Most fixed annuities are designed to provide safety and secure your assets and income for retirement. When financial markets are tanking, whether in the short or long term, these annuities provide guaranteed stability along with tax advantages.
Annuities are simply accumulation or income vehicles sold and guaranteed by insurance companies. They fall into two camps: deferred annuities with cash value that let your money grow tax-deferred and income annuities that have no cash value but guarantee a stream of current or future income.
How can you decide if an annuity is right for you? And if it is, what type(s) make the most sense? Here are some guidelines and questions to ask yourself.
Start with taking a close look at your current financial situation and where you want to go. If you’re working, estimate your income needs in retirement. (If you’re retired, you should already have a good idea.)
- What will your future expenses be, at least in the early years of retirement? How much of them will be covered by Social Security and other guaranteed pensions if you have any? If they won’t cover all of your expenses, how will you use your savings to cover the remainder, especially if you (and/or your spouse if you’re married) live to a very old age?
- Does your asset allocation match up with your risk tolerance and goals? Are you too heavily or too lightly invested in equities? Are you getting a reasonable yield on your safe, fixed-income assets, or can you do better?
- Are your savings and investments tax-efficient, or is there room for improvement? Are you willing to give up control over some of your assets now in exchange for a promise of guaranteed future income? A lifetime income annuity is the only financial product that can guarantee an income for life.
Once you get some answers to these questions, you can start creating your investment and income strategy and determine how an annuity or annuities fit into it.
Unfortunately, some financial advisers are biased against annuities. Their opposition may stem from a lack of knowledge about how annuities work. And while the vast majority of annuities are good deals for investors, a few aren’t — and they’ve gotten a lot of attention. Or it may be based on conscious or subconscious awareness that they won’t earn fees on the assets in your annuities (if that’s the case). If you have an adviser, you may need to educate him or her about annuities and why you want to include them in your plan.
On the other hand, avoid annuity agents who make unrealistic claims about annuities or quote unusually high interest rates.
Two options in deferred annuities
If you’re not yet willing to give up control over some of your assets now in exchange for future income, consider accumulation-type annuities. They provide tax-deferred growth and can be converted into an income annuity in the future. Since they’re tax-deferred, they’re also known as deferred annuities. This article focuses on them. Our next article will focus on income annuities.
Deferred annuities were created to help Americans save more for retirement through tax deferral. By shifting some of your money into a deferred annuity, you can cut your federal and state income tax and see your money compound faster. Annuity interest is not taxed until it’s withdrawn. You get to decide when to withdraw interest and pay taxes on it.
If you withdraw money from your annuity before age 59½, you’ll typically owe the IRS a 10% penalty on the accumulated interest earnings you’ve withdrawn (unless you’re permanently disabled) as well as ordinary income tax on the amount. Therefore, deferred annuities are generally most appropriate for people in their 50s or older who are fairly sure they won’t need the money before 59½.
Variable annuities, which entail market risk, have their merits, but since I don’t work with them, this article won’t cover them. Instead, we’ll focus on fixed annuities, which come in two major types.
Multi-year guarantee annuities for your fixed-income allocation
If because of the stock market’s advance or other reasons, you’re now too heavily invested in equities, you should boost your fixed-income allocation. If you can afford to tie up some of your money for a few years, a fixed-rate annuity can be optimal.
The most popular type is the multi-year guarantee annuity, often called a CD-type annuity. Like a bank certificate of deposit, it pays a guaranteed interest rate for a set period, usually two to 10 years. Interest is tax-deferred when left in the annuity to compound.
These annuities currently pay much higher rates than CDs and most other fixed-rate investments of the same term. There’s no sales charge.
The market value of a bond fluctuates with changes in interest rates. If rates go up and you sell a bond before maturity, you’ll have a loss. With an individual bond, you can avoid this problem by holding it to maturity, but investors in bond funds and bond ETFs don’t have that option. Individual bonds (except Treasuries) also face default risk.
With fixed annuities, the insurance company guarantees both interest payments and principal. It bears the underlying investment risk, shielding annuity owners from bond market volatility and default risk.
Although state regulators constantly monitor the financial strength of insurers, it’s prudent to check the insurer’s A.M. Best rating. While annuities aren’t FDIC insured, state guaranty associations provide an additional layer of protection to annuity owners.
Most fixed-rate annuities offer some liquidity because they let you withdraw up to 10% of the value annually without penalty. (Larger withdrawals before the surrender period has ended will result in early surrender charges.) You will owe income taxes on any interest withdrawn.
Fixed-indexed annuities offer market growth potential without downside risk
These complex instruments are essentially a new asset class. They pay a varying rate of interest depending on the performance of a market index, such as the S&P 500, but never post an annual loss. In exchange for this guarantee, you usually get only a portion of the index’s gain during up years.
A cap rate is the maximum rate of interest the annuity can earn during the index term. For instance, the limit might be 5.25% for an annual index term. If the index performance does not exceed the cap, you’ll get the full return.
The participation rate determines what percentage of the increase in the underlying market index will be used to calculate the index-linked interest credits during the index term. For instance, it may say you’ll get 40% of the increase. So, for instance, if the S&P rises by 20%, with a 40% participation rate, you’d earn 8% for that year.
Consider your goals before investing
To grow your long-term money while protecting your principal: If that’s what you’re focusing on, look for indexed annuities that are most likely to credit the most interest over time. Avoid extra-cost features like guaranteed-income options. They can work against your goal of maximizing growth.
You can also rank indexed annuities by their current cap rates or participation rates, but that doesn’t provide a complete picture. Your agent or adviser can run back-testing based on historical index performance to get an idea of how a particular indexed annuity sub-account might perform in the future.
Most back-testing assumes that the current cap rates and participation rates remain unchanged for the entire test period. However, many insurance companies adjust cap and participation rates annually. Understanding a particular insurance company’s history on cap and participation rate adjustments is helpful.
To guarantee future income: If this is your main goal, look for an indexed annuity that guarantees future income, typically via an income rider. You may be less concerned with account value growth as long as the maximum future income goal is achieved.
The amount of guaranteed future income is important, but since you’ll be relying on the insurance company to provide income payments for your lifetime, you should also consider its financial strength.
What if two income riders produce the same income payments? Look at other factors to break the tie. Which underlying annuity has higher cap or participation rates? Which issuing company is financially stronger and better rated? Which annuity offers indexes that you like — is the S&P 500 the only choice, or are there other options? Which one has better liquidity provisions?
To get both reasonable growth potential and future income guarantees: With this balanced approach, you will probably not get the very best growth potential or the best future income guarantees. But by comparing for the best combination of growth and income, you should be able to do well in both areas. This will let you take advantage of both growth potential and guaranteed income and gives you the most flexibility to meet developing needs in the future.
A free quote comparison service with interest rates from dozens of insurers is available at https://www.annuityadvantage.com or by calling 800-239-0356.
Retirement-income expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. Interest rates from dozens of insurers are constantly updated on its website. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities. More information is available from the Medford, Oregon, based company at https://www.annuityadvantage.com or (800) 239-0356.
Louisiana Tax Relief Granted After Seawater Intrusion
Tax Relief The IRS has granted Louisiana tax relief to affected taxpayers following seawater intrusion of the Mississippi River.
By Katelyn Washington Last updated
A 10-Year Checklist For Retirement Planning
This checklist for retirement planning will help you get in shape 10 years out.
By David Rodeck Published
You've Just Inherited an IRA: What Do You Do Now?
The rules on inherited defined contribution plans (not just IRAs) seem like a moving target, but here’s what you need to know (as the rules stand now).
By Evan T. Beach, CFP®, AWMA® Published
Five Tips for Becoming a Financially Successful Couple
Husband-wife financial adviser team practice what they preach, recommending lots of open communication and aligned priorities.
By Tim Schultz, NSSA® Published
Roth IRA Conversions: Benefits and Considerations Beyond Taxes
You could pay a lower tax rate now if you convert savings into a Roth IRA, but there could be more complex issues for you to consider.
By Troy Sharpe, Certified Financial Planner Published
Do You Have Enough Income to Retire? That Is the Question
To be or not to be secure in retirement… Income planning is critical, and that means testing different strategies and products to get your best outcome.
By Jerry Golden, Investment Adviser Representative Published
Deferring Taxes Until Retirement? You May Want to Rethink That
If tax rates go up in the future (such as when provisions in the TCJA sunset), that could lead to a bigger tax hit, depending on the types of accounts you have.
By Scott Noble, CPA/PFS Published
How to Plan for Your Three Acts of Retirement
Planning for your retirement years may seem daunting, but considering your differing needs and wants as you transition through these three phases can set you up for success.
By Angie O’Leary Published
Focusing Too Much on a Bull Market Could Lead You Astray
When a bull market is driven by only a handful of stocks, not all investors will benefit from the gains. What should you look at instead?
By Kurt Fillmore, Investment Adviser Published
Advisory Annuities Let You Eliminate the Middlemen
With a traditional annuity, multiple entities take a cut before you get yours, but there’s a new, interesting option that, for some, is worth considering.
By Samuel V. Gaeta, CFP® Published