Annuities are great tools for retirement planning, but they can be complicated, too. And the terminology can be confusing even when the underlying concept is simple. When it comes to this important piece of the retirement-security puzzle, how well do you understand annuities?
Here are 12 things we bet you didn’t know about annuities.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC (opens in new tab) or with FINRA (opens in new tab).
1. One of the top selling points of annuities has nothing to do with retirement.
Everyone thinks of annuities as income providers for retirees, but they can be a helpful tax-planning tool in your arsenal, too.
Accumulation annuities offer a tax-advantaged way to save for retirement. You make a deposit, and your earnings are completely tax-deferred until you withdraw them. Deferring taxes lets your savings compound faster.
A deferred annuity has two phases: the accumulation phase, where you let your money grow for a period of time, and the payout phase. During accumulation, your money grows tax-deferred until you withdraw it, either as a lump sum or as a series of payments. You decide when to take income from your annuity and therefore, when to pay any taxes owed. Gaining increased control over your taxes is one of the key benefits of deferred annuities. When you start taking withdrawals in retirement, you may be in a lower tax bracket.
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. Without the drag of taxes, your money can grow faster until you need it.
2. While an annuity's growth is not taxed, your withdrawals and income payments will be.
Annuity interest accumulates tax-deferred and is not taxed until it’s withdrawn. With a deferred annuity, you decide when to withdraw interest and pay taxes on it. Interest credits and gains from all types of annuities are taxed as ordinary income, not long-term capital gain income.
Annuity withdrawals are taxed on a Last In, First Out (LIFO) basis, meaning that accumulated interest earnings are considered to be withdrawn first, before you get any of your tax-free principal back. This is a disadvantage for partial withdrawals, which may all count as taxable income, depending on how much un-taxed gain there is in the annuity.
However, instead of making lump-sum withdrawals, you can extend tax benefits by converting a deferred annuity into a deferred income or immediate income annuity. With income annuities, each monthly payment includes both tax-free return of principal and taxable interest. If you live past your life expectancy and eventually get your entire principal back, the payments will become fully taxable, but that won’t occur for a number of years.
3. An annuity can be swapped tax-free for another annuity.
A “1035 exchange” lets you switch annuity companies while continuing to defer taxes, ensuring that your annuity stays up-to-date with the latest advantages and benefits and the best rates. You can stay with the same type of annuity, or you could switch from one type of annuity to another, if it would meet your changing needs better.
For example, let’s say you invested in a variable annuity when you were in your 40s. It made sense then because variable annuities let you participate in the stock and bond markets’ potential gains while deferring taxes. Now you’re in your 60s and looking for principal protection and guarantees.
A good choice might be a fixed-rate annuity, which pays a set interest rate for a set term. They’re similar to bank CDs with a couple of key differences. A fixed-rate annuity offers tax deferral. Your principal is guaranteed by the issuing insurance company and backstopped by a state guaranty fund. A CD is guaranteed by a bank and insured by the FDIC.
You could exchange your variable annuity for a fixed annuity. Since you’ve had your annuity for years, there would be no surrender charge, so all of your money will go to work for you.
4. An unneeded life insurance policy can be exchanged for an annuity.
Many older people have paid-up cash-value life insurance policies that they no longer need because they’re retired, collecting a pension and Social Security, and have paid off their mortgage or are perhaps divorced, widowed or no longer have any beneficiaries they are concerned for at their death. Section 1035 lets you exchange such a policy for an annuity tax-free. The owner or owners of the life insurance policy and the new annuity must be identical.
For example, a retiree might want to swap a life insurance policy for an income annuity. This product lets you convert your life insurance policy’s cash value into a guaranteed stream of income. They come in deferred and immediate varieties. The latter type provides income starting immediately or within a year at most (your choice). Deferred income annuities pay a stream of income at a future date that you choose.
Income annuities can pay out for a set term, such as 10 years, or for a lifetime. Lifetime annuities are more popular. They act as longevity insurance, protecting owners and their spouses from the financial risks that come with living to a very ripe old age.
5. An annuity with 'the upside of the market but none of the risk' may not be as good as it sounds.
A fixed indexed annuity does do just that. However, in exchange for getting the guarantee that you’ll never have a loss in a down market, you do give up some of the upside.
A cap rate is the maximum rate of interest the annuity can earn during the index term. For instance, the annuity may stipulate that the limit is 6% for an annual index term. If the index performance does not exceed the cap, you’ll get the full return — unless there’s also a participation rate.
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 60% of the increase.
A spread rate or margin is a percentage that’s deducted from the change in the underlying index value to determine the net amount of index-linked interest credited to the annuity.
6. Most types of annuities can work well within an IRA.
It may sound counterintuitive to use a tax-deferred product inside a tax-deferred account, but annuities can work well. Their income, guaranteed interest rates and principal protections still offer advantages within an IRA.
For instance, if you’re looking for a guaranteed yield, fixed-rate annuities usually pay higher rates than bank CDs with the same terms. Insurers that offer IRA annuities usually let you take out your required minimum distribution without penalty, so you don’t have to worry about being penalized for taking RMDs.
Fixed indexed annuities also work well in an IRA. Fixed indexed annuities can be a great long-term play because they offer more upside potential than other fixed annuities. They pay a fluctuating interest rate pegged to the annual percentage change of an index, such as the S&P 500. But the lowest you can earn in any year is 0%. You get a portion of the market’s upside in return for protection against loss.
I normally do not recommend using variable annuities for IRAs. Here you’re typically better off investing in mutual funds directly without the annuity wrapper. You don’t need to pay variable annuity fees for tax-deferral since the IRA is already tax-deferred.
A deferred income annuity (DIA) can work well with IRAs, but you’ll need to make sure your income payments begin no later than age 72 to comply with required minimum distribution (RMD) rules under the new Secure Act. (The age 72 start date applies only to people born after June 30, 1949. People born prior to then already had to start their RMDs at 70½.)
7. A 'no-load' or 'no-fee' annuity does have costs associated with it. They're just in another form.
Like all other financial companies, the insurer issuing the annuity wants to make a profit after covering its expenses and paying a commission to the sales agent. These costs are built into the product. But the vast majority of fixed annuities are good deals because the costs are fairly modest thanks to economies of scale.
High costs can be a problem with some variable annuities. The buyer should get a clear picture of all costs and ongoing fees before buying a variable annuity.
8. Naming anyone other than your spouse as your sole primary beneficiary could be a mistake.
If you name your spouse as your sole beneficiary, upon your death your spouse will usually have the option of filing a claim to take the distribution as a spousal beneficiary or assume ownership of the annuity, continuing it without a taxable event. Non-spouse beneficiaries do not have the option of assuming ownership and must pay income tax on the increase in value of the annuity when it is distributed to them.
9. Withdraw earnings before age 59½? You could pay penalties and taxes. (But there are exceptions.)
These types of early withdrawals are normally subject to a 10% IRS tax penalty plus ordinary income tax. But there are exceptions. For instance, if you purchase an immediate income annuity with a lifetime income payout, you can avoid the 10% penalty on qualified (IRA) or non-qualified funds, even if payments begin prior to age 59½. This lets you receive income from an annuity before 59½ without penalty. It gives you flexibility in case you need cash flow right away because of early retirement or other reasons.
10. The person selling you an annuity might not be required to put your best interests first.
All people selling fixed annuities must possess a state insurance license. Investment Representatives selling variable annuities must also have a securities license. However, financial professionals with these credentials are not held to the fiduciary rule. Instead, they can meet a lower bar, called the suitability standard. The fiduciary rule requires financial professionals to act in the best interests of their clients. The suitability standard only requires the person to offer investments that are suitable for their clients, but not necessarily the best option.
Most state insurance department websites provide consumers with the ability to look up licensed agents in their state. You can learn if the agent you are talking with is properly licensed, how long they have been licensed, and if they have had any complaints filed against them. This is a good starting point to ensure you are speaking with someone who is licensed, experienced and does not have a history of client dissatisfaction.
You can also check the Better Business Bureau (BBB), review sites such as Trustpilot and ask the agent about any industry association memberships they maintain.
11. There's a special type of annuity that lets you put off IRA distributions.
If you want to defer required minimum distribution (RMD) payments past age 72, then you should consider a qualified longevity annuity contract (QLAC). It’s a special income annuity designed to meet specific IRS requirements so that you don’t need to take RMDs on the assets in the QLAC. It’s the only way you can legally delay RMDs for a portion of your IRA funds and thus keep more tax-deferred money in your IRA longer.
You can invest up to 25% of your total IRA money, up to a limit of $135,000, in a QLAC. You can delay taking income payments from the QLAC as late as age 85.
12. Or, you can use an annuity to help fulfill your RMDs.
Holding an immediate annuity within an IRA, if you’re 72 or older, can help you fulfill your required minimum distributions (RMDs). An immediate annuity produces income that counts toward your RMD, and is a great way to get a guaranteed lifetime income.
An immediate annuity converts an asset to income efficiently, but in return, you no longer have cash value and you have little or no ability to change the income stream once it starts. So, you need to understand your total financial situation and make sure you have adequate liquidity before you buy one.
Written by Ken Nuss, the founder and CEO of AnnuityAdvantage (opens in new tab), a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. It provides a free quote comparison service. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities.
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 (opens in new tab) or (800) 239-0356.
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