Understanding Annuities

Planning for retirement income raises many questions, including whether annuities should be part of your future income strategy. While there’s no one-size-fits-all answer, understanding annuities is key to making informed decisions. In this blog, we’ll break down the complexities to help you make an informed decision.

What Is an Annuity?

First, let’s clarify what the term “annuity” means. “Annuity” originates from the Latin term “annuus,” meaning “yearly.” There are two definitions to consider:

1. annuity (with a small “a”): This refers to a fixed sum of money paid annually, typically for the rest of one’s life. Examples include pension payments, Social Security, and some insurance or trust payments. The annuity recipient has no claim on any principal balance.
2. Annuity (with a capital “A”): This is a financial product that provides a series of annual payments to the investor. Annuities are tax-sheltered retirement vehicles, allowing for tax-deferred growth similar to an IRA. Withdrawals before age 59½ incur penalties, and distributions are taxed as ordinary income, even on capital gains. Most Annuity products offer the option to convert the account balance to lifetime income, as their name implies, but interestingly, few Annuity owners use this option.

Annuities (the financial product) are regulated by state insurance departments and must be sold by licensed agents, who may earn commissions.

Types of Annuities

For simplicity, let’s categorize annuity products into three groups:

1. Income NOW

Single Premium Immediate Annuity (SPIA): You make a single deposit in exchange for guaranteed annual payments for your lifetime, a joint lifetime, or a set period. You forfeit access to the principal, trading it for regular income. The concern for many retirees is that if they die before receiving the equivalent of their deposit, heirs are short-changed.

Fear of an early death and loss of principal is the likely explanation for the failure of retirees to choose lifetime income options.  Potential buyers may also be worried about the effect inflation will have since the payments are not inflation-adjusted; hence the purchasing power of the income payment is declining over time.

2. Income LATER

These products usually have two phases: an accumulation period and a distribution phase.

• Deferred Fixed Rate Annuity: Your after-tax contributions grow at a fixed rate for a set time (e.g., 3 to 5 years) before potentially resetting to a new rate, similar to CDs. Withdrawals are taxed as ordinary income, and there are no tax deductions for making a contribution.
• Qualified Longevity Annuity Contract (QLAC): A newer product purchased within an IRA, designed to start paying out at a future age, thus avoiding Required Minimum Distributions (RMDs) prior to payout. QLACs ensure an income at a future date and by avoiding RMDs mean greater accumulation.

3. Income LATER or NEVER

• Variable Annuity: This type offers variable returns based on investments in mutual funds. While growth is tax-deferred, withdrawals are taxed as ordinary income. This raises the question of whether it’s better to pay lower capital gains taxes (outside an annuity) or defer gains inside the annuity and pay tax at a higher rate later.
• Indexed Annuity: This product combines features of fixed and variable annuities. It offers a guaranteed minimum interest rate and the potential for higher return through a mechanism linked to a stock market index (like the S&P 500), often with principal protection. However, be careful to understand how the caps work because they often do not include dividends, which reduce potential returns. This type of annuity is mainly used for tax-deferred accumulation, and despite being tied to an index, it generates ordinary income.

Like fixed annuities, variable and indexed annuities offer tax deferral and, in addition, potentially higher returns, given the ability to invest in equity funds.  The downside is the higher tax rate at some point in the future.

Tax Implications

Annuities are governed by various regulations, including IRS tax rules and state insurance regulations. Here are some key tax aspects for annuities not held in retirement accounts:

• Tax-deferred growth until withdrawal.
• Basis equals after-tax contributions minus prior withdrawals.
• Gains (the difference between basis and account value) are taxed as ordinary income.
• Unless a lifetime income or periodic payment is selected, the gain is presumed to be withdrawn first, followed by basis.
• Penalties for withdrawal before 59 ½.
• If a lifetime income option is selected, the gain is prorated over the expected lifespan, and each payment represents a return of both gain and basis.
• Non-spousal heirs must withdraw and pay taxes on gains within five years of the owner’s death.
• Annuities do not have RMDs like IRAs, making them attractive for those not needing withdrawals.

Annuities are not designed to defer income indefinitely

Unlike IRAs, annuities don’t require minimum withdrawals. This is beneficial for those who don’t plan to withdraw funds. Typically, if the owner passes away, the benefits go to a surviving spouse. However, non-spousal heirs have only five years to withdraw the funds and pay taxes on the gains.

Additionally, if you live long enough, your annuity will “mature,” requiring you to withdraw the full amount. Maturity ages can range from 85 to 95, so it’s important to check your specific contract.

When maturity approaches, consider making partial withdrawals over several years or exchanging the annuity for one that provides regular income. This approach can help spread out any tax impact. It’s wise to consult an insurance professional to explore your options.

Costs and Penalties

Fixed annuities often have no stated costs because the fees are embedded in the interest rate you earn.  Variable and indexed annuities come with various fee structures:

• Mortality and Expense Risk Charges: Typically range from 0.1% to 1.5% of the account value annually.
• Administrative Fees: Vary by provider, possibly as a flat fee or a percentage.
• Investment Management Fees: Subaccounts may have their own fees, generally between 0.2% and 2%.
• Surrender Charges: These may apply if you withdraw funds within the surrender period (often 5 to 10 years).
• Transaction Fees: Some annuities charge for specific transactions, like fund exchanges.
• Rider Fees:  Additional costs for optional benefits.  These deserve careful scrutiny.

The costs associated with annuities range from low to high and are often complex and hard to understand.  If you aren’t willing to read the fine print and understand the costs, they may not be a good choice.

Using Annuities Wisely

Regular income during retirement is vital. While fixed sources like pensions and Social Security provide security, they may lack growth, leading to erosion in purchasing power due to inflation. The key is finding a balance between stable income and options that offer inflation protection.

In conclusion, understanding the types, tax implications, and costs of annuities can help you decide if they fit your retirement income plan. Consulting a financial advisor is advisable to explore your options further.