You're not alone. Many people have difficulty understanding them. The main reason for all the confusion: Annuities may be single or flexible-payment; fixed or variable; deferred or immediate. No matter the type, annuities are financial contracts with an insurance company that are designed to be a source of retirement income. This article will help you decide if an annuity is right for you and help you to choose the type of annuity that best meets your needs.
In the broadest sense, there are 2 main types of annuities from which to choose from, those being fixed and variable. Fixed annuities are the more conservative option in that they offer a guaranteed growth. Variable annuities offer more side investment options that cannot be guaranteed to increase in value. Therefore they are considered a more "hands-on" annuity option for a risk-oriented investor. (It should be noted that although variable annuities do not guarantee growth, they do have potential for a growth that far exceeds that of fixed annuities)
A fixed annuity's guaranteed growth is born out of an interest rate that remains constant throughout the designated time frame. Once said timeframe ends, another one is established with a new interest rate that better reflects the current state of the market. Although the interest rate might vary slightly throughout fixed annuity timeframe, it still guarantees more of a return than a variable. Fixed plans offer fewer features and side investment vehicles than a variable annuity, however their fees are also much lower.
Another benefit of a fixed annuity is the fact that its death benefit is immediately passed on to your designated beneficiaries following the unfortunate occurrence of the policyholder's death. Standard protocol with death benefits is that they go through probate in which it is verified that the beneficiaries were in fact designated by the policyholder. (This can be an uncomfortable process following the death of a loved one)
Simply stated, fixed annuities bring stability and safety to your investment portfolio.
Equity-Indexed Annuity
A variation of the fixed annuity is the equity-indexed annuity. With this type
of annuity, your account accumulates at a minimum fixed rate of return. Your
account also may earn additional interest based on the performance of an
equity index. Generally, the indices used are widely reported common stock
indices, the most prevalent being the Standard & Poor’s 500 Composite Stock
Price Index.
What Are Immediate Annuities?
Single Premium Immediate Annuities (SPIAs) are purchased by a single deposit.
They usually start making regular monthly payments to you immediately
after the date you make that deposit. The key ingredient for an immediate
annuity is the exchange which takes place between the insurance company and
the buyer. The company promises to pay a monthly income for the life of the
annuitant and the buyer gives up his rights to ever receiving his deposit back
in a lump sum. Once an immediate annuity makes its first payment, it generally
cannot be cashed in.
An immediate annuity can be purchased with funds from a variety of possible sources, such as: a maturing Certificate of Deposit (CD); monies which have accumulated in a Deferred Annuity account (see below); or funds from a tax-qualified defined benefit or profit-sharing plan, or from an IRA account.
An immediate annuity is a financial vehicle that can provide guaranteed income for life. 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, semi-annually or annually, there's a payout plan to fit your particular needs.
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 principal, which represents your initial deposit made with money that had already been taxed, is not taxable.
Funds That Purchase an Immediate Annuity
Source of Funds - Qualified vs. Non-Qualified
The term Qualified (when applied to Immediate Annuities) refers to the tax status of the source of funds used for purchasing the annuity. These are premium dollars which until now have "qualified" for IRS exemption from income taxes. The whole payment received each month from a qualified annuity is taxable as income (since income taxes have not yet been paid on these funds). Qualified annuities may either come from corporate-sponsored retirement plans (such as Defined Benefit or Defined Contribution Plans), Lump Sum distributions from such retirement plans, or from such individual retirement arrangements as IRAs, SEPs, and Section 403(b) tax-sheltered annuities, or Section 1035 annuity or life insurance exchanges. Generally speaking, insurance companies use male/female (sex-distinct) rates to price qualified annuities in situations where the purchaser and/or owner is a corporation. When the annuity is being purchased by an individual, annuity rates are generally unisex. Some states, however, require that unisex rates be used for all qualified annuities.
Non-qualified immediate annuities are purchased with monies which have not enjoyed any tax-sheltered status and for which taxes have already been paid. A part of each monthly payment is considered a return of previously taxed principal and therefore excluded from taxation. The amount excluded from taxes is calculated by an Exclusion Ratio, which appears on most annuity quotation sheets. Non-qualified annuities may be purchased by employers for situations such as deferred compensation or supplemental income programs, or by individuals investing their after-tax savings accounts or money market accounts, CD’s, proceeds from the sale of a house, business, mutual funds, other investments, or from an inheritance or proceeds from a life insurance settlement. While most insurance companies apply their male/female (sex-distinct) tables to non-qualified annuities, some states require the use of unisex rates for both males and females.
So why should you consider investing in an annuity? How about these reasons:
Another type of annuity is Variable which we currently don't offer through MultiQuote Insurance. What is the difference between a fixed annuity and a variable annuity?
Fixed annuities pay the same amount each month, while variable annuities pay an amount that depends on the investment performance of the investments held by the particular annuity. Thus, a fixed annuity is like a defined benefit pension plan, such as Social Security, while a variable annuity is like a defined contribution pension plan, such as a 401k.
Variable annuities became very popular after the federal government reduced the tax benefits for people with higher income in the 1980s. In fact, they jumped from $9 billion in variable annuity sales in 1986 to $98 billion in 1998. Are they being oversold? First let's look at what they are and how they work.
Variable annuities are a tax-deferred investment vehicle that comes with a minimal insurance contract so they can qualify for their tax-deferred status. The insurance is not much more than a thin wrapper to secure that favorable tax treatment. It only covers your contributions. It does not cover any of your investment gain.
Variable annuities can be immediate or deferred. Once you reach 59 1/2 you can begin withdrawing the funds without penalty. Prior to that time withdrawals are subject to tax and a 10% penalty. When you withdraw the funds, they are taxed at ordinary income tax rates, which can be as high as 39.6%. Many financial advisors think you have to hold a variable annuity for 15 to 20 years before it is more tax efficient than a mutual fund, whose capital gains are taxed at the more favorable long term rate of 20%.
Another major disadvantage of the variable annuity are the fees you will need to pay. The average annual expenses on variable annuities total 2.08% according to Morningstar, which includes fund expenses and insurance expenses. The average mutual fund charges 1.34%. Many variable annuities also have loads on their subaccounts, surrender charges for selling early (usually prior to a required holding period, say seven years) and annual contract charges of about $25. They also don't make sense as an estate planning vehicle. If you die with money remaining in your annuity, your beneficiary will inherit all the taxes you have deferred. If the money were in a mutual fund, the basis is stepped-up at death.
Before considering a variable annuity, you should definitely have maxed out on all other retirement investment options, including an employer sponsored 401(k), 403 (b), Simple IRA, SEP-IRA, or Keogh and any other IRA options available to you. If you have no other good options and want to buy a variable annuity, be certain to find one with low fees. Mutual fund companies such as Vanguard, Fidelity, T.Rowe Price, and Scudder have some of the lowest fees. Also be certain that there is a wide range of investment options in your investment subaccount.