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Annuities: How They Work and When You Should Use Them
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Annuities: Frequently Asked Questions
Annuities: How They Work and When You Should Use Them
Annuities may help you meet some of your mid and long-range goals such as planning for your retirement and
for a child's college education. This Financial Guide tells you how annuities work, discusses the various
types of annuities, and helps you determine which annuity product (if any) suits your situation. It also
discusses the tax aspects of annuities and explains how to shop for both an insurance company and an
annuity, once you know which type you'll need.
How Annuities Work
While traditional life insurance guards against "dying too soon," an annuity, in essence, can be used as
insurance against "living too long." In brief, when you buy an annuity (generally from an insurance company,
that invests your funds), you in turn receive a series of periodic payments that are guaranteed as to amount
and payment period. Thus, if you choose to take the annuity payments over your lifetime
(keep in mind that there are many other options), you will have a guaranteed source of "income" until your
death. If you "die too soon" (that is, you don't outlive your life expectancy), you will
get back from the insurer far less than you paid in. On the other hand, if you "live too
long" (and do outlive your life expectancy), you may get back far more
than the cost of your annuity (and the resultant earnings). By comparison, if you put your funds into a
traditional investment, you may run out of funds before your death.
The earnings that occur during the term of the annuity are tax-deferred. You are not taxed on them until
they are paid out. Because of the tax deferral, your funds have the chance to grow more quickly than they
would in a taxable investment.
How Annuities Best Serve Investors
Tip: Assess the costs of an annuity relative to the alternatives. Separate purchase of
life insurance and tax-deferred investments may be more cost effective.
The two primary reasons to use an annuity as an investment vehicle are:
- You want to save money for a long-range goal, and/or
- You want a guaranteed stream of income for a certain period of time.
Annuities lend themselves particularly well to funding retirement and, in certain cases, education
costs.
One negative aspect of an annuity is that you cannot get to your money during the growth period without
incurring taxes and penalties. The tax code imposes a 10 percent premature-withdrawal penalty on money taken
out of a tax-deferred annuity before age 59½, and insurers impose penalties on withdrawals made before the
term of the annuity is up. The insurers' penalties are termed "surrender charges," and they usually apply
for the first seven years of the annuity contract.
These penalties lead to a de facto restriction on the use of annuities primarily as an investment. It only
makes sense to put your money into an annuity if you can leave it there for at least ten years and the
withdrawals are scheduled to occur after age 59½. These restrictions explain why annuities work well for
either retirement needs or for cases of education funding where the depositor will be at least 59½ when
withdrawals begin.
Tip: The greater the investment return, the less punishing the 10 percent penalty on
withdrawal under age 59½ will appear. If your variable annuity investments have grown substantially, you
may want to consider taking some of those profits (despite the penalty, which applies only to the taxable
portion of the amount withdrawn).
Annuities can also be effective in funding education costs where the annuity is held in the child's name
under the provisions of the Uniform Gifts to Minors Act. The child would then pay tax (and 10 percent
penalty) on the earnings when the time came for withdrawals.
Caution: A major drawback is that the child is free to use the money for any purpose,
not just education costs.
Types Of Annuities
The available annuity products vary in terms of (1) how money is paid into the annuity contract, (2) how
money is withdrawn, and (3) how the funds are invested. Here is a rundown on some of the annuity products
you can buy:
- Single-Premium Annuities: You can purchase a single-premium annuity, in which the
investment is made all at once (perhaps using a lump sum from a retirement plan payout).
The minimum investment is usually $5,000 or $10,000.
- Flexible-Premium Annuities: With the flexible-premium annuity, the annuity is funded
with a series of payments. The first payment can be quite small.
- Immediate Annuities: The immediate annuity starts payments right after the annuity is
funded. It is usually funded with a single premium and is usually purchased by retirees with funds they
have accumulated for retirement.
- Deferred Annuities: With a deferred annuity, payouts begin many years after the annuity
contract is issued. You can choose to take the scheduled payments either in a lump sum or as an annuity,
that is, as regular annuity payments over some guaranteed period. Deferred annuities are used as long-term
investment vehicles by retirees and non-retirees alike. They are used to fund tax-deferred retirement
plans and tax-sheltered annuities. They may be funded with a single or flexible premium.
- Fixed Annuities: With a fixed annuity contract, the insurance company puts your funds
into conservative fixed income investments such as bonds. Your principal is guaranteed and the insurance
company gives you an interest rate that is guaranteed for a certain minimum period from a month to several
years. This guaranteed interest rate is adjusted upwards or downwards at the end of the guarantee period.
Thus, the fixed annuity contract is similar to a CD or a money market fund, depending on the length of the
period during which interest is guaranteed. The fixed annuity is considered a low-risk investment vehicle.
All fixed annuities also guarantee you a certain minimum rate of interest of 3 to 5 percent for the
entirety of the contract. The fixed annuity is a good choice for investors with a low-risk tolerance and a
short-term investing time horizon. The growth that will occur will be relatively low. Fixed annuity
investors benefit if interest rates fall, but not if they rise.
- Variable Annuities: The variable annuity, which is considered to carry with it higher
risks than the fixed annuity--about the same risk level as a mutual fund investment--gives you the ability
to choose how to allocate your money among several different managed funds. There are usually three types
of funds: stocks, bonds, and cash-equivalents. Unlike the fixed annuity, there are no guarantees of
principal or interest. However, the variable annuity does benefit from tax deferral on the earnings.
Tip: You can switch your allocations from time to time for a small fee or sometimes for
free.
The variable annuity is a good annuity choice for investors with a moderate to high-risk tolerance and a
long-term investing time horizon.
Caution: Variable annuities have higher costs than similar investments that are not
issued by an insurance company.
Caution: The taxable portion of variable annuity distributions is taxable at full
ordinary rates, even if they are based on stock investments. Unlike dividends from stock investments
(including mutual funds), there is no capital gains relief.
Tip: Annuities are available that combine both fixed and variable features.
Tip: Before buying an annuity, contribute as much as possible to other tax-deferred
options such as IRA's and 401 (k) plans. The reason is that the fees for these plans are likely to be
lower than those of an annuity and early-withdrawal fees on annuities tend to be steep.
Tip: IRA contributions are sometimes invested in flexible premium annuities with IRA
deduction, if otherwise available. You may prefer to use IRAs for non-annuity assets. Non-annuity assets
gain the ability to grow tax-free when held in an IRA. The IRA regime adds no such benefit to annuity
assets which grow tax-free in or outside IRAs.
Choosing A Payout Option
When it's time to begin taking withdrawals from your deferred annuity, you have a number of choices. Most
people choose a monthly annuity-type payment, although a lump sum withdrawal is also possible.
Caution: Once you have chosen a payment option, you cannot change your mind.
The size of your payout (settlement option) depends on:
- The size of the amount in your annuity contract
- Whether there are minimum required payments
- Your life expectancy (or other payout period)
- Whether payments continue after your death
Here are summaries of the most common forms of payout:
Fixed Amount
This type gives you a fixed monthly amount (chosen by you) that continues until your
annuity is used up. The risk of using this option is that you may live longer than your money lasts. Thus,
if the annuity is your only source of income, the fixed amount is not a good choice. And, if you die before
your annuity is exhausted, your beneficiary gets the rest.
Fixed Period
This option pays you a fixed amount over the time period you choose. For example, you
might choose to have the annuity paid out over ten years. If you are seeking retirement income before some
other benefits start, this may be a good option. If you die before the period is up, your beneficiary gets
the remaining amount.
Lifetime or Straight Life
This type of payment continues until you die. There are no payments to survivors. The life annuity gives
you the highest monthly benefit of the options listed here. The risk is that you will die early, thus
leaving the insurance company with some of your funds. The life annuity is a good choice if (1) you do not
need the annuity funds to provide for the needs of a beneficiary and (2) you want to maximize your monthly
income.
Life With Period Certain
This form of payment gives you payments as long as you live (as does the life annuity) but with a minimum
period during which you or your beneficiary will receive payments, even if you die earlier than expected.
The longer the guarantee period, the lower the monthly benefit.
Installment-Refund
This option pays you as long as you live and guarantees that, should you die early, whatever is left of
your original investment will be paid to a beneficiary. Monthly payments are less than with a straight life
annuity.
Joint And Survivor
In one joint and survivor option, monthly payments are made during the annuitants' joint lives, with the
same or a lesser amount paid to whoever is the survivor. In the option typically used for retired employees
(employment model), monthly payments are made to the retired employee, with the same or a lesser amount to
the employee's surviving spouse or another beneficiary. The difference is that with the employment model,
the spouse's (or other co annuitant's) death before the employee won't affect what the survivor employee
collects. The amount of the monthly payments depends on the annuitants' ages, and whether the survivor's
payment is to be 100 percent of the joint amount or some lesser percentage.
How Payouts Are Taxed
The way your payouts are taxed differs for qualified and non-qualified annuities.
Qualified Annuity
A tax-qualified annuity is one used to fund a qualified retirement plan, such as an IRA, Keogh plan, 401(k)
plan, SEP (simplified employee pension), or some other retirement plan. The tax-qualified annuity, when used
as a retirement savings vehicle, is entitled to all of the tax benefits (and penalties) that Congress saw
fit to attach to such qualified plans.
The tax benefits are:
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Any nondeductible or after-tax amount you put into the plan is not subject to income tax when
withdrawn
- The earnings on your investment are not taxed until withdrawal
If you withdraw money from a qualified plan annuity before the age of 59½, you will have to pay a 10
percent penalty on the amount withdrawn in addition to paying the regular income tax. There are exceptions
to the 10 percent penalty, including an exception for taking the annuity out in a series of equal periodic
payments over the rest of your life.
Once you reach age 70½, you will have to start taking withdrawals in certain minimum amounts specified by
the tax law (with exceptions for Roth IRAs and for employees still working after age 70½).
Non-Qualified Annuity
A non-qualified annuity is purchased with after-tax dollars. You still get the benefit of
tax deferral on the earnings; however, you pay tax on the part of the withdrawals that represent earnings on
your original investment.
If you make a withdrawal before the age of 59½, you will pay the 10 percent penalty only on the portion of
the withdrawal that represents earnings.
With a non-qualified annuity, you are not subject to the minimum distribution rules that apply to qualified
plans after you reach age 70½.
Tax on Your Beneficiaries or Heirs
If your annuity is to continue after your death, other taxes may apply to your beneficiary (the person you
designate to take further payments) or your heirs (your estate or those who take through the estate if you
didn't designate a beneficiary).
Income tax: Annuity payments collected by your beneficiaries or heirs are subject to tax on the
same principles that would apply to payments collected by you.
Exception: There's no 10 percent penalty on withdrawal under age 59½ regardless of the recipient's
age, or your age at death.
Estate tax: The present value at your death of the remaining annuity payments is an asset of your
estate, and subject to estate tax with other estate assets. Annuities passing to your surviving spouse or to
charity would escape this tax.
If a particular fund has a great track record, ascertain whether the same management is still in place.
Although past performance is no guarantee, consistent management will grant you better odds.
How To Shop For An Annuity
Although annuities are typically issued by insurance companies, they may also be purchased through banks,
insurance agents, or stockbrokers.
There is considerable variation in the amount of fees that you will pay for a given annuity as well in the
quality of the product. Thus, it is important to compare costs and quality before buying an annuity.
First, Check Out The Insurer
Before checking out the product itself, it is important to make sure that the insurance company offering it
is financially sound. Because annuity investments are not federally guaranteed, the soundness of the
insurance company is the only assurance you can rely on. Consult services such as A.M. Best Company, Moody's Investor Service, or
Standard & Poor's Ratings to find out how the insurer is rated.
Next, Compare Contracts
The way you should go about comparing annuity contracts varies with the type of annuity.
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Immediate annuities: Compare the settlement options. For each $1,000 invested, how much of a
monthly payout will you get? Be sure to consider the interest rate and any penalties and charges.
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Deferred annuities: Compare the rate, the length of guarantee period, and a five-year history
of rates paid on the contract. It is important to consider all three of these factors and not to be swayed
by high interest rates alone.
- Variable annuities: Check out the past performance of the funds involved.
If a particular fund has a great track record, ascertain whether the same management is still in place.
Although past performance is no guarantee, consistent management will grant you better odds.
Costs, Penalties, And Extras
Be sure to compare the following points when considering an annuity contract:
Surrender Penalties
Find out the surrender charges (that is, the amounts charged for early withdrawals). The typical charge is
seven percent for first-year withdrawals, six percent for the second year, and so on, with no charges after
the seventh year. Charges that go beyond seven years, or that exceed the above amounts, should not be
acceptable.
Tip: Be sure the surrender charge "clock" starts running with the date your contract
begins, not with each new investment.
Fees And Costs
Be sure to ask about all other fees. With variable annuities, the fees must be disclosed in the prospectus.
Fees lower your return, so it is important to know about them. Fees might include:
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Mortality fees of 1 to 1.35 percent of your account (protection for the insurer in case you live a long
time)
- Maintenance fees of $20 to $30 per year
- Investment advisory fees of 0.3 percent to 1 percent of the assets in the annuity's portfolios.
Extras
These provisions are not costs per se, but should be asked about before you invest in the contract.
Some annuity contracts offer "bail-out" provisions that allow you to cash in the annuity if interest rates
fall below a stated amount without paying surrender charges.
There may also be a "persistency" bonus which rewards annuitants who keep their annuities for a certain
minimum length of time.
In deciding whether to use annuities in your retirement planning (or for any other reason) and which types
of annuities to use, professional guidance is advisable.
Risk To Retirees of Using An Immediate Annuity
At first glance, the immediate annuity would seem to make sense for retirees with lump-sum distributions
from retirement plans. After all, an initial lump-sum premium can be converted into a series of monthly,
quarterly, or yearly payments that represent a portion of principal plus interest and is guaranteed to last
for life. The portion of the periodic payout that constitutes a return of principal is excluded from taxable
income.
However, this strategy contains risks. For one thing, when you lock yourself into a lifetime of level
payments, you fail to guard against inflation. Furthermore, you are gambling that you will live long enough
to get your money back. Thus, if you buy a $150,000 annuity and die after collecting only $60,000, the
insurer often gets to keep the rest. Unlike other investments, the balance doesn't go to your heirs.
Finally, since the interest rate is fixed by the insurer when you buy it, you may be locking yourself into
low rates.
You can hedge your bets by opting for a "period certain," or "term certain" which, in the event of your
death, guarantees payment for some years to your beneficiaries. There are also "joint-and-survivor" options
(which pay your spouse for the remainder of his or her life after you die) or a "refund" feature (in which
some or all of the remaining principal is resumed to your beneficiaries).
Some plans offer quasi-inflation adjusted payments. One company offers a guaranteed increase in payments of
$10 at three-year intervals for the first 15 years. Payments then get an annual cost-of-living adjustment
with a three percent maximum. However, for these enhancements to apply, you will have to settle for much
lower monthly payments than the simple version.
Recently, a few companies have introduced immediate annuities that offer potentially higher returns in
return for some market risk. These "variable immediate annuities" convert an initial premium into a lifetime
income; however, they tie the monthly payments to the returns on a basket of mutual funds.
Older seniors--75 years of age and up--may have fewer worries about inflation or liquidity. Nevertheless,
they should question whether they really need such annuities at all.
If you want a comfortable retirement income, consider a balanced portfolio of mutual funds. If you want to
guarantee that you will not outlive your money, you can plan your withdrawals over a longer time
horizon.
Annuities: Frequently Asked Questions
What are variable annuities?
Variable annuity contracts are sold by insurance companies. Purchasers pay a premium of, for example,
$10,000 for a single payment variable annuity or $50 a month for a periodic payment variable annuity. The
insurance company deposits these premiums in an account that is invested in a portfolio of securities. The
value of the portfolio goes up or down as the prices of its securities rise or fall.
After a specified period of time, which often coincides with the year the purchaser turns age 65, the
assets are converted into annuity payments. Although the insurance company guarantees a minimum payment,
these payments are variable, since they depend on the periodic performance of the underlying
securities.
Almost all variable annuity contracts carry sales charges, administrative charges, and asset charges. The
amounts differ from one contract to another and from one insurance company to another.
Fixed annuity contracts are not considered securities and are not regulated by the SEC (Securities and
Exchange Commission).
How do annuities work?
An annuity, in essence, is insurance against "living too long." In contrast, traditional life insurance
guards against "dying too soon." Briefly, here is how annuities function: An investor hands over funds to an
insurance company. The insurer invests the funds. At the end of the annuity's term, the insurer pays the
investor his or her investment plus the earnings. The amount paid at maturity may be a lump sum or an
annuity, which is a set of periodic payments that are guaranteed as to amount and payment period.
Earnings that occur during the term of the annuity are tax-deferred and an investor is not taxed until the
amounts are paid out. Because of the tax deferral, your funds have the chance to grow more quickly than they
would in a taxable investment.
Should I invest in annuities?
There are two reasons to use an annuity as an investment vehicle:
- You want to save money for a long-range goal, and/or
- You want a guaranteed stream of income for a certain period of time.
Annuities lend themselves well to funding retirement, and, in certain cases, education costs.
One negative aspect of an annuity is that you cannot get to your money during the growth period without
incurring taxes and penalties. The tax code imposes a 10 percent premature withdrawal penalty on money taken
out of a tax-deferred annuity before age 59-1/2, and insurers impose penalties on withdrawals made before
the term of the annuity is up. The insurers' penalties are termed "surrender charges," and they usually
apply for the first seven years of the annuity contract.
These penalties lead to a de facto restriction on the use of annuities as an investment. It really only
makes sense to put your money in an annuity if you can leave it there for at least ten years, and only when
the withdrawals are scheduled to occur after age 59-1/2. This is why annuities work well mostly for
retirement needs, or for education funding in cases where the depositor will be at least 59-1/2 when
withdrawals begin.
Annuities can also be effective in funding education costs where the annuity is held in the child's name
under the provisions of the Uniform Gifts to Minors Act. The child would then pay tax on the earnings when
the time came for withdrawals. A major drawback to this planning technique is that the child is free to use
the money for any purpose, not just education costs.
If an investment adviser recommends a tax-deferred variable annuity, should you invest it? Or would a
regular taxable investment be better?
Generally, you should be aware that tax-deferred annuities very often yield less than regular investments.
They have higher expenses than regular investments, and these expenses eat into your returns. On the plus
side, the annuity provides a death benefit. You should also be aware that there may be a commission on the
product an investment adviser may be entitled to a commission on the product he or she is recommending.
Should a retiree purchase an immediate annuity?
At first glance, the immediate annuity would seem to make sense for retirees with lump-sum distributions
from retirement plans. After all, an initial lump-sum premium can be converted into a series of monthly,
quarterly or yearly payments, representing a portion of principal plus interest, and guaranteed to last for
life. The portion of the periodic payout that is a return of principal is excluded from taxable income.
However, there are risks. For one thing, when you lock yourself into a lifetime of level payments, you
aren't guarding against inflation. You are also gambling that you will live long enough to get your money
back. Thus, if you buy a $150,000 annuity and die after collecting only $60,000, the insurer often gets to
keep the rest. Unlike other investments, the balance doesn't go to your heirs. Furthermore, since the
interest rate is fixed by the insurer when you buy it, you are locking into today's low rates.
You can hedge your bets by opting for what's called a "certain period," which, in the event of your death,
guarantees payment for some years to your beneficiaries. There are also "joint-and-survivor" options, which
pay your spouse for the remainder of his or her life after you die, or a "refund" feature, in which a
portion of the remaining principal is resumed to your beneficiaries.
Some plans offer quasi-inflation adjusted payments. One company offers a guaranteed increase in payments of
10 percent at three-year intervals for the first 15 years. Payments are then subject to an annual
cost-of-living adjustment, with a 3 percent maximum. However, for these enhancements to apply, you will have
to settle for much lower monthly payments than the simple version.
A few companies have introduced immediate annuities that offer potentially higher returns in return for
some market risk. These "variable, immediate annuities" convert an initial premium into a lifetime income;
however, they tie the monthly payments to the returns on a basket of mutual funds.
If you want a comfortable retirement income, your best bet is a balanced portfolio of mutual funds. If you
want to guarantee that you will not outlive your money, you can plan your withdrawals over a longer time
horizon.
How do life annuities differ from life insurance?
While traditional life insurance guards against "dying too soon," an annuity, in essence, can be used as
insurance against "living too long." With an annuity, you will receive in return a series of periodic
payments that are guaranteed as to amount and payment period. Thus, if you choose to take the annuity
payments over your lifetime (there are many other options), you will have a guaranteed source of "income"
until your death.
If you "die too soon" (that is, you don't outlive your life expectancy), you will get back from the insurer
far less than you paid in. On the other hand, if you "live too long" and outlive your life expectancy you
may get back far more than the cost of your annuity--along with the resultant earnings. By comparison, if
you put your funds into a traditional investment, you may run out of funds before your death.
What's the down side to buying an annuity?
You cannot get to your money during the growth period without incurring taxes and penalties. The tax code
imposes a 10 percent premature-withdrawal penalty on money taken out of a tax-deferred annuity before age
59-1/2 and insurers impose penalties on withdrawals made before the term of the annuity is up. The insurers'
penalties are termed "surrender charges," and they usually apply for the first seven years of the annuity
contract.
What types of annuities are available?
You can purchase a single-premium annuity, in which the investment is made all at once
(perhaps using a lump sum from a retirement plan payout).
With the flexible-premium annuity, the annuity is funded with a series of payments. The
first payment can be quite small.
The immediate annuity starts payments right after the annuity is funded. It is usually
funded with a single premium, and is usually purchased by retirees with funds they have accumulated for
retirement.
With a deferred annuity, payouts begin many years after the annuity contract is issued.
Deferred annuities are used as long-term investment vehicles by retirees and non-retirees alike. They are
used in tax-deferred retirement plans and as individual tax-sheltered annuity investments, and may be funded
with a single or flexible premium.
With a fixed annuity contract, the insurance company puts your funds into conservative,
fixed income investments such as bonds. Your principal is guaranteed, and the insurance company gives you an
interest rate that is guaranteed for a certain minimum period--from a month to a year, or more. A fixed
annuity contract is similar to a CD or a money market fund, depending on length of the period during which
interest is guaranteed, and is considered a low risk investment vehicle.
This guaranteed interest rate is adjusted upwards or downwards at the end of the guarantee period.
All fixed annuities also guarantee you a certain minimum rate of interest of 3 to 5 percent for the
entirety of the contract.
The fixed annuity is a good annuity choice for investors with a low risk tolerance and a short-term
investing time horizon. The growth that will occur will be relatively low. In times of falling interest
rates, fixed annuity investors benefit, while in times of rising interest rates they do not.
The variable annuity, which is considered to carry with it higher risks than the fixed
annuity (about the same risk level as a mutual fund investment) gives you the ability to choose how to
allocate your money among several different managed funds. There are usually three types of funds: stocks,
bonds, and cash-equivalents. Unlike the fixed annuity, there are no guarantees of principal or interest.
However, the variable annuity does benefit from tax deferral on the earnings.
You can switch your allocations from time to time for a small fee or sometimes for free.
The variable annuity is a good annuity choice for investors with a moderate to high risk tolerance and a
long-term investing time horizon.
Tip: Today, insurers make available annuities that combine both fixed and variable
features.
What are my options for collecting my annuity?
When it's time to begin taking withdrawals from your deferred annuity, you have several choices. Most
people choose a monthly annuity-type payment, although a lump sum withdrawal is also possible. The size of
your monthly payment depends on several factors including:
- The size of the amount in your annuity contract
- Whether there are minimum required payments
- The annuitant's life expectancy
- Whether payments continue after the annuitant's death
Summaries of the most common forms of payment (settlement options) are listed below. Keep in mind that once
you have chosen a payment option, you cannot change your mind.
Fixed Amount gives you a fixed monthly amount (chosen by you) that continues until your
annuity is used up. The risk of using this option is that you may live longer than your money lasts. If you
die before your annuity is exhausted, your beneficiary gets the rest.
Fixed Period pays you a fixed amount over the time period you choose. For example, you
might choose to have the annuity paid out over ten years. If you are seeking retirement income before some
other benefits start, this may be a good option. If you die before the period is up, your beneficiary gets
the remaining amount.
Lifetime or Straight Life payments continue until you die. There are no payments to
survivors. The life annuity gives you the highest monthly benefit of the options listed here. The risk is
that you will die early, thus leaving the insurance company with some of your funds.
Life with Period Certain gives you payments as long as you live (as does the life annuity)
but with a minimum period during which you or your beneficiary will receive payments, even if you die
earlier than expected. The longer the guarantee period is, the lower the monthly benefit will be.
Installment-Refund pays you as long as you live and guarantees that, should you die early,
whatever is left of your original investment will be paid to a beneficiary.
Joint and Survivor. In one joint and survivor option, monthly payments are made during the
annuitants' joint lives, with the same or a lesser amount paid to whoever is the survivor. In the option
typically used for retired employees, monthly payments are made to the retired employee, with the same or a
lesser amount to the employee's surviving spouse or other beneficiary. In this case, the spouse's (or other
co-annuitant's) death before the employee won't affect what the survivor employee collects. The amount of
the monthly payments depends on the annuitants' ages and whether the survivor's payment is to be 100 percent
of the joint amount or some lesser percentage.
What's the tax on payouts from a qualified plan or IRA annuity?
A tax-qualified annuity is one used to fund a qualified retirement plan, such as an IRA, Keogh plan, 401(k)
plan, SEP (Simplified Employee Pension), or some other retirement plan.
Any nondeductible or after-tax amount you put into the plan is not subject to income tax when
withdrawn
The earnings on your investment are not taxed until withdrawal.
If you withdraw money before the age of 59-1/2, you may have to pay a 10 percent penalty on the amount
withdrawn in addition to the regular income tax. One of the exceptions to the 10 percent penalty is for
taking the annuity out in equal periodic payments over the rest of your life.
Once you reach age 70-1/2, you will have to start taking withdrawals in certain minimum amounts specified
by the tax law (with exceptions for Roth IRAs and for employees still working after age 70-1/2).
Is it a good idea to buy annuities for my IRA or qualified plan?
Though this is sometimes done, no tax advantage is gained by putting annuities in such a plan since
qualified plans and IRAs as well as annuities are tax-deferred. It might be better, depending on your
situation, to put other investments such as mutual funds in IRAs and qualified retirement plans, and hold
annuities in your individual account.
How will my annuity payouts be taxed?
Payouts are taxed differently for qualified and non-qualified plans. These differences are summarized
below.
Qualified and Non-Qualified Annuities
A tax-qualified annuity is one used to fund a qualified retirement plan, such as an IRA, Keogh plan, 401(k)
plan, SEP (Simplified Employee Pension), or some other retirement plan. The tax-qualified annuity, when used
as a retirement savings vehicle, is entitled to all of the tax benefits-and penalties--that Congress saw fit
to attach to such plans.
The tax benefits are:
- The amount you put into the plan is not subject to income tax, and/or
- The earnings on your investment are not taxed until withdrawal.
A non-qualified annuity, on the other hand, is purchased with after-tax dollars. You still get the benefit
of tax deferral on the earnings.
Tax Rules for Qualified Annuities
When you withdraw money from a qualified plan annuity that was funded with pre-tax dollars, you must pay
income tax on the entire amount withdrawn.
Once you reach age 70-1/2, you will have to start taking withdrawals, in certain minimum amounts specified
by the tax law.
Tax Rules for Non-Qualified Annuities
With a non-qualified plan annuity that was funded with after-tax dollars, you pay tax only on the part of
the withdrawal that represents earnings on your original investment.
If you make a withdrawal before the age of 59-1/2, you will pay the 10 percent penalty only on the portion
of the withdrawal that represents earnings.
With a non-qualified annuity, you are not subject to the minimum distribution rules that apply to qualified
plans after you reach age 70-1/2.
What tax must my beneficiaries or heirs pay if my annuity continues after my death?
Taxes may apply to your beneficiary (the person you designate to take further payments) or your heirs (your
estate or those who take through the estate if you didn't designate a beneficiary).
Income tax. Annuity payments collected by your beneficiaries or heirs are subject to tax on the
same principles that would apply to payments collected by you.
Exception: There's no 10 percent penalty on withdrawal under age 59-1/2 regardless of the
recipient's age, or your age at death.
Estate tax. The present value at your death of the remaining annuity payments is an asset of your
estate and subject to estate tax with other estate assets. Annuities passing to your surviving spouse or to
charity would escape this tax.
How should I shop for an annuity?
Check Out The Insurer. Make sure that the insurance company offering it is financially sound.
Annuity investments are not federally guaranteed, so the soundness of the insurance company is the only
assurance you can rely on. Several services rate insurance companies.
Compare Contracts. For immediate annuities: Compare the settlement options. For each $1,000
invested, how much of a monthly payout will you get? Consider the interest rate and any penalties and
charges.
Deferred annuities. Compare the rate, the length of guarantee period, and a five-year history of
rates paid on the contract, not just the interest rates.
Variable annuities. Check out the past performance of the funds involved.
If a particular fund has a great track record, ascertain whether the same management is still in place.
Although past performance is no guarantee, consistent management will grant you better odds.
What are the added or hidden costs in buying an annuity?
There are costs associated with annuities. Here are the most important items you should be aware of:
Sales Commission. Ask for details on any commissions you will be paying. What percentage is the
commission? Is the commission deducted as a front-end load? If so, your investment is directly reduced by
the amount of the commission. A no-load annuity contract, or at least a low-load contract, is the best
choice.
Surrender Penalties. Find out the surrender charges (that is, the amounts charged for early
withdrawals). The typical charge is 7 percent for first-year withdrawals, 6 percent for the second year, and
so on, with no charges after the seventh year.
Tip: Be sure the surrender charge "clock" starts running with the date your contract
begins, not with each new investment.
Other Fees and Costs. Ask about all other fees. With variable annuities, the fees must be
disclosed in the prospectus. Fees lower your return, so it is important to know about them. Fees might
include:
-
Mortality fees of 1 to 1.35 percent of your account (protection for the insurer in case you live a long
time)
- Maintenance fees of $20 to $30 per year
- Investment advisory fees of 0.3 percent to 1 percent of the assets in the annuity's portfolios
Other Considerations. Some annuity contracts offer "bail-out" provisions that allow you to cash in
the annuity if interest rates fall below a stated amount without paying surrender charges.
There may also be a "persistency" bonus which rewards annuitants who keep their annuities for a certain
minimum length of time.
Is it better to take an annuity or a lump-sum distribution?
As in so many areas of retirement planning, that depends upon your particular needs and circumstances.
An annuity preserves the tax shelter for funds not yet paid out as annuity income, continuing to grow
tax-free to fund future payouts.
A lump sum withdrawal may be preferable for those in questionable health.
-
Consider an annuity with a "refund feature" that guarantees a fixed sum to your heirs should you die
earlier than expected.
What is a joint and survivor annuity?
A joint and survivor annuity pays a certain annuity during your life and half that amount (it could be
more) to your surviving spouse for life.
In almost all cases, the annual amount you will get under a joint and survivor annuity will be less than
you would get under an annuity on your life alone.
Can I change from a joint and survivor annuity if it doesn't meet my needs?
Joint and survivor annuities are almost always required in pension plans, and sometimes in other plans. But
you and your spouse can still agree to some other form.
Chief reasons for such agreement are so that your child or other family member can share in the income, or
to take a lump sum distribution, or to take a larger annual amount over the participant's life alone.
