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Focus on Finance: Straight talk about annuities

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By Steve Wright

Question: I am so confused about annuities. Can you break it down for me in layman’s terms?

Answer: People are confused about annuities because the same word is applied to many different types of financial instruments. Hopefully, this tutorial will end the confusion.

Deferred annuities are term deposits with insurance companies. They are similar to certificates of deposits at a bank. (Note: Bank deposits are FDIC-insured while annuities are guaranteed by the issuing insurance company.) There are two types of deferred annuities: fixed and variable. Fixed annuities have these features:

  • Your principal is guaranteed. It will never decline. It could, however, be eroded by surrender charges which also could be called early withdrawal penalties and, of course, by withdrawals you make.
  • The insurance company adds interest to your deposit each year (depending on the formula, the interest added could be zero).
  • The annuity is for a specific term that you select — generally, the longer the term, the higher the interest.
  • All interest is tax-deferred. You do not report it on your tax return until withdrawn.
  • You may withdraw 10 percent of your balance annually without a surrender charge. This is a common feature, and the withdrawal privilege will vary from company to company.

Most deferred fixed annuities offer an initial one-year rate with the rate changing each year. A few companies offer a locked-in rate for the entire period.

Another type of annuity is called a variable annuity. With this type of annuity, rather than receiving interest from the insurance company, your money is invested into stock or bond accounts. With a variable annuity, you can earn more than a fixed annuity, or you could lose principal, depending on the accounts you select; and if the stock and bond markets rise or fall. Variable annuities are therefore riskier than fixed annuities.

There has been significant growth in purchases of index annuities, a type of deferred fixed annuity. In this type of annuity, your principal is guaranteed like the fixed annuity, but your interest each year is based on increases in a financial index (for example, the S&P 500 index). So, your interest is tied to performance in the index, but you can never lose principal because of the index performance. (You can, however, lose principal because of surrender charges incurred if you make withdrawals prior to the end of the term). Index annuities generally are subject to a lengthy surrender charge period. In addition, purchasers of an fixed index annuity do not get the full rate of return from the corresponding index, as there may be a cap or limited participation for each annuity on the index-linked rate of return. Further, such annuities generally guarantee an investor will receive 90 percent of the premiums paid, plus at least a specified interest rate; thus, if interest is not earned, it is possible to lose money.

Everything discussed up until this point describes the growth phase (called the accumulation phase) of the annuity. The accumulation phase typically interests people saving for retirement or putting money away for the future. During the accumulation phase, your interest grows tax-deferred in the annuity. Withdrawals are taxable.

When and how do you get your money out? At the end of the term, you have a few options:

  • You can leave the annuity alone and continue to let it grow. Many companies may force you to take withdrawals or annuitize at a specific age.
  • You can change the annuity to another company that may pay you a higher rate, or offer you a preferable structure. Note that a 1035 exchange into another insurance product may result in new or increased surrender charges or higher charges, such as annual fees associated with the new product. Features and benefits of the new product may have higher costs associated with them, and may not be necessary.
  • You can make withdrawals.
  • You can annuitize the annuity — trade in your accumulated balance for periodic payments for a specified term of years or life.

The withdrawal phase is called the distribution phase. This phase is of interest to retirees.

What is an immediate annuity?

An immediate annuity has no accumulation phase. You make a deposit with the insurance company and immediately begin receiving payments. These annuities are generally suited for senior investors (age 70 plus) who desire to increase their monthly income.

Annuities have significant flexibility because of the many types of available, and the various ways that they can be used.

Steve Wright is the managing partner of The Wright Legacy Group.