Going broke is a top concern in retirement according to the American Institute of CPA's Personal Financial Planning Trends Survey. Annuities have special features and tax benefits courtesy of Uncle Sam. That’s because they’re intended to provide retirement income.
Nonqualified variable annuities are a way to supplement your retirement plan.
Contact your independent insurance agent and ask them if an annuity is right for you.
What Are Variable Annuities?
Variable annuities are policies issued by insurance companies. They pay a regular income for life or a period of years. You buy a variable annuity contract by making either a single payment or a series of payments.
Deferred variable annuities accumulate money in investments selected by the owner called subaccounts. Like mutual funds or other investments, the value of the subaccounts is based on market performance. They aren’t guaranteed.
Immediate variable annuities pay income right away. The income from an immediate variable annuity changes based on the investment performance of the subaccounts.
What Are Nonqualified Variable Annuities?
Nonqualified annuities are personally owned and paid for with after-tax dollars. They are not part of an IRA or a pension plan. They don't have any limits on contributions.
How Do Nonqualified Variable Annuities Work?
There are two stages to a deferred variable annuity, accumulation and payout. During the accumulation stage, the subaccount investments increase or decrease based on market performance. Growth in the subaccounts is deferred. Unlike mutual funds, capital gains and dividends are tax-deferred.
A feature of the variable annuity is tax-free transfers between subaccount investments. The investor can rebalance their variable annuity portfolio percentages of stocks, bonds, and cash without paying tax.
During the payout stage the investor receives income. Nonqualified variable annuities offer many options for income. The income can be variable, fixed, or a combination. Living benefit riders like the Guaranteed Lifetime Withdrawal guarantee a minimum income regardless of market performance.
How Nonqualified Annuities Are Taxed
Income from an annuity option is taxed differently than income from a withdrawal.
Annuity options pay income for one or the longer of two lifetimes. When the investor selects an annuity option, they give up access to principle. A portion of income from an annuity option is excluded from taxes as a return of the investors payments. The balance is taxed at ordinary rates.
Nonperiodic distributions are income received from an annuity as a withdrawal, surrender, death benefit, or loan. Nonperiodic distributions are taxed as gain first at ordinary rates.
This means that the distribution is fully taxable until the investment gains are exhausted. There is a penalty tax of 10% on distributions taken before age 59 1/2.
Inherited Nonqualified Annuities
All annuities have to pay out at the death of the owner. The only exception is for spouse beneficiaries. If the owner dies during the accumulation period, the spouse can choose to "step into" the nonqualified variable annuity and continue it as their own.
How Nonqualified Annuity Death Benefits Are Taxed
If the owner dies, the annuity has to be distributed. Other than the exception for spouses, there are four options for the beneficiaries if the owner dies during the accumulation stage.
The beneficiary can take a lump sum, defer the payout for up to five years, take an annuity income option, or take fractional income. The deferred payout is taxed as gain first. The annuity and fractional options are partly excluded from taxable income based on the exclusion ratio.
If the owner dies during the income stage, the beneficiary can take any proceeds remaining as either a lump sum or as a new annuity option. Gains will be taxed as ordinary income. Part of the income from a new annuity option will be excluded from taxable income.
Five Annuity Myths
1. Myth - Annuities are only for income
Reality - Annuities can also be used to accumulate money
Immediate annuities turn accumulated wealth into guaranteed income right away. Deferred annuities can be used to accumulate wealth on a tax-deferred basis that can be turned into income later. Nonqualified variable annuities can supplement retirement savings. They can also be used as a portfolio and risk management tool.
2. Myth - Annuities are too expensive
Reality - There are many low-cost, nonqualified variable annuity options available. Other annuities offer features that have higher cost such as living benefit riders and enhanced death benefits. They can be valuable for specific risks, but they are not for everyone.
3. Myth - There is no point in buying an annuity for income before retirement
Reality- As you get closer to retirement, the ups and downs of the market become more of a concern. A drop in the market at the wrong time can have real impact on a retirement plan. Some types of nonqualified variable annuities can offer some protection from market volatility.
Variable indexed annuities can partially protect you from market losses. In exchange for covering losses up to a percentage, the growth in the account has a limit, or cap. Variable annuity living benefit riders guarantee a minimum lifetime income regardless of market performance.
4. Myth - I can create more income from my retirement portfolio than an annuity can
Reality - That's always a possibility. The question is what happens if you're wrong? No one can predict how the markets will behave in the future, and no one can predict how long they will actually live. Other than social security and pensions, only annuities an provide guaranteed lifetime income.
5. Myth - The insurance company gets my money when I die
Reality - Your beneficiaries get your money
There is only one income option, life only that has no payments to beneficiaries if you die prematurely. There are many ways to include annuity death benefit and income options in your legacy planning.
Annuities can provide a way to accumulate money and receive income in retirement. They can be a flexible financial tool in your retirement planning. Talk to an independent insurance agent. They can help you explore if a nonqualified variable annuity is right for you.