Deferred annuities are a financial tool designed for two things. Building wealth and creating lifetime retirement income. Americans bought $200 billion of deferred annuities in 2018, so it's certainly worth finding out more about them.
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So you want to know about deferred annuities? Here’s everything you ever wanted to know, and maybe a little more.
Owners, Annuitants, and Beneficiaries
An annuity policy is a contract between the insurance company and these folks. The owner has the sole right to the values and payments in the contract. The owner decides who the annuitant and beneficiaries are.
The age and sex of the annuitant are how the insurance company determines how much and when income is paid. The annuitant and owner don't have to be the same. The beneficiary receives the proceeds at the death of the owner or annuitant.
The insurance company issues the policy and has to honor the promises in it. Guarantees in the policy are only as good as the financial ability of the insurance company to pay claims.
What's A Deferred Annuity?
Deferred annuities are policies issued by insurance companies. You buy a deferred annuity policy by making a single payment or a series of payments. Deferred annuities have two phases, accumulation and payout.
During the accumulation phase the account value grows tax deferred. That means no tax on interest or gains is paid until money is withdrawn.
During the payout phase the insurance company pays lifetime income to the owner or annuitant.
- Traditional qualified deferred annuities are part of a pension plan or IRA. They are purchased with before-tax dollars.
- Roth-qualified deferred annuities are part of a Roth IRA or pension. They are purchased with after-tax dollars.
- Non-qualified deferred annuities are personally owned and paid for with after-tax dollars.
Deferred annuities can be fixed, variable, or indexed.
What Is a Fixed Deferred Annuity?
The values of a fixed annuity are guaranteed by the insurance company. The guarantees apply to:
- The cash value: Payments accumulated at the interest rates applied
- The surrender value: The cash value minus any charges for cashing in the policy
- The annuity payout factors: The rate applied to calculate annuity income
- Minimum interest rate applied to the cash value
Fixed deferred annuities offer competitive low risk returns. Fixed annuity interest rates are usually higher than CD or savings account rates.
What Is a Fixed Index Deferred Annuity?
Fixed index annuities have the same features as fixed annuities with one important difference. Fixed index annuities offer tax-deferred growth based on the stock market without stock market risk. Index accounts credit some of the gains of a market index like the S&P 500 and none of the losses.
What Is a Variable Deferred Annuity?
Deferred variable annuities accumulate money in investments selected by the owner called subaccounts. Like mutual funds or other investments, the values of the subaccounts are based on market performance. They aren’t guaranteed. Money can be transferred between subaccounts without any tax consequences.
Variable annuities have features that offer “downside protection” to investors during down markets.
What If the Insurance Company Goes Bankrupt?
When you contribute to a fixed annuity, the insurance company puts the money into its general account. The general account is mostly a portfolio of corporate and government bonds. The interest the insurance company pays to you is based on what they earn from the portfolio.
The bad news? If the insurance company goes bankrupt your money can go with it. That's why it's important to buy a fixed annuity from a reputable and financially strong insurance company.
Variable annuity contributions are held in a separate account that is not subject to creditor claims. Insurance companies are regulated by each of the 50 state insurance departments. These departments have financial standards for licensed companies. Each state has guarantee funds to reimburse policyholders if the insurance company fails. The limits for each state are different.
What Do Deferred Annuities Cost?
- Front end sales loads: The front end sales load is deducted from your purchase payment. Most products on the market today don’t have a front end sales load.
- Fees and expenses: Variable annuities have mortality and expense fees, investment management fees and administrative fees.
- Surrender penalties: Most deferred annuities charge a fee if you cash in your contract, or withdraw more than 10% of the cash value. Surrender penalties decline to 0 over a period of years, usually not more than 10.
- Market value adjustment: Fixed and fixed index annuities may have market value adjustments during the surrender period. The market value adjustment will be a cost or a bonus depending on interest rates.
- Rider fees: Optional riders like living benefits have a cost. The fee is usually a percentage of the cash value.
How Do I Get Income from a Deferred Annuity?
Deferred annuities have a lot of options to choose from. Some options exchange account values for income, others leave account values available. The chart below outlines the options.
|During Lifetime||At Death||Advantages||Disadvantages|
|Life||Pays income for annuitants’s life||None||Highest income. Partly taxable||No refund of unused principle|
|Life and 10 Years Certain||Pays income for life. Not less than 10 years||Balance if death occurs before the end of 10 years||Protection for beneficiaries. Partly taxable||Lower Income|
|Life And 20 Years Certain||Pays income for life. Not less than 20 years||Balance if death occurs before the end of 20 years||Protection for beneficiaries. Partly taxable||Lower Income|
|Life With Cash Refund||Pays income for life. Payments are at least specified refund amount||Balance of refund amount||Protection for beneficiaries. Partly taxable||Lower Income|
|Period Certain||Pays Income for a specified number of years||Balance of payments||Useful for certain planning purposes||Outliving income|
|Joint & Survivor 100%||Pays income for longer of two lives||No further payments at 2nd death||Surviving spouse continues to receive income for life Partly taxable||Lower Income|
|Guaranteed Lifetime Withdrawal Benefit Single Life||Pays income for annuitant’s life||Balance of account||Access to account values, death benefit||Income taxed as withdrawals|
|Guaranteed Lifetime Withdrawal Joint Life||Pays income for lifetimes of annuitant and 2nd life||Balance of account at 2nd death||Access to account, death benefit||Income Taxed As Withdrawals|
How Are Deferred Annuities Taxed?
Tax treatment for traditional qualified annuities, Roth-qualified annuities, and non-qualified annuities is different.
The chart below summarizes tax treatment of retirement annuities.
|Contributions||After-tax. Unlimited||Pre-tax. Limits for RAs and qualified plans apply.||Afte-tax. Limits for IRAs and qualified plans apply.|
|Surrender||Gain is taxed at ordinary rates.||All proceeds taxable||Tax-free|
|Annuity Income||Partially taxable at ordinary rates||100% taxable at ordinary rates||Tax-free|
|Withdrawals||Withdrawals are gain first. Gain is taxed at ordinary rates.||100% taxable at ordinary rates||Tax-Free|
|Loans||Loans are considered withdrawals. Gain first is taxed at ordinary rates.||IRA loans not permitted. Pension plans may have exceptions for home purchase and loans repaid in 5 years.||IRA loans not permitted. Pension plans may have exceptions for home purchase and loans repaid in 5 years.|
|Death Benefits||Gain is taxed at ordinary rates. Proceeds will be taxed as "gain first."||Rules for inherited traditional IRAs and qualified plans apply.||Rules for inherited Roth IRAs and plans apply.|
|Sales||Proceeds in excess of basis taxed at ordinary rates||N/A||N/A|
|Penalties||10% for withdrawals before age 59-1/2||10% for withdrawals before age 59-1/2||10% for withdrawals before age 59-1/2. Penalty for withdrawals prior to end of the 5th year|
What Happens to the Money in a Deferred Annuity When You Die?
If you die during the deferral period, your beneficiary will receive the account value. If you die during the distribution period, the income option that you selected will determine what the beneficiary will receive.
Optional riders may enhance the death benefit.
Is a Deferred Annuity Right for Me?
Deferred annuities are financial tools. Whether they are right for you depends on the job you want them to do. Here are some considerations:
- Tax-deferred growth is a major benefit of annuities. Is tax control important to you? Can you benefit from tax-deferred growth?
- Deferred annuities have surrender and tax penalties. Do you have adequate resources for emergencies and other short-term needs?
- Deferred annuities can guarantee an income for life. Do you want a fixed guaranteed income for life instead of income that may benefit from market returns?
- Deferred annuities can offer downside market protections and other benefits. Do these options enhance your retirement plan?
What Next ?
Deferred annuities can be an important part of your retirement plan. While they have many features and benefits, they are not for everyone. Talk to your independent insurance agent. They can help you decide if a deferred annuity is right for you.
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