One of the first things to consider when shopping for an annuity is annuities pros and cons.
Annuities are a unique financial and retirement planning tools, because they are the only way to guarantee that an individual or family does not outlive their resources. Retiring at sixty-five and living into your nineties can burn through a lot of resources. Unless a retiree starts with a very large nest egg, cash flow can get pretty thin after thirty years. The ability to guarantee a lifetime income makes annuities an extremely valuable financial tool.
In addition to offering a lifetime income, annuities also deferred income taxes. The growth of annuity cash values are not taxed until a distribution is made from the annuity. This gives the annuity a tax advantage over other accumulation methods including Bank CD’s and savings accounts, bonds, stocks, mutual funds and EFT’s representing portfolios of stocks and bonds.
If a twenty-year old saver puts money into an annuity that accumulates to age 65, he or she will enjoy forty-five years of cash value growth and never pay a dime of taxes during the accumulation period. The chart below compares funds in a taxable account to those that are not taxed. Funds accumulate at 5% in a 25% tax bracket.
An annuity is a way to deferred taxes, not avoid them. When annuity distributions are paid out they are taxed. However, there are some tax advantaged payout options that can be elected. (See ‘How are Annuities Taxed?’)
Other advantages of an annuity include:
- Competitive yields
- Option to tie returns to a stock market index
- Safety of Principal
- Ability to bypass probate
- A variety of lifetime income options
- Elections to enhance lifetime income
- Special provisions for long term care funding
As discussed above there are a number of compelling reasons to include tax deferred annuities in your retirement planning. However, annuities do have some drawbacks and potential annuity buyers should have all the facts.
Annuities have a sales load. It is not reflected in the cash value. Almost all modern annuities have what is called a read-end load. On their accounting statement, the annuity owner receives 100% credit for their premiums paid. They pay in $100,000 and $100,000 shows in their cash accumulation account, earning interest from day one. However, there is a surrender charge if the annuity is canceled prior to a certain time period. Most surrender charges decline over time typically ranging from five to fifteen years. Ten years seems to be the most common.
The surrender schedule gives the carrier time to earn back the sales and marketing costs of the annuity. Surrender charges are often considered a negative for annuities. However, all savings and investment products have some form of sales fee. Bank CDs have fine print that allows the bank to avoid paying interest on CD’s that are terminated early. Stocks and bonds have brokerage fees at both purchase and sale. Neither is refundable. Mutual funds and ETF’s have marketing fees levied on the portfolio, in addition to their internal costs of buying and selling the individual securities that make up their portfolios.
Liquidity is also often cited as an annuity disadvantage. Most companies will surrender or make a distribution within a few business days. By comparison, stocks, bonds and bank CD’s can often be cashed out the same day. Some annuity companies provide a withdrawal book, similar to a check book. These greatly simply access to annuity cash values.
An avid stock market investor will shun an annuity because of is middle of the road yield. They prefer investments that can double or triple in a short time period. To them annuity earnings power is a huge disadvantage. However, the stock market is a risky place to put retirement funds. History has proven time and again that stock markets can plunge with little or no warning and quickly wipe out years of wealth accumulation. If an annuity policy is carefully selected, it will provide a return competitive with other principal guaranteed alternatives.
Fixed interest annuities are backed by investment grade commercial bonds and are therefore limited to the interest rates these types of bonds earn, less a small portfolio management fee and an annual charge designed to recapture the company’s origination costs. Historically, fixed equity indexed annuities have performed a little better than fixed interest, but policy caps, spreads and participation rates all limit their upside potential. Additionally, since these products are tied to a market index, there will be years in which the annuity earns no gain or only the guaranteed minimum.
If you are looking to get rich quick, Annuities are not for you. However you’re your goal is to gradually accumulate a retirement nest egg over time, annuities are an excellent choice and one that offers complete safety of principal and full protection from stock market declines.
A ‘Market Value Adjustment’, also known as an MVR, is a policy feature that adjusts your cash values to market value in the event of a full surrender. When interest rates change, bond prices rise or fall in the opposite direction. A bond paying $50 is worth a $1,000 if interest rates are 5% ($50/$1,000 =5%). However, if interest rates rise to 7%, that same bond will only be worth $714 ($50/$714=7%). Alternatively, at 2% interest our bond rises to $2,500 ($50/$2,500= 2%). [These sample calculations ignore the redemption value of the bond and are strictly for illustrative purposes]
If an annuity policy is surrender shortly after a rise in interest rates the value of the company’s bond portfolio could be severely depressed and they would have to sell at t loss. The market value adjustment clause protects the carrier from these types of bond price fluctuations and can work to the advantage or disadvantage of the consumer. Market value adjustments generally only apply in the event of a total surrender and only during the surrender period. Some states ban the use of market value adjustments and require carriers to protect themselves entirely with sufficient the surrender charges.
When an annuitant dies prior to the election of an annuity payout, the entire deferred taxes on the accumulations are immediately due and taxed according to the tax bracket of the beneficiary. If for example an annuity worth $250,000 has an original cost of $120,000, then $130,000 is taxable income. If the heir receiving the policy is in a 30% tax bracket, they owe $39,000 in income taxes.
In the above example the annuity has a cash value of $250,000, but only $211,000 in wealth was passed along. This tax disadvantage can be avoided by used a single premium life insurance policy in place of the annuity. The yield and taxation during life are almost identical and the life policy has the advantage of transferring completely tax free at death. In this situation, estate would have transferred the full $250,000.
A high percentage of tax deferred annuities are not used during life and are transferred at death less the taxes due. Annuities that are converted to lifetime income payouts do not encounter this tax trap. If there is a high probability that the annuity you are considering will be transferred, essentially intact, at the death, then a single premium life should be considered as an alternative.
Another was to avoid the annuity tax at death, is to trigger a lifetime payout and use the monthly payments to purchase a guaranteed premium life policy. There will be some taxes due on the annuity payout, but these will be spread over the life of the payments. In the event of death, the life insurance will be transferred tax free to your survivors and your wealth transfer will be increased by the amount of the death benefit.
If you have annuities that will not be used during life, then this wealth transfer trick will substantially increase the cash that is passed to your family.
Please work with an expert at matching your individual financial and retirement planning needs to the most appropriate annuity.
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