For many consumers the decision to invest can be a difficult one. With so many options available, so many banks and corporations offering investment terms, the process can be such a headache many will simply not invest. This however would be a...
Fixed Annuities
Annuities are financial products provided by insurance companies. Clients invest their savings into annuities to guarantee income for a specified period of time to supplement retirement or social security benefits. Guaranteed income intervals may range from 5 to 30 years. Clients provide insurance companies with the desired investment amount. Insurance companies determine how long the investment will provide an income for the client. Monthly payments will be made to the client for a specified period of time.
Fixed annuity rates are based upon low risk investments, typically government securities or corporate bonds. By contrast, variable annuities may yield a greater return. However, the investment involves a higher risk because the interest rates vary based upon securities. Clients purchase a fixed rate annuity to guarantee their rate of return or interest rate will never decrease during the lifetime of the annuity. Fixed annuity rates vary based upon the maturation period of the annuity and the amount invested. Fixed rate maturation periods may be 1, 3, 5, 10, or 15 years.
For example, clients may invest less than $100,000 in an annuity that will reach maturation in 1 year. This annuity may yield 3.17 percent upon maturity. Clients investing more than $100,000 in an annuity may expect yields of 4.19 percent in 1 year. Annuities with fixed annuity rates for 5 years or more may have a smaller yield of 2.2 percent. Smaller interest rates account for inflation and the total amount collected over 5 years. Interest rates vary from insurance company to insurance company. Individuals should verify the rates prior to investing.
Fixed annuity rates provide clients with a safe investment and guaranteed income, while deferring taxes. The annuity savings are not taxed until the money is withdrawn. When an annuity reaches maturation, clients have two options. The money can be withdrawn on a monthly basis as income or clients can reinvest the money into another annuity or financial product. During the maturation period, some insurance companies allow the withdrawal of interest or a percentage of the principal. The amount varies. Clients should inquire with insurance companies prior to investing.
Penalties
If the client withdraws the funds under the age of 59 ½, the client will suffer a 10 percent penalty. If the client withdraws funds after the age of 59 ½, the client will be responsible for taxes on the interest earned.
Insurance companies also penalize clients a percentage for withdrawing funds before the maturation period. The penalties differ based upon the insurance company.
Immediate annuities with fixed annuity rates allow clients to begin receiving monthly income immediately after an investment is made. In this scenario, the client does not have to wait for the security to reach maturation before withdrawing income. Immediate annuities are tax-deferred; however, clients must pay taxes on monthly income received. The interest rates remained fixed despite immediate withdrawal.
Clients with fixed rate lifetime annuities receive a fixed annuity rate over a lifetime. Insurance companies allow clients to pay higher premiums to ensure the client's income will continue after the client’s savings have expired. If the client dies, a beneficiary can receive any funds remaining in the account.
Pros and Cons of the Fixed Annuity
A fixed annuity is a very attractive vehicle for retirement planning. It can provide a guaranteed fixed rate of A fixed annuity is a very attractive vehicle for retirement planning. It can provide a guaranteed fixed rate of return and a set amount that can be paid out on a monthly basis. Each annuity contract has a number of different features that must be examined to determine the advantages and disadvantages for each individual's particular circumstances.
Pros
Guaranteed Rate of Return The contract will lock in a fixed rate for the time period of the annuity, like a CD. This gives the investor peace of mind in knowing exactly how much money he is going to receive.
Payment Flexibility Payments can be made into the contract by either a lump-sum single payment or by an installment schedule. This gives the investor considerable flexibility in funding the annuity contract. An investor cannot add funds to a single premium contract, but he can purchase additional contracts.
Tax Deferral The income from the annuity accumulates tax-free. There is no tax paid until withdrawal. The tax-free feature creates a much higher compounded rate of return.
No limitations on Amount Invested Unlike the limitations placed on a 401(k) and an IRA, an individual can invest as much as he wants into annuities. This is beneficial for individuals who have larger sums to invest and are looking to take advantage of guaranteed returns and tax-deferred income.
Low Risk There is virtually no risk of loss of principle. There may be some variation in the rate of return, but unless the insurance company becomes insolvent, the investor will never lose his principle.It is prudent to check the financial rating of the insurance companies with recognized rating firms such as Moody's, Standard and Poor's and AM Best and be sure that you are dealing with the highest rated companies.
Flexible Terms Fixed annuities can be set up for short, medium, and long term. The rate of return will normally be higher for the longer term contracts. This allows the investor considerable flexibility in setting up the cash flow timing that he needs from his retirement plan.
Cons
Limits on Guaranteed Rate While a fixed annuity has a guaranteed rate of return, the period of time for this guarantee is usually not the full period of the contract. When the guaranteed period elapses, the interest rate will be reset, sometimes at a lower rate. A bailout provision provides a degree of protection against large adverse changes in the interest rate. If there is a change of 1% or more, the annuitant has the option to cash out penalty-free and to re-invest in another more competitive vehicle.
Surrender Charges A fixed annuity is designed to be a long-term investment. In the unfortunate circumstance that funds might need to be withdrawn for emergency needs, most annuity contracts will have a severe withdrawal penalty. This can range up to 10% of the contract amount. There will be a schedule that reduces this withdrawal penalty on an annual basis for the early years of the contract.
Taxation While earnings of a fixed annuity will accumulate tax-free, they will be taxed at withdrawal at higher ordinary tax rates instead of capital gains rate. It is anticipated that the annuitant will have lower income during the retirement years and the ordinary rate would be lower at that time.
Outliving the Contract There are two types of fixed annuities: term certain and life. With a term certain contract payments are made with a given amount up to a specified date. The issuing company keeps the balance of the contract if the annuitant dies prior to the specified date. A term certain annuity is less expensive than a life annuity.
A straight life annuity, on the other hand, will continue to make payments until the annuitant passes away. This negates the possibility of outliving the investment and assures the investor that he will continue to receive funds throughout his retirement years.
Glossary of Annuity Terms
1035 Exchange – A transaction in which ownership of one insurance product – such as an annuity - is exchanged for ownership of a similar insurance product without triggering a taxable event. Named for the section of the Internal Revenue Code defining and regulating them, these can be complex and should be undertaken only with professional guidance – for example, a life insurance policy can be 1035-exchanged for an annuity, but an annuity cannot be 1035-exchanged for a life insurance policy.
401(k) – The section of the IRS Code that defines the retirement savings plans commonly known by that name. 401(k) plans are employer-sponsored, but generally funded by contributions made by the individual, although some employers will also make contributions. Contributions to, and interest earned on, a 401(k) plan are tax-deferred – no tax is due until funds are withdrawn, but there's a penalty on any withdrawals before age 59.5.
Accrued Monthly Benefit (AMB) – a calculation of what the guaranteed monthly income would be if an annuity were annuitized – because of the many variables included in the calculation of the guaranteed income, it can increase significantly from one year to the next.
Accrued Interest – interest income that's been earned but not yet credited to the account. Although it's still accounted for as interest for tax purposes, once interest is credited to an account's value, it essentially becomes part of the principal and earns interest itself – the “miracle of compound interest.”
After Tax Saving – savings plans, mostly retirement-oriented, that utilize “after-tax” funds as their principal amount. When these plans pay out, taxes are charged only on that portion of the payment attributable to interest. However, ROTH are after-tax savings plans whose interest earned is tax-exempt if withdrawn after age 59½. The term can also refer to actual savings after taxes are paid, such as in a CD, where tax liability is incurred when interest is credited.
Annuitant – the person established in an annuity contract to receive the annuity payments, even if the annuity hasn't been annuitized. The annuitant is often the owner, and it's the age of the annuitant upon which payment amounts (both annuitized and required minimum distributions, or RMDs) and tax penalties (if any) are based. The annuitant must be an actual person; all other parties to an annuity contract may be companies.
Annuity – An insurance product, sold only by insurance companies, designed primarily to provide a guaranteed income for life in return for premiums paid. Most annuities are deferred – that is, they don't start paying the income until some later point, until which time they earn interest and grow in value. Annuities can be paid for with qualified or non-qualified funds; all interest earned is tax-deferred until actually paid out. At any time after age 59½, an annuity can be converted to a guaranteed lifetime income, generally payable monthly.
Annuity Certain – a relatively uncommon form of annuity, which provides for the payment of a guaranteed stream of income to an annuitant for just a set period of time, after which the payments stop even if the annuitant is still living.
Annuity contract – the document establishing the annuity itself and setting forth the relationship between and among the various parties to the contract – the insurance company, the contract owner, the annuitant, and the beneficiary, who receives any payment triggered by the death of the owner or the annuitant. The annuitant must be a real person (all other parties may be organizations), and the owner and annuitant are often the same person.
Annuity Period – the period of time between annuity payments to the annuitant – usually monthly, they can also be quarterly, semi-annual or annual.
Annuitization – the process of converting an annuity from a lump sum to a guaranteed income, payable periodically (monthly, quarterly or annually). Once annuitized, original amount paid in to purchase the annuity, plus all earned interest, is beyond the owner's (or annuitant's) control.
Annuitant-Driven – events defined in an annuity contract which are triggered by events in the life of the annuitant, such as death or disability.
Asset Allocation – the practice of distributing assets (money) among different investment options so as to maximize return and minimize the potential for overall loss.
Certificate of Deposit (CD) – a time deposit issued by a bank or other financial institution, usually for one, three or five years, although other terms are available. Taxes are due on the interest earned when credited. FDIC-insured, but interest rates are not guaranteed if the issuing bank fails.
Contract Owner – the person or other entity who actually owns an annuity and makes all decisions such as withdrawing funds and annuitizing. The owner is often also the annuitant, though it must be kept in mind that the annuitant must be a real person, not a company.
Death Benefit – some annuities provide for a payment to be made to the beneficiary in the event of the owner's death. The death benefit is usually the full purchase price, plus interest and minus all regular fees and withdrawals, is paid over without any penalty, and terminates the annuity.
Deferred Annuity – an annuity which hasn't been annuitized – the annuitization has been deferred to some later (unspecified) date, and the annuity is usually growing in value. Ann annuity that hasn't yet been annuitized is said to be in its “accumulation” phase.
Deferred Income Annuity - the same as a deferred annuity – an annuity whose value is allowed to grow over time until some point in the future when it's either annuitized (converted to a guaranteed income stream) or redeemed.
Diversification – the concept that investments made with the principal of a variable annuity be spread among a number of different investment types and industries, so that if one industry in general does poorly, other investments will be performing normally and limit the investor's losses.
Equity Indexed Annuity – (EIA) – an annuity whose interest rate is based on a market index such as the Standard & Poor's 500 (S&P 500). Most EIA's are set up to prevent loss of principal in the event the index declines.
Fixed Annuity – An annuity with a fixed interest rate. The interest rate may be for the life of the annuity, but it is usually for a year and is then reset annually by the insurance company on the anniversary date.
Fixed Deferred Annuity – a fixed annuity that hasn't yet been annuitized.
Flexible Premium Annuity – an annuity to which additional payments of principal are permitted long beyond the initial premium is paid. Some flexible premium annuities require a minimum annual premium payment.
Free Look – a period of time set by law, usually from ten to thirty days starting with the physical receipt of the annuity contract, during which a annuity owner may return the annuity, “no questions asked,” for a full refund of all monies paid and no further obligation. Free look period vary from state to state.
Guaranteed Interest Rate – fixed annuities with interest rates reset annually usually guarantee a minimum interest rate, so that no matter how poorly conditions may be, they will always pay at least that minimum.
Immediate Annuity – An annuity which, immediately upon its purchase, starts paying a guaranteed income to the annuitant.
Income or Payout Options – the different ways the owner of an annuity can elect to have the annuity paid to the annuitant – for example, regular monthly payments to the annuitant for life, or the longer of the annuitant's life or a “period certain” to guarantee full payout of funds, or a lump-sum payout, or the life of the annuitant and the life of his spouse, etc.
Income for a Guaranteed Time Period Annuity – a fairly uncommon annuity type, this guarantees a set income for a set period of time, in return for a single premium. Income payments stop at the end of the period regardless of whether or not the annuitant is still alive.l
Income for Life Annuity – an annuity which has been annuitized to provide a guaranteed income for the life of the annuitant. Actuarially calculated, the monthly payments continue regardless of how long the annuitant lives.
Income for Life with a Guaranteed Time Period Annuity – also called “Life or a period certain,” this payout option guarantees payment to the annuitant for the annuitant's lifetime, but at least the “period certain.” Thus, if the annuitant dies early in the payment period, the payments will continue to the beneficiary until the period certain has been satisfied. This option is selected to insure that the full value of the annuity is paid out.
Income For Two Lives Annuity – usually issued to married couples, this is an annuitization option that guarantees income for as long as at least one of the spouses is alive.
Individual Retirement Account/Annuity (IRA) – a retirement savings account generally established by an individual. Annual contributions are limited by law, but are exempt from income taxes until paid out. Funds drawn out before the owner is age 59½ will incur a substantial penalty as well.
Non-Qualified Annuity – an annuity paid for with funds that are not tax-qualified – that is, taxes have already been paid on the principal amount. Only the interest earned by a non-qualified annuity is taxable.
Prospectus – a financial document that is legally required to be provided to potential investors in variable annuities and other investments where there's a risk of losing principal. Intended to help consumers make an informed decision, a prospectus is unique to the particular company and investment, and includes such information as past performance, fees and surrender charges, and other information material to investing in the specific variable annuity.
Purchase Payments – the payment or payments made to purchase an annuity.
Qualified Annuity – an annuity paid for with tax-qualified funds – that is, funds on which taxes have been deferred because they're being rolled over from a 401(k) plan or other tax-qualified retirement savings plan.
Renewal Rate – an annuity's new interest rate declared by the insurance company, usually on the anniversary date of an annuity. Most renewal rates remain in effect for a full year, until the next anniversary date.
Roth IRA – an IRA whose principal is purchased with non-qualified funds – that is, taxes have already been paid on them. Interest earned on a Roth IRA is not taxable if withdrawn after age 59½, and principal may be withdrawn at any time without penalty.
Single Life Annuity – an annuity that's been annuitized to provide a guaranteed income for the life of the annuitant, after which no more payments are made.
Single Premium – the funding method for most annuities, usually paid in a single lump sum. Some companies permit additional premium payments during the first year; annuities established to receive contributions past the first year are considered flexible premium annuities.
Single Premium Deferred Annuity – the most common form of annuity sold in the US, this is an annuity that's paid for with a single premium that will accumulate value until surrendered or annuitized.
Single Premium Immediate Annuity – an annuity paid for with a single lump sum premium that is immediately annuitized – the guaranteed lifetime income is established upon purchase and will begin within 30 days of the contract date.
Surrender Charge – A penalty charged for withdrawing funds from an annuity before the maturity date. In most cases, the surrender charge declines over time. Surrender charges apply only to the amount withdrawn, and most annuities provide for some amount of penalty-free withdrawal.
Tax-Deferred – a term applied to funds on which tax has been postponed until some later date, usually due to their having been deposited into a retirement savings account that's been approved by the IRS.
Tax-Free Transfers – also called “1035 exchanges,” see above, for the Internal Revenue Code section defining them, these are transactions that exchange one product for another very similar product without incurring any tax liability. These can be complex and should be undertaken only with professional guidance – for example, a life insurance policy can be 1035-exchanged for an annuity, but an annuity cannot be 1035-exchanged for a life insurance policy.
Tax-Sheltered Annuity – a type of annuity available generally to employees of organizations that can offer 403(b) savings plans, where regular contributions are made on a pre-tax basis, with taxes deferred until withdrawal. In addition, annuities purchased with qualified funds (from a 401(k) or IRA, for example) can be considered tax-sheltered, and the interest earned on all annuities is tax-sheltered.
Variable Annuity – an annuity whose principal is invested and whose earnings are based on the performance of those investments. Variable annuities do not protect the owner from the loss of some or all of the principal amount.
Variable Immediate Annuity – a variable annuity which is annuitized immediately upon purchase, but the principal amount of which is invested. The income stream generated by a variable immediate annuity is dependent upon the performance of the invested principal.
Withdrawal Charge – a penalty imposed on amounts withdrawn from an annuity before it's annuitized, according to a schedule set forth in the contract. Withdrawal charges generally decline over time, and some insurance companies eliminate them entirely after a certain period of time.
Withdrawals – Amounts taken from the account value of an annuity before annuitization (no withdrawals can be made once an annuity is annuitized). Because withdrawals above a certain amount are usually penalized, emergency funds shouldn't be kept in annuities.