other than
death or disability. However, if you have already retired and
need annuity income right away, opt for immediate annuities,
which skip the accumulation phase and begin to issue payments
as soon as you invest in the contract.
If you have already contributed
the maximum amount to your existing tax-deferred retirement plan,
such as a 401(k), 403(b), or IRA, you are the ideal annuity buyer.
That's because you are already building up tax-deferred money
in those plans, and the fees associated with those savings vehicles
usually are much lower than those of annuities.
Three types of annuities
There are three kinds of annuities
and each differs in how the money in your contract is invested.
Fixed annuity
The money you invest earns a
fixed rate of interest that is guaranteed by the insurance company.
The upside is that there is no risk involved. The downside is
that you will miss out on any gains you could have made if the
stock market performs well. When you annuitize, your payments
are also fixed.
Variable annuity
Your money is placed in investment
options known as subaccounts, which are similar to mutual funds.
Each subaccount has its own degree of risk, ranging from aggressive
growth funds to bond funds. The upside is that you have the opportunity
to make substantial gains, depending on the performance of your
investment. The downside is that you will lose money if your
investments perform poorly. Another VA downside: It may cost
you to switch your money among subaccounts. When you annuitize,
your payments fluctuate depending on the performance of your
investments. Some VAs allow "fixed annuitization,"
in which you receive fixed payments. The insurance or investment
company recalculates your payments each year based on the performance
of your investments.
Equity-indexed annuity
Your money is invested in a fixed
account and you may earn additional interest based on the performance
of a particular stock index, such as the Standard & Poor's
500 Index, the Dow Jones Industrial Average, the NASDAQ Composite
Index, or the Russell 2000 Index. The upside is that you get
the best of both worlds - the opportunity to earn money based
on stock performance and the stability of a fixed account. The
downside is that you still essentially have a fixed annuity,
and the gains you can make in the contract due to the performance
of the stock index are fairly small. When you annuitize, your
payments are fixed.
Surrendering Your
Contract
If you buy an annuity and then
decide you want to get out of the contract, you can surrender
your annuity. Most companies charge you a surrender fee if you
decide to get out your annuity within the first seven to eight
years of owning it. The shorter amount of time you are in the
annuity, the more you'll pay in surrender fees. For example,
if your annuity has a seven-year surrender period, and you surrender
your annuity in the first year, you may pay 7 percent of the
value of your investment to the company. If you surrender in
the second year, you may pay 6 percent, and so on.
If you want to switch one annuity
for another, you can do so without paying taxes. Exchanging one
contract for another is known as a 1035 exchange (named after
Section 1035 of the federal tax code). In a 1035 exchange, you
can exchange a life insurance policy for another life insurance
policy, an annuity for another annuity, or a life insurance policy
for an annuity without paying taxes. However, you cannot exchange
an annuity for a life insurance policy without paying taxes on
the gains in your contract.
If you need to tap into your
money before the surrender period, some insurers will allow you
to access a small percentage of your investment, about 10 to
15 percent, under certain circumstances, such as serious illness
or disability. After the surrender period, you can withdraw as
much out of your annuity as you want. However, if you take out
that money before age 59½, it is subject to 10 percent
penalty tax.
See The Basics of Annuities for the complete
article. |
