Use Annuities to Plan for Your Future

Synopsis:

If you’re investing for retirement and are looking for an investment vehicle that may
complement your existing portfolio, you may want to consider an annuity. Why?
Because an annuity provides potential growth that is tax deferred, which means
its investment earnings can accumulate and compound untouched by federal,
state, or local income taxes until you begin making withdrawals. One trade-off
of this tax deferral benefit is that withdrawals made from an annuity are taxed
as ordinary income. In addition, withdrawals made before age 59½ may be subject
to a 10% federal penalty tax. Furthermore, the issuing insurance company may
also have its own set of surrender charges for withdrawals taken during the
initial years of the contract.

So what really is an annuity? Essentially, it’s a contract between the purchaser and
the issuing insurance company. Until the 1970s, most annuities were sold
through insurance companies and offered only a fixed amount to be paid out.
Annuities today are sold through banks and insurance companies and are much
more flexible. They may include both fixed accounts and potentially higher-returning
variable investment options.

Another important advantage of an annuity is that it generally allows unlimited
after-tax contributions, whether you have earned income or not, and your
contributions can continue even after retirement. At withdrawal, only the
investment earnings on your annuity contributions are taxable.

Key Points

Annuities are one of the most popular investment products
available today. One reason annuities are attractive is that they can help
build more value over time. By providing potential growth that is tax deferred,
an annuity’s investment earnings can accumulate and compound untouched by
federal, state, or local income taxes until you begin making withdrawals, which
is usually after retirement. Keep in mind that withdrawals made from an annuity
before age 59 ½ are taxed as ordinary income and may be subject to a 10%
federal penalty tax. In addition, the issuing insurance company may also have
its own set of surrender charges for withdrawals taken during the initial years
of the contract.

In addition to tax advantages, annuities also offer a choice of investment
options. These may include fixed accounts, which may help protect principal
from market risk, and variable investment accounts in stock and bond
portfolios, which offer the potential for higher returns.

Together, these features make annuities attractive to those who seek
investments that can help supplement future retirement benefits, and to
retirees who want greater control over their income and the flexibility to
continue deferring taxes on investment earnings.

What Are Annuities?

Annuities are essentially contracts between the purchaser and
the issuing insurance company. Until the 1970s, most annuities were sold
through insurance companies and offered only a fixed amount to be paid out.
Annuities today are sold through banks and insurance companies and are much
more flexible. They may include both fixed accounts and potentially
higher-returning variable investment options.

Money is accumulated in an annuity through contributions and investment
earnings.

Features of Annuities*
  • You
    can make a single contribution or a series of payments over time.
  • You
    can contribute any amount, regardless of your income level or sources of
    income.
  • When
    you begin making withdrawals, you can choose from different payout methods,
    including a fixed amount for life for you and/or your spouse, or payments to
    your beneficiaries or heirs.
  • Payout
    methods include insurance features, which guarantee payment to your
    designated beneficiaries if you die before withdrawals begin. In most cases
    this payment does not have to pass through probate.

 

*You should fully investigate the insurance company’s
stability and financial strength through an independent agency, such as
Moody’s, Standard & Poor’s, or A.M. Best Company, before committing to a
contract.

Deferring Taxes May Help Build Value

The power of tax-deferred growth can be substantial compared
with a comparable taxable investment. Compared with other tax-deferred
accounts, such as IRAs or 401(k)s, you have much greater control over the
income generated from your annuity. The same 10% tax penalty that applies to
early withdrawals from retirement accounts also applies to annuity withdrawals
made before age 59½. In some instances you may be able to defer making
withdrawals until several years past retirement. (Check your annuity contract
for details.)

Another important advantage of annuities is that they generally allow unlimited
after-tax contributions, whether you have earned income or not, and your
contributions can continue even after retirement. At withdrawal, only the
investment earnings on your annuity contributions are taxable.

Here are six ways to help maximize the value of an annuity:

  1. Take advantage of low fees. Fees charged for annuities are similar
    to those on other investments, but with additional expenses of insuring the
    total value of premiums paid. In choosing an annuity, you may want to compare
    both annual expenses and insurance charges as well as sales charges. Many
    annuities collect a surrender charge if the contract is canceled prematurely.
    But if you plan to use your annuity as a long-term investment, you’ll likely be
    more concerned with front-end sales loads and annual contract charges than
    surrender fees.
  2. Choose an annuity that offers a variety of investment options. Many
    experts suggest that individuals in their 30s or 40s concentrate their
    long-term investments in stocks, which provide the greatest potential for
    long-term capital appreciation over time. Of course, these investments also
    carry higher risk. You might also want to diversify your investments to help
    reduce investment risk.1 As your lifestyle changes or your financial
    needs change, you will want the flexibility to rearrange your investments to
    keep in step. Look for annuities with no-fee exchanges and a variety of
    investment options.
  3. Dollar cost averaging could potentially boost long-term returns. By
    investing the same amount at regular intervals, you essentially buy more when
    prices are low and less when prices are high. This may help smooth out some of
    the normal fluctuations of the stock markets over the years. Using this
    strategy, however, does not assure an investment profit or protect against loss
    in declining markets. Before you consider dollar cost averaging, be sure to
    review your financial ability to invest during periods of declining prices.
  4. Increase the potential return on aggressive investments. Even though the maximum federal capital
    gains tax rate is well below the top income tax rates, you may still benefit by
    deferring taxes on your long-term capital gains until you make withdrawals.
    Annuities can make your aggressive investments even more rewarding as taxes on
    both long- and short-term capital gains are deferred.
  5. Enjoy the benefits of diversification. Spreading your money among
    different types of investments has been shown to lower your investment risk.
    Annuities offer opportunities to diversify among fixed account and variable
    investments, thereby reducing your risk while still allowing you to potentially
    benefit from higher returns.1
  6. Use annuities to pass money along to heirs quickly. Annuities can
    offer a number of advantages in estate planning. For example, if you designate
    family members as beneficiaries to the annuity, your loved ones will (in most
    cases) receive the insurance benefit directly, without having to wait for your
    estate to be settled. If your spouse is named beneficiary, he or she may even
    be able to keep the annuity in place and continue tax deferral on any
    investment earnings.
A
Choice of Investment Options
With little risk to principal, fixed annuities offer a
stated rate of return for a specified period of time. Variable annuities
include a variety of investments that may offer higher potential for return
but may also fluctuate with market conditions. Variable investment choices
can include:

  • Equity portfolio:
    common stocks
  • Fixed-income portfolio:
    bonds, preferred stocks
  • Balanced portfolio:
    stocks and bonds
  • Money market portfolio:
    bonds and notes
  • Fixed-rate portfolio:
    no risk to principal; bonds and notes

Balance Costs and Benefits

An annuity can be an excellent retirement investment vehicle
if you are able to forgo use of the money for several years. Annuities also
offer unlimited contributions, protection of principal on fixed accounts, and
the potential to earn higher rates of return on your investments in variable
accounts. Annuities may also entail higher fees and expenses than some other
investment vehicles, in part due to the insurance feature annuities provide.

Although annuities today are flexible investment vehicles that can be used to
meet a variety of financial needs, most people don’t appreciate their
usefulness. If you have been investing in mutual funds, a variable annuity
might be the next logical step for a portion of your retirement investment
plan.

Points to Remember

  1. Annuities are available in fixed accounts and
    variable investment accounts.
  2. An annuity offers a choice of investment options.
  3. Money is accumulated in an annuity through contributions and investment earnings.
  4. An annuity’s earnings are tax deferred.
  5. Annuities allow unlimited after-tax contributions.
  6. Your contributions to annuities can continue even after retirement.
  7. Annuities allow you to diversify, thereby reducing your risk, while still allowing you to
    potentially benefit from higher returns.

Source/Disclaimer:

1Diversification does not ensure against loss.

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© 2012 McGraw-Hill Financial Communications. All rights
reserved.

March 2012 — This column is provided through the Financial
Planning Association, the membership organization for the financial planning
community, and is brought to you by Ronald J VanSurksum, CFP®, a local member
of FPA.

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