Fixed Annuities

Building, Growing, Protecting your Wealth

An annuity is a contract with an insurance company to provide a regular periodic payment made by an insurance company to a policyholder for a specified period of time. Annuities can be a great way to build additional capital for retirement as they can provide deferred tax savings

When you buy an annuity, you agree to make payments-known as premiums-to the company in exchange for which the insurance company agrees to make payments to you at a later time for a specified period. The time during which you pay premiums is called the accumulation period; you might pay your premium in one lump sum or in installments over the course of many years.

The person who receives the benefit payments is known as the annuitant; this person is usually (though not always) the owner of the annuity.

When the accumulation period is over, the company begins distributing your funds. Either you can receive them in one lump sum, or you can choose to annuitize your funds. If you annuitize, the insurance company begins paying the annuitant a regular income, usually on a monthly basis, for a term is known as the payout period.

There are a variety of payout options available for annuities:

  • The annuitant can receive all of the funds at once in a lump sum payment.

  • A life annuity makes payments of regular income for as long as the annuitant lives.

  • Joint and survivor annuities make payments for the life of the annuitant and a beneficiary, such as a spouse.

  • Period certain annuities make regular payments for a set term, whether or not the annuitant dies.

  • The life annuity with refund option provides the annuitant with a guaranteed income for life and continues the payments to the beneficiaries according to the refund provision. With the refund provision, upon the death of the annuitant the beneficiaries receive an amount equal to the difference between the annuity's accumulated value prior to annuitization (payout) and the total of benefits received by the annuitant.

  • A final payout option to be discussed is the fixed amount option. For the previous options, a period determines the size of benefits. With the fixed amount option, the annuity holder selects the size of the benefit payments, which then determines the length of time over which the benefits are received. This option is less commonly used.

  • Interest-only annuities pay the interest on the account value to the annuitant, who can then withdraw all the funds from the account as a lump sum when he or she chooses.

  • With traditional fixed annuities, the insurance company invests your premium in its general account. Whatever payout option you select, the interest gains and payment amounts are guaranteed by the insurance company, which assumes the risk of investing the general account.

    A fixed annuity is fixed in two ways:

    1. While your premiums are accumulating, your principal is guaranteed and your account is guaranteed to grow at a fixed income rate. Your interest income grows tax-deferred.

    2. During the payout period, your monthly income is fixed at a guaranteed amount, calculated according to your age, sex, and the payout option you select.

    In this way, a fixed annuity is distinguished from a variable annuity. With a variable annuity, your premiums are invested in your choice of available investment options. The return on your investment cannot be fixed and your principal is not guaranteed; instead, returns and account values will vary with market conditions. (An exception to this can be guaranteed death provisions.)

    If a fixed annuity is beginning to look like a good deal to you, that's because it is one of the safest ways to generate a guaranteed future income. But, as with any investment, there are trade-offs for the guarantees of fixed annuities.

    While the rate of return on fixed annuities compares favorably to other "safe" investments such as CDs or government bonds, they are generally lower than could be realized if you invested in higher-risk investments such as stocks or high-yield bonds. Because return rates are relatively low, fixed annuities can lose much of their value to inflation, especially if you live a long time.

    Annuities and Taxes

    When considering taxes, you must be careful in the use of annuities. Though annuities can be used outside of a retirement plan, such as an IRA, 403(b) plan, or 401(k) plan, they should still be treated as one. An annuity outside of a retirement plan is called a non-qualified annuity, and premiums are paid with after tax dollars. While interest still grows tax-deferred in a nonqualified annuity, early withdrawals (before age 59 1/2) are subject to both ordinary income tax rates and a 10% tax penalty, just as they would be from a retirement plan. In addition, there may be early surrender charges from the insurance company as well. (These charges do decline and eventually disappear over a period of time.)

    Further, nonannuitized withdrawals from nonqualified annuities are taxed as income (earnings) first and tax-free return of principal last. Annuitized distributions are treated as a combination of tax-free return of principal and taxable income (earnings) through the life expectancy of the annuitant, then all taxable income thereafter.

    Annuities and Retirement

    Suppose you purchased your annuity with long-term retirement objectives in mind and you have now reached that magic time in your life called retirement. Now, what do you do about all those payout options? Be careful-with every benefit there is usually a trade-off. One of the unique benefits of annuities is that they can guarantee an income that you cannot outlive-for a price.

    If you select a life payment option without a period certain or refund provision (whether it be on a single life or joint life), you give up the right to transfer to your beneficiary the remaining value of your annuity upon your death or the death of your survivor (usually your spouse). Why might you select this option? A life payment option without a period certain or refund provision provides a higher payment than otherwise; thus a trade-off on benefits. What is best for you depends upon your particular goals and objectives.

    Annuities and Estate Planning

    A final strategic consideration is estate planning. In our discussion of annuities, we have often referred to the beneficiary of an annuity, the person who receives the value of the annuity upon the death of the owner or annuitant. With a beneficiary designation in an annuity, wealth can be distributed outside the probate process, the legal method of transferring the assets of a deceased person.

    This can be beneficial if you do not wish this transfer of wealth to be a matter of public record and subject to the claims of creditors upon your estate, not to mention disputes among heirs. Once again, there are trade-offs. The proceeds of an annuity to the beneficiaries are subject to income taxation, while proceeds of life insurance and the transfer of stock are not.

    *Guarantees are subject to the claims paying ability and principal strength of the annuity issuer.


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