Annuities as an Investment For RetirementAs a retirement-planning tool, an annuity is a contract between you and an insurance company for guaranteed interest and income payments. During the accumulation phase, the investor makes payments to the issuing company, which will eventually be given back to the investor with added interest during the distribution phase, or annuity period. The accumulation phase can last from as long as one day to several decades, depending on the size and frequency of payments. While most investors make payments over long periods of time, an investor could choose to make a single lump sum payment; both methods will result in future payments that include interest. The insurance company will then take the contributions, whether it was a lump sum payment or many dispersed payments, and invest it accordingly. The distribution phase begins when contributions stop and you start receiving annuity payments, this is when the annuity is said to be annuitizing. Distributions can be made to you as a lump sum or through regular distributions over time. Once contributions are being distributed, you cannot withdraw any of the funds, and you receive funds according to the distribution schedule agreed upon. Annuities also provide tax benefits to investors by deferring the taxes paid on the earned interest.
Annuities are not for everyone. They are generally overpriced, they limit the owner's investment choices, and they lack liquidity. We recommend annuities only for people that fit the following guidelines:
- If you plan to keep the annuity for at least 15 years, whether you make one lump sum payment or periodic payments over this time.
- If you are currently in a high tax bracket and expect to be in a lower income tax bracket in retirement
- If you do not need distributions until age 59 1/2
- If you do not have heirs (because they will have to pay ordinary income taxes on any appreciation)
- If you want a guaranteed income for life in retirement
A fixed annuity provides you with pre-determined monthly distributions starting on a specific date. The insurance company invests the money and agrees to make the payments in the future. Investors choose fixed annuities to provide them with a steady source of future income. But your "guaranteed return" will be affected by
inflation. Distributions can be increased by 3% to 5% each year (fee involved) and can last for a fixed period or for life.
Investors planning for retirement often choose variable annuities. They are long-term investments that allow you to choose your portfolio, with the intention of earning more money through the stock market. The money is placed in investment options referred to as "sub accounts", which are similar to "mutual funds" or segregated "investment portfolios" that are managed by professional investment managers. The payments vary depending on the performance of the investments over time.
Equity-indexed annuities provide the best of both worlds, having a stable fixed account and having the opportunity to profit from stock performance. This type allows you to invest the money in a fixed account while earning additional interest based on a particular stock index. The payments are fixed for this type of annuity.
All annuities are tax-deferred, meaning that the earnings from investments in these accounts grow tax-deferred until withdrawal. Annuity earnings are tax-deferred so they cannot be withdrawn without penalty until age 59 1/2.Distributions and withdrawals are taxed as income. If the distribution is made to the annuity-hold in a single lump sum payment, then the full amount is taxed as ordinary income for that year. If you annuitized the fixed income distributions, then part of the payment is considered principal-which won't be taxed-and part of it is considered interest earnings-which are taxed as ordinary income. Variable annuities are different, since the payments will vary according to the market value of your investments. Similarly to fixed income annuities, the principal portion of the distributions won't be taxed.An annuity has a death benefit equivalent to the higher of the current value of the annuity or the amount you have paid into it. If the owner dies during the accumulation phase, his or her heirs will receive the accumulated amount in the annuity. This money is subject to ordinary income taxes in addition to estate taxes. If the owner purchased a term-certain annuity and the payout phase started, the beneficiary can receive payments until the end of that period.
One should consider the fees associated with annuities. Mortality and Expense charges are fees associated with the insurance guarantee, commissions, selling, and administration expenses. In variable annuities, these are charged as a percentage of the average value of the investment. Surrender charges are made if the annuity is cashed in before a specific date. They are typically about 7% of the annuity. Management fees are charged for variable annuities, much like mutual fund companies charge management fees.
Guaranteed investment contracts are contracts between an insurance company and a corporate retirement plan. The insurance company invests the money, guarantees a fixed rate of return and keeps the rest of the profits above that rate. One type of GIC is a stable value fund.
By InvestorGuide Staff
Posted in ...Personal FinanceRetirement