If you are a regular follower of my blog, you know that I normally write on senior living-related issues, most often about continuing care retirement communities (CCRCs, also called life plan communities). Choosing a retirement community, particularly a CCRC, is a big financial decision, which is why I want to dig into a tangent topic this week: annuities.
Prior to founding myLifeSite, I spent 14 years as a financial planner, and I still enjoy educating people on retirement-related financial matters, so occasionally I get asked about annuities. It is understandable that this topic is a source of confusion for a lot of people, but I’m hoping this post will clarify the basic differences between the types of annuities.
Annuities in a nutshell
Annuities are actually insurance contracts, issued by insurance companies, even though they do not work exactly like traditional types of insurance. Whereas life insurance pays out in the event of death, annuities pay out during life. There are many different types of annuities, and understanding one from another can be challenging.
The first thing to know is that all annuities fall under one of two main types: immediate annuities and deferred annuities, and there are variations of each type. As you’ll see below, deferred annuities in particular can vary a great deal and require a more detailed explanation.
An immediate annuity is a stream of income received for a certain period of time in exchange for a lump sum of money. For example, a lifetime annuity pays out a certain amount per month for the rest of the annuitant’s life, backed by the insurance company. The annuitant is the “insured” person upon whose lifetime payouts are based and who also will receive the monthly payments. The owner and the annuitant are usually the same person but may be different. For example, a person could own an annuity on an elderly parent to help provide supplemental retirement income for the parent.
The specific amount paid out each month is based in large part on the age and life expectancy of the annuitant, as well as current interest rates. If the annuitant lives to life expectancy, the total amount received in income will exceed the initial cash installment. However, if the annuitant does not live to life expectancy, the total received could be less than the original cash installment, particularly if death were to occur only within a couple of years of purchasing the annuity. Annuity payout options include, but are not limited to, the following:
- Lifetime annuity: As described above, a lifetime annuity will pay out until the annuitant’s death. It may also be purchased as a joint-life annuity, which will pay out until the death of the second spouse. Payouts will be lower for a joint-life annuity than with a single-life annuity.
- Life with period certain: This type of annuity will pay an income stream for life, or a minimum period of time in the event of death. It can also be a joint-life annuity, which will pay out until the death of the second spouse, or a minimum period of time.
- 10-year certain: This type of annuity will pay an income stream for 10 years, regardless of whether the annuitant lives less than or more than 10 years. If the annuitants’ life expectancy is longer than 10 years, then this option would pay a higher monthly amount than a lifetime annuity.
Be sure to find out what other payout options are available.
Tax exclusion ratio
An added benefit of an immediate annuity is that part of each payment is considered a return of principal, which is not taxable. For example, if the monthly payment is $1,000 and 60 percent is considered a return of principal, then income tax is due only on the remaining $400. The amount of each payment that is excluded from income tax is determined by the “exclusion ratio.” The older a person is, the higher the exclusion ratio will be.
Covering fixed expenses or retirement community fees
Immediate annuities are a great way for retirees to provide a guaranteed income stream, which along with other fixed income sources, cover all non-discretionary expenses. Discretionary expenses can then be covered by other savings and retirement accounts. For those living in a retirement community, such as a CCRC (also known as a life plan community), an immediate annuity could be utilized to help cover the monthly fee.
Unlike immediate annuities, deferred annuities do not begin paying out until some point in the future. The money used to purchase the annuity is set aside in an account to build interest. One of the big advantages of a deferred annuity is that taxes are not due on the interest growth until money is withdrawn. This is why they are often referred to as “tax-deferred” annuities. Contrast this with a certificate of deposit (CD), for example, whereby you must pay taxes each year on the annual interest.
The owner of a deferred annuity usually will have two options for how to access the money in the future. The first option is to convert the deferred annuity into an immediate annuity as described above, and begin taking a guaranteed income under one of the payout options. In some cases, converting to an immediate annuity at a specific date may actually be required by the contract.
The second, and more common, option for accessing the funds is to simply make withdrawals as desired while keeping the remaining funds in the account to grow. Any remaining account value will ultimately pass to a designated beneficiary after the annuitant’s death.
Taxes on withdrawals from deferred annuities
When the owner of a deferred annuity makes withdrawals, the growth on the account balance is considered to have been withdrawn first, before the principal. In accounting terms, this is referred to as “LIFO,” or last in, first out. If withdrawals are taken before the annuitant reaches the age of 59 ½, there is an additional 10 percent tax penalty. Withdrawals of principal are not taxable, however. For example, suppose someone’s initial annuity installment amount was $100,000, and now the annuity has grown to $120,000. The first $20,000 of withdrawals will be taxable at ordinary income tax rates, and any additional withdrawals will be considered a return of principal. (Of course, if the annuity was converted to an immediate annuity, then the exclusion ratio would apply to each payment, as explained previously.)
Fixed or variable annuities
There are three main types of accounts into which the funds in a deferred annuity may be deposited or invested:
Fixed annuity: The money is placed into an interest-bearing account; therefore, this is technically not an “investment.” Some fixed annuities offer a fixed rate for a period of time—anywhere between one year and seven years, or even longer. Others may offer a rate that can fluctuate from year to year. A fixed annuity cannot lose value. Furthermore, the contract will almost always stipulate a minimum lifetime interest rate.
Variable annuity: The money is placed in an investment account called a “separate account.” A separate account works very much like a mutual fund, and the annuity owner will be given a wide variety of choices for how to invest the money—from conservative, short-term bond accounts to high-growth stock accounts, and everything in between. Unlike a fixed annuity, the account value of a variable annuity can actually go down due to fluctuations in the stock or bond markets. In other words, variable annuities can lose money, just like any other investment. The hope, as with most investments, is that despite short-term fluctuations, the account will experience higher growth over the long term, and on a tax-deferred basis.
Equity-indexed annuity: The account value in an equity-indexed annuity is linked to the performance of the stock market, but it is not actually invested directly in the stock market. There are many variations of how such a contract works, but, as an example, a contract might say that the annuitant will be credited up to a certain amount of stock market growth each year, or possibly every two years, usually as measured by the performance of the S&P Index. However, if the stock market goes down in value, then the annuity will earn nothing over that period of time. In other words, they would not gain any value in this scenario, but they also don’t lose any value. I should mention that this example is an over-generalization of how equity-indexed annuities work. There are different methods of how equity-indexed contracts credit interest. In fact, many contracts will offer different crediting options within one annuity contract so that the owner of the contract can spread their money out among different choices within the contract. As with any type of annuity, understanding the contract specifications is very important. The key point here is that equity-indexed annuities allow for some participation in stock market performance without the concern of losing money.
Other important details about annuities
Withdrawal penalties (surrender charges)
I mentioned previously that withdrawals from a deferred annuity prior to age 59 ½ will result in a tax surcharge of 10 percent, in addition to any applicable ordinary income taxes. Aside from tax implications, however, deferred annuity contracts also have a “surrender period.” This is a period of time during which if the annuity holder makes a withdrawal, he/she will be subject to a withdrawal penalty, often referred to as a “surrender charge.” The surrender period may be anywhere from a couple of years all the way up to 10 years or more. As it relates to fixed rate annuities, the longer the surrender period, the higher the guaranteed interest rate will be. Unlike the early withdrawal tax penalty, the surrender period is not based on age, but instead, is based on the number of years since the time of purchase.
10 percent free withdrawals
Almost all annuity contracts will allow the annuity holder to withdraw a certain amount each year before the surrender penalty applies. Most often this amount is 10 percent of the current contract value. Sometimes it may be 10 percent of the original purchase amount, as opposed to current contract value.
Previously I described that annuities are considered insurance contracts. Another reason for this is because the annuitant’s beneficiary will receive the amount of the original principal plus interest, less withdrawals. In the case of a variable annuity, the beneficiary would receive at least the amount of the original deposit, less withdrawals, even if the value has declined. Although often overlooked, this is a major benefit because a retiree who wants to have money in the stock market but doesn’t want to risk what they will leave to their heirs will know that even in the event of market decline, their principal will still pass to the heirs. Annuities also are insurance contracts in the sense that they offer guaranteed payout options when annuitized.
Guaranteed minimum withdrawal benefits
Over the last 10 years or so, variable annuity contracts have evolved, and today, many offer a benefit called a guaranteed minimum withdrawal benefit (GMWB), which was preceded by a less robust, but similar feature, called a guaranteed minimum income benefit (GMIB). The way a GMWB works is that the annuity contract specifies that the contract owner may withdraw a certain amount from the annuity every year–let’s say 5 percent for example–either for life or for a specific period of time. Although this sounds very similar to an immediate annuity, the difference is that the contract is never actually annuitized. In other words, the contract owner still maintains an account value and the withdrawals come out of the account value. But the guarantee essentially states that, in the event that the contract value fell all the way to zero, the guaranteed income payments would continue, thus the name “guaranteed minimum withdrawal benefit.” It simply guarantees withdrawals irrespective of account value. Obviously, the hope is that the account value grows and ultimately surpasses, or at least offsets, the amount of withdrawals. The guaranteed minimum withdrawal is generally not subject to early withdrawal surrender charges because the amount withdrawn will be less than the 10 percent free withdrawal each year. However, if the person is under the age of 59 ½, it would be subject to tax penalties as described above.
There’s actually one other advantage of a GMWB: The longer the contract owner waits to begin taking guaranteed minimum withdrawals, the higher the amount they’ll be able to withdraw under this guarantee in the future. For example, if the GMWB is 5 percent and the contract owner delays taking the withdrawal for several years, then the guaranteed amount that can be withdrawn in the future will grow by 5 percent in each of those years.
NOTE: This does not mean the actual account value is guaranteed to grow by 5 percent. It just means that the guaranteed withdrawal amount will grow by 5 percent. The growth of the actual account value depends solely on the performance of the separate account investments chosen by the annuity owner. Unfortunately, I have had a number of people over the years who didn’t fully understand their contract tell me that they have an annuity that is guaranteed to grow by 5 percent (or higher) each year.
The fees to obtain a GMWB are rather high, but for some people, they are willing to pay the fee in exchange for a guaranteed withdrawal benefit. They view it as paying for extra security on their investments. In other words, even if they account value were to decline at least they have a guaranteed income stream available. Keep in mind that income guarantees, and the death benefit options described above, are only as strong as the insurance company backing them up.
Combined with other fixed income sources, GMWBs also can be a great way to help fund the cost of monthly fees at a retirement community, while using other savings or retirement accounts to cover discretionary expenses.
Annuities held in IRAs
Purely from a tax-deferral standpoint, it does not make sense to hold a tax-deferred annuity within an individual retirement account (IRA). Why? Well, there is no additional advantage to be gained since an IRA’s annuities are tax-deferred already.
Furthermore, since annuities tend to carry higher fees (mostly when it comes to variable annuities), there is no reason for someone to pay higher fees for tax deferral when they can already get this by holding other funds or investments in an IRA. In fact, financial advisors who sell annuities–and often earn rather high commissions for doing so–have been under a great deal of scrutiny over the years for recommending that clients purchase variable deferred annuities using IRA money. The reason behind the scrutiny is that the client is gaining no additional tax benefit by holding a variable annuity in an IRA, and furthermore the client may be subjecting themselves to higher fees and possible penalties, all while the advisor earns a new commission.
However, in more recent years, there has been some loosening of this perception because, unlike in the early years of annuities, people often purchase annuities for benefits other than pure tax deferral. The best example would probably be the GMWB that I described above. There are some who might like to have the added assurance of a GMWB, especially after what happened with the market collapse of 2008, and maybe most of their funds just happen to be held in retirement accounts. In this case, one may choose to use some of their IRA money to buy a variable deferred annuity with a GMWB. It is critically important, however, for the purchaser of the annuity to understand the fees for the annuity and the fact that, from a pure tax deferral standpoint, they are gaining no advantage by having an annuity inside of an IRA.
To sum things up…
It’s easy to see why annuities can be confusing, and I know that this was a lot of information to absorb, but I hope this post provided you with a helpful summary of the various annuity options that are available. With the guidance of your financial advisor, choosing the right annuities can be a cost-effective, practical way to fund your retirement years.
To learn more about annuities, talk with your financial planner, or you can visit the Financial Industry Regulatory Authority’s website for additional unbiased information on the benefits and tax implications of purchasing an annuity.
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