Running out of retirement income is a major concern for many Americans. Annuities that offer a guaranteed fixed rate of return and tax deferral on earnings, as well as income that can last for life, can be an appealing money management option for present and future retirees with a low risk tolerance and/or a need to diversify assets.
When you purchase a fixed annuity, you receive a guarantee that your money will earn interest at a specified rate and that your return (the money paid back to you) will occur on a set schedule in fixed amounts. There are two payment options: single premium (one lump-sum payment) or multiple premiums (payments made in installments). Payouts to you can begin immediately or at a future time, but they are usually scheduled for retirement and can last for your lifetime or another scheduled length of time.
Retirees often favor immediate annuities, which can begin to provide income at regular intervals as soon as a single lump-sum premium has been paid. Deferred annuities, often favored by those saving for retirement, accrue premium payments (your contributions) over time (the accumulation period) with the payout scheduled for a future date. In both cases, earnings on premiums are tax deferred.
Favorable Tax Treatment
Because annuities help people save for retirement, they receive favorable tax treatment. Tax deferral allows your potential earnings to enjoy compound interest without immediate taxation, which can significantly impact the value of your savings. Consider the following hypothetical example, which assumes earned interest at 6%, a 30% combined state and federal income tax rate, and no inflation. Compare the value of saving $100 per month for 30 years in a taxable instrument to a tax-deferred instrument.
After 30 years, savings in a tax-deferred instrument could be worth $28,518 more than those in a taxable instrument receiving the same rate of return. This attests not only to the power of tax deferral, but also to the positive effect time can have on your long-term savings.
Unlike some qualified retirement plans, annuities are not subject to income or contribution limits. Annuity premiums that are not part of a qualified retirement plan are paid with after-tax dollars. Your principal contribution will not be taxed again, but interest earnings are taxable. The Internal Revenue Service (IRS) determines the amount not taxable using an annuity exclusion ratio, which accounts for your principal contributions and life expectancy, as well as the annuity's expected return for the life of the contract. The total amount you may exclude from income is limited to the total amount of premium you put into the annuity.
When you reach the point where you have fully recovered your initial premium, the remaining payouts are fully taxable. If payouts cease prior to the date the premium has been recovered, the amount not recovered is allowed as a deduction to you for your last taxable year.
The tax benefits of fixed annuities do come with a restriction: Payouts must begin after you reach age 59½, or earnings may be subject to a 10% federal income tax penalty. Furthermore, if you withdraw funds during the accumulation period, the issuing company may levy withdrawal charges. If you cash in the full value of the annuity, you may incur surrender charges.
Income for Life?
How much you receive from an annuity generally depends on your age when you begin to receive payments and the amount of money available (gender may also play a role). Once you own an annuity, you'll need to select a payout option when you reach the annuitization date, usually at retirement. Most annuities offer a number of different payout choices. Here's a brief overview of the basic options:
Life Only. This option provides income for life and generally provides the largest benefit of all the options. You can receive payments monthly, quarterly, semi-annually, or annually. Note that after you die, all payments stop.
Life with Term Certain. With this option, you'll receive income for life. If you die before a stipulated time (the term certain), usually 5, 10, 15, or 20 years, the payments will then continue to a beneficiary for the remainder of the term certain.
Joint and Survivor Life. Under this arrangement, two individuals receive annuity payments for both their lives. When one dies, the other continues to receive income, or some portion of it, for the remainder of his or her life.
Installment Refund Life. With this option, if you die before you have received at least as much as your original premium payment(s), the balance will be paid out to a beneficiary in installments.
Unit Refund Life. This option is similar to the installment refund life option, except that the beneficiary receives the balance in a lump sum.
Payments for a Specified Period. With this option, payments are made for a pre-specified term, generally ranging from one to 30 years, and then continue to a beneficiary if you die before the term ends.
Fixed annuities can be an important part of your overall savings and income strategy, helping to meet diverse financial goals and objectives. If you are currently saving for retirement, a fixed annuity can help supplement your existing long-term vehicles, such as a 401(k) plan or an Individual Retirement Account (IRA). If you are a retiree, a fixed annuity can provide you with a regular income stream during your golden years. Remember that in order to plan for the future, you must consider it before it occurs. 20/20
Note: Fixed annuities are neither insured nor guaranteed by the FDIC; they may decline in value if surrendered prior to maturity. Guarantees are based on the claims-paying ability of the issuing company