This unique investment option offers tax deferral for individuals investing for retirement.
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.
- What Are Annuities?
- Features of Annuities
- Deferring Taxes May Help Build Value
- A Choice of Investment Options
- Balance Costs and Benefits
- Points to Remember
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.
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.
*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.
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:
- 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.
- 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.
- 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.
- 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.
- 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
- 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.
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:
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.
- Annuities are available in fixed accounts and variable investment accounts.
- An annuity offers a choice of investment options.
- Money is accumulated in an annuity through contributions and investment earnings.
- An annuity’s earnings are tax deferred.
- Annuities allow unlimited after-tax contributions.
- Your contributions to annuities can continue even after retirement.
- Annuities allow you to diversify, thereby reducing your risk, while still allowing you to potentially benefit from higher returns.
1Diversification does not ensure against loss.
© 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 D3 Financial Counselors, a local member of FPA.