Annuities offer a tax-deferred retirement savings vehicle that can include a stream of guaranteed lifetime income. There are a number of annuity types and they differ as to the underlying investments, the way interest is paid and other factors. Annuities can be an option for investors looking for a guaranteed source of lifetime income. Two popular types of annuities are fixed annuities and indexed annuities.
Fixed annuities offer a fixed rate of return on the premium dollars invested in the contract. They also offer a fixed interest rate on the premium dollars invested and principal guarantee. Fixed annuities can be annuitized on an immediate basis or deferred to some commencement date in the future.
Fixed annuities are fairly straightforward and easy to understand. Their predictability can make them a good alternative for investors who feel they need to supplement their retirement income with a lifetime stream of income that is guaranteed.
Advantages of fixed annuities include:
- Guaranteed rate of return
- Simple, straightforward contract terms
- Improved ability to budget
- Death benefit options
Disadvantage of fixed annuities can include:
- Limited upside potential
- Inflation risks
- Limited term fixed rate guarantee
An indexed annuity pays an interest rate that is tied to a market index such as the S&P 500. Index annuities usually have a cap on the portion of the index’s returns that are paid. They are sometimes also called fixed indexed annuities.
Indexed annuities generally have a participation rate in the gains of the index being tracked, as well as a cap on the maximum amount of interest that can be received for the period. For example, if the annuity tracks the S&P 500 with an 80% participation rate, if the index increases by 10% you would earn an 8% interest rate. If the annuity has a cap of 7% on the participation rate, your interest rate would be capped at 7%.
Indexed annuities typically offer a guaranteed minimum rate of interest or a floor with a maximum level of loss regardless of how the index performs. There are a number of annuitization options for indexed annuities as well.
Advantages of indexed annuities include:
- Potential for higher returns
- Minimum guaranteed rate offers stability
- Security of principal
Some disadvantages can include:
- Limited upside due to the participation rate and any rate caps
- Fluctuations in the participation rate and rate cap can occur depending upon the contract
Best time to consider annuities
This will vary from person to person, but many investors look at annuities as they near or enter retirement. Annuities can offer a guaranteed stream of lifetime income which can take the place of pension plans, which are disappearing from the landscape, and supplement income from other retirement assets.
Annuity tax issues
Annuities offer tax-deferred growth of the premiums contributed to the contract. However, if you need to withdraw money from the contract, the money withdrawn will be taxed on a last in, first out basis. This means that withdrawals are first assumed to be from gains in the contract. This money will be taxed as ordinary income until the gains in the contract are fully withdrawn.
If you take a distribution prior to age 59 ½, there will generally be a 10% penalty in addition to any taxes.
Once annuitized, the annuity payments are taxed based on the exclusion ratio. The distribution is assumed to be part gain and part return of basis in the contract.
If the annuity is a qualified annuity held in an annuity or qualified retirement plan, distributions are taxed in accordance with the rules for that type of retirement plan account.
Annuities will impact your taxes for a given year based on any withdrawal activity or to the extent that annuity payments are taxed via the exclusion ratio.
Annuity surrender charges
Annuities of all types may be subject to surrender charges if you attempt to take a distribution from the contract or to move the contract to another annuity carrier. Surrender charges are typically for a set period of time. They are a percentage of the amount distributed from the contract; the percent may be fixed for the entire surrender period or may decline at certain points during this period.
For example, if the contract is worth $100,000 with a 10% surrender charge, you would pay a $10,000 surrender charge if you wanted to cash out the entire contract or move it to another carrier. You would also be subject to any taxes or penalties that might apply.
Annuity death benefits
There are generally death benefit options for both types of annuities. This may be a lump-sum or an annuity payment if the contract has already been annuitized. In the latter case, this will depend upon the annuitization option chosen.
Both fixed and indexed annuities can be a viable option for a guaranteed lifetime stream of income in retirement. These types of contracts might be used to supplement other retirement savings.
Contact your Wedbush financial advisor to discuss whether annuities are a good fit for your retirement income needs. They can help you decide if an annuity is the right choice for you and, if so, what type of annuity is best for your situation.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information presented is not intended to constitute an investment recommendation for, or advice to, any specific person. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. The information in these materials may change at any time and without notice.