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The basics of annuities
Dissecting how annuities work, whether you should buy one, and what kind to buy is not an easy task. Here's how you can cut through the complexity of annuities to determine whether they are the right long-term product for you.
Annuities in a nutshell
An annuity is a retirement-planning tool that has two phases: the accumulation phase and the annuitization phase. In the accumulation phase, you give money to an insurance or investment company over a period of time or in a lump sum, and it earns a rate of return. In the annuitization phase, you begin to withdraw regular payments (such as monthly or annually) from your contract until you die.
Accumulation phase. The phase in which you pay into your annuity. You can either contribute a lump sum of money or make payments into your annuity over time.
Annuitization phase. The phase in which you receive monthly payments from your annuity.
Basis points. The fees in your annuity. The number of basis points reflects a percentage of your investment. For example, 200 basis points would be 2 percent of your investment.
Death benefit. The amount of money your beneficiary receives if you die before you begin the annuitization phase. It is generally the value of your annuity or the amount you have invested, whichever sum is greater.
Mortality and expense (M&E). The fee the insurance company charges you to provide you with a lifetime income, and your beneficiaries with a death benefit should you die during the accumulation phase.
Non-qualified annuity. An annuity that is funded with after-tax dollars.
Qualified annuity. An annuity that is funded with pre-tax dollars.
Rider. A feature on your annuity that provides an additional benefit. For example, a long-term care rider would cover nursing home costs. A bonus rider would give you an extra 1 to 5 percent of your investment upon buying the annuity.
Surrender. The act of getting out of your annuity. There is usually a fee if you surrender your annuity within the first seven or eight years of owning it. This fee is also known as a contingent deferred sales charge (CDSC) or a back-end sales load.
Tax deferral. The money that accumulates in your annuity grows tax-deferred, meaning you do not pay taxes on it until you begin receiving annuity payments. The death benefit on your annuity is also taxable to your beneficiary.
Term certain annuity. An annuity that provides you with income payments for a specific period of time, such as 10 or 20 years, rather than a lifetime.
An annuity has a death benefit, although it is not like one found in a life insurance policy. If you die before you annuitize, your beneficiary receives either the current value of your annuity or the amount you paid into it, whichever is greater. For example, if you die when your investments are performing poorly and your account value is less than what you contributed, your beneficiary would receive the amount you contributed.
Once you begin to receive monthly payments, you no longer have a death benefit in your contract. For example, if you annuitize at age 65 and die at age 67, the insurance company keeps the money in your contract. However, you can buy "term certain" annuities, which guarantee that either you or your beneficiary will receive payments for a certain period of time, such as 10 to 15 years. For example, if you died three years after you began receiving payments from a 10-year term certain annuity, your beneficiary would still receive payments for the next seven years.
The money in your annuity grows tax-deferred, meaning that it’s not taxable until you begin to receive payments from your annuity. Once you receive payments your gains are taxed at your ordinary income tax rate. If you die before you annuitize, your beneficiary pays taxes on the death benefit. In either case, the person who receives the money (the annuity holder or your beneficiary) is taxed at his or her ordinary income tax rate.
Annuities are designed to be long-term retirement investments because they grow tax deferred. There is a 10 percent federal tax penalty if you withdraw money from your annuity before age 59½ for reasons other than death or disability (similar to the tax penalty for premature withdrawals from IRAs). However, many people who have already retired and need annuity income right away opt for immediate annuities, which skip the accumulation phase and begin to issue payments as soon as you invest in the contract. (For more on this, read the ups and downs of immediate variable annuities.)
The ideal annuity buyer is a person who has already contributed the maximum amount to their existing tax-deferred retirement plan, such as a 401(k), 403(b), or IRA. That's because you are already building up tax-deferred money in those plans, and the fees associated with those savings vehicles usually are much lower than those of annuities.
Three flavors of annuities
There are three kinds of annuities and each varies in how the money in your contract is invested.
• Fixed annuity. The money you invest earns a fixed rate of interest that is guaranteed by the insurance company. The upside is that there is no risk involved. The downside is that you may miss out on any gains you could have made if the stock market performs well. When you annuitize, your payments are also fixed.
• Variable annuity. Your money is placed in investment options known as subaccounts, which are similar to mutual funds. (For more on subaccounts, read variable life and variable annuity subaccounts: the more the merrier?) Each subaccount has its own degree of risk, ranging from aggressive growth funds to bond funds. The upside is that you have the opportunity to make substantial gains, depending on the performance of your investment. The downside is that you may lose money if your investments perform poorly. Another VA downside: You may be charged a fee to switch your money among subaccounts. When you annuitize, your payments fluctuate depending on the performance of your investments. Some VAs allow "fixed annuitization," in which you receive fixed payments. The insurance or investment company recalculates your payments each year based on the performance of your investments.
• Equity-indexed annuity. Your money is invested in a fixed account and you may earn additional interest based on the performance of a particular stock index, such as the Standard & Poor's 500 Index, the Dow Jones Industrial Average, the NASDAQ Composite Index, or the Russell 2000 Index. The upside is that you get the best of both worlds — the opportunity to earn money based on stock performance and the stability of a fixed account. The downside is that you still essentially have a fixed annuity, and the gains you can make in the contract due to the performance of the stock index are fairly small. (For more on this, read equity-indexed annuities: indexing methods explained.) When you annuitize, your payments are fixed.
Surrendering your annuity contract
If you buy an annuity and then decide to cancel the contract, you can surrender your annuity. But most companies will charge you a surrender fee if you cancel within the first seven to eight years of owning it. The shorter amount of time you own the annuity, the more you'll pay in surrender fees.
For example, if your annuity has a seven-year surrender period, and you surrender it in the first year, you may pay 7 percent of the value of your investment to the company. If you surrender in the second year, you may pay 6 percent, and so on. (For more, read about getting out of your annuity.)
If you want to switch one annuity for another, you can do so without paying taxes. Exchanging one contract for another is known as a 1035 exchange (named after Section 1035 of the federal tax code). In a 1035 exchange, you can exchange a life insurance policy for another life insurance policy, an annuity for another annuity, or a life insurance policy for an annuity without paying taxes. However, you cannot exchange an annuity for a life insurance policy without paying taxes on the gains in your contract.
If you need to tap into your money before the surrender period, some insurers allow you to access a small percentage of your investment, about 10 to 15 percent, under certain circumstances, such as serious illness or disability. After the surrender period, you can withdraw as much out of your annuity as you want. However, if you take out that money before age 59½, it is subject to a 10 percent federal tax penalty.
Annuity shopping tips
If you decide to shop for an annuity, here are some things to consider:
Breaking down the fees
The fee structure for annuities is complicated. Here we break down the fee structure for each annuity.
Variable annuity. There are three elements to a variable annuity fee: the "mortality and expense" (or M&E) fee, the subaccount fee, and the annual contract maintenance charge.
M&E covers insurance expenses, which include the risk the insurance company assumes to pay you a lifetime income stream, the death benefit, and the guarantee that annual insurance charges will not increase.
The subaccount fee covers the cost of managing your annuity's investment accounts. The annual contract maintenance charge is a flat fee, usually between $30 and $40. The average fee for a variable annuity is 2.45 percent, according to Morningstar.
Fixed annuity and equity-indexed annuity. There are no up-front charges in either of these annuities. The insurance company makes money on these by subtracting the amount of money it is required to pay on these by investing the assets in the annuities.
• Figure out how much you have accumulated in other tax-deferred savings plans or pensions. Determine if there is a possibility that you could outlive your retirement assets.
• Determine what kind of annuity you want. Do you want your investment to be steady and guaranteed? Then you may want to consider a fixed annuity. Are you willing to ride out the highs and lows of the stock market in the hopes of making more money? Then you may want to opt for a variable annuity.
• Estimate how long you plan to have your money in the contract. On most annuities, you will pay hefty surrender fees if you surrender during the first seven to eight years on your contract. You also must have your money in the contract for a long time in order to have the tax deferral justify the high fees.
• Consider the financial strength of the provider. Most, though not all, states will protect you from the insolvency of an annuity provider through "guarantee associations" or "guarantee funds" but there are limits to that protection—in most states a limit of $100,000 for the current value of the annuity, or $300,000 in total lifetime benefits. This means that if the annuity provider goes belly-up you will no longer be assured an income for the rest of your life.
• Examine the mortality and expense (M&E) fee structure of a contract carefully. Fees vary by company and by contract, so make sure you receive good value for your purchase.
• Some annuities have features and riders that can meet a future need. For example, some variable annuities have long-term care riders that will pay for nursing home costs. Others give you a bonus of 1 to 5 percent of your investment when you open an annuity.
• Can you increase contributions to other retirement investments, such as a 401k or IRA account? Experts recommend investing in annuities only after you've maxed out contributions to other retirement vehicles, which provide the same tax deferral benefits without the high fees of annuities.