Going flat broke is a pretty big concern for many when it comes to retirement, according to the American Institute of CPAs' Personal Financial Planning Trends Survey. One simple solution, however, is choosing a variable annuity to help create a form of supplemental regular income.
And best yet, they've even got a number of special features and tax benefits to offer, because they’re intended to help provide a sustainable retirement income.
Careful, though, there are a number of different types of variable annuities, some qualified and some nonqualified, that are important to understand. For that, it's best to have an independent insurance agent on your side.
Independent insurance agents are absolute experts when it comes to confusing puzzles like these, and their job is to help simplify the whole process for you. They’ll help guide you through all your options, weigh the good and the bad, and even see you through it all from start to signature.
What could be simpler?
First Things First ... What Is a Variable Annuity?
Annuities are one of many different types of policies issued by insurance companies. With an annuity, the policyholder (or annuitant) receives regular guaranteed income for life, or an agreed-upon number of years. Your annuity contract begins by making either a single payment or a series of payments.
There are actually a number of different types of annuities, including:
- Deferred variable annuities accumulate money for a period of time before the policy pays income.
- Immediate variable annuities pay income right away.
- 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’re not guaranteed.
- Indexed variable annuities offer partial protection from market losses and accumulate money by tracking a market index, like the S&P 500.
- Qualified variable annuities are part of a pension plan or IRA. They are purchased with before-tax dollars.
- Nonqualified annuities are personally owned and paid for with after-tax dollars.
- Group variable annuities were created by life insurance companies as a vehicle to administer 401k plans. Group annuities are often used for small- and medium-sized plans.
Who are the Owners, Annuitants, and Beneficiaries?
An annuity policy is a contract between the insurance company, the owner, the annuitant, and the beneficiaries. It all works like this:
The owner of the policy has the sole right to the values and payments in the contract, and the owner decides who both the annuitant and the beneficiaries are. The age and sex of the annuitant is how the insurance company determines how much and when income is paid.
Despite what you may think, the annuitant and owner don't have to be the same person. And if and when the owner passes away, the beneficiary receives the proceeds and can create their own schedule of payments at that time.
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 Are Nonqualified Variable Annuities?
Nonqualified variable annuities are personally owned and paid for with after-tax dollars. They aren't part of any IRA or pension plan and don't have any limits on contributions.
Nonqualified annuities have three key tax benefits worth thinking about:
- Tax-deferred growth: No tax is paid on the growth, capital gains, or dividends of the subaccounts until money is taken out.
- Tax-free transfers between subaccounts: There is no tax for transferring between subaccount investments.
- Tax-favored income: Income from an annuity option is partially taxable.
Also, the income you receive from nonqualified variable annuities is taxed at ordinary income rates.
Why Buy a Nonqualified Annuity?
Honestly, there's a number of reasons. Nonqualified annuities are a popular, flexible retirement planning tool. They can be used to accumulate money and provide a nice supplemental retirement income.
The tax benefits and unlimited contributions make them attractive for investors who have maxed out their IRA or pension contributions. Investors can also use nonqualified annuities to protect a portion of retirement savings from market downturns.
Among the benefits of nonqualified annuities are:
- Lifetime income: Variable annuities have lots of options for lifetime guaranteed income. Options include income for the lifetimes of two people, called joint and survivor.
- Money management tool: For some investors who “rebalance” their portfolios between stocks bonds and cash, the tax-free transfer between subaccount investments is an attractive feature.
- Market protection: Variable annuities have features called living benefits that guarantee a minimum lifetime income regardless of market performance. Some variable annuities, called indexed variable annuities, offer a level of protection against market losses. The investor selects a percentage of downside protection, 10% and 20% are common. The insurance company absorbs losses in the account up to the selected percentage. In exchange, the growth in the account is limited or capped by the insurance company.
What Are Qualified Variable Annuities?
Qualified annuities are part of pension plans or IRAs, both traditional and Roth, and paid for with before-tax dollars. Roth qualified annuities are paid for with after-tax dollars.
Qualified annuities are included in the contribution limits of pension plans and IRAs. There is no tax benefit to buying a qualified annuity. Pensions and IRAs already offer tax-deferred growth and tax-free transfers between investments.
Why Buy a Qualified Variable Annuity?
If you have an IRA or pension plan, you already have the cool stuff that annuities offer like tax-deferred growth and tax-free transfers between investments. Why pay fees for something you already have? And the answer is you wouldn't unless you were getting close to retirement or really worried about losing money.
If you're getting close to retirement you are probably thinking about a lot of things. Wahoo! I don't have to go to the office! You might also be thinking about your retirement money and how to get income from it. That's what annuities are for. They can guarantee income for the rest of your life.
If you're really worried about down markets (think 2008 - 2009) annuities can offer some protection. Variable indexed annuities and variable annuity living benefits offer growth and protection from losses. Other annuities, like fixed and fixed indexed annuities, offer guaranteed returns that are usually higher than bank products like CDs.
How Are Qualified and Nonqualified Variable Annuities Taxed?
Qualified and nonqualified annuities are treated differently for tax purposes. The chart below is a summary.
|Contributions||After-tax. Unlimited.||Pre-tax. Limits for IRAs and qualified plans apply.||After-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 five years.||IRA loans not permitted. Pension plans may have exceptions for home purchase and loans repaid in five 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 fifth year.|
The big picture — if you didn't pay taxes on the money going in, you pay taxes on the money coming out.
What if the Insurance Company Goes Bankrupt?
Insurance companies are regulated by state insurance departments. The insurance company has to meet financial standards and report on their condition.
Each state has a guaranty fund to protect consumers if an insurance company can’t meet its obligations. Variable annuities are separate accounts of the insurance company. They are not subject to creditor’s claims. The variable annuity separate accounts are regulated by the SEC.
Financial strength ratings of insurance companies are available from A.M. Best, Fitch, Moody’s and Standard & Poor. The rating each service assigns reflects their opinion on the insurance company's ability to pay claims.
Look for high quality ratings from at least 2 of the 4. The chart below summarizes the financial strength ratings of the different services.
|Highest Ability to Meet Obligations||Medium Ability to Meet Obligations||Lowest Ability to Meet Obligations|
|A.M. Best||A++ to A-||B++ to B-||C++ to C-|
|Moody’s||Aaa to Aa||A to Baa||Ba to Caa|
|S&P||AAA to A||BBB to B||CCC to C|
|Fitch||AAA to AA-||A+ to BBB-||BB+ to CC|
What's So Great about Independent Insurance Agents?
Insurance policies are complex, and searching through options can be confusing, time-consuming and frustrating. An independent insurance agent's role is to simplify the process.
They will make sure you get the right coverage that meets your unique needs and break down all the jargon so that you understand exactly what you're getting.