When it comes to deferring taxes, people normally think of retirement accounts like 401(k)s, Keoghs, SEPs, and IRAs. But there’s another way to defer taxes on your investment earnings until you reach retirement: by purchasing an annuity.
What is an Annuity?
An annuity is a contract between a purchaser and an insurance company. All tax-deferred annuities have two phases: an accumulation phase and a distribution or payout phase. During the accumulation phase, the value of the annuity potentially grows on a tax-deferred basis. In the distribution or “annuitization” phase, distributions are paid out in installments over a period of time. Earnings that are generated in an annuity are then taxed as ordinary income as they are paid out. Withdrawals taken prior to age 59 ½ may be subject to an additional 10% federal income tax penalty.
Immediate annuities differ from other annuities in that the distribution phase begins “immediately,” meaning payments start upon purchase of the annuity. In most cases, the payout option that best suits the buyer’s financial needs is selected upon purchase.
Depending on the purchaser’s objectives and risk tolerance, the buyer can purchase either a fixed annuity or a variable annuity. A fixed annuity is somewhat comparable to a certificate of deposit in that it offers a guaranteed rate of return for a specified period of time. Also, a fixed annuity may include an early withdrawal penalty and surrender charges if not held long enough. However, the tax-deferred status of the earnings generated in a fixed annuity account clearly distinguishes it from a certificate of deposit (CD). CD interest is generally taxed yearly. Penalties for cashing a CD before maturity vary by institution and product. In addition, bank CDs are FDIC insured and offer a fixed rate of return. The fixed annuity returns are subject to the claims paying ability of the issuing insurance company.
The other type of annuity product is a variable annuity. A variable annuity is a product specially designed for long-term needs, like retirement, and offers multiple subaccount options. It is considered a hybrid product, regulated by both the state securities and insurance divisions. As such, a variable annuity is a contract between a purchaser and an insurance company.
Variable annuities contain both an investment element and an insurance component, and have fees and charges, including mortality and expense, administrative, and advisory fees. Optional features, such as lifetime income living benefits, are available for an additional charge and are based on the financial strength of the insurer. The annuity’s value fluctuates with the market value of the underlying investment options and all assets accumulate tax-deferred.
Variable annuities are offered by prospectus. A purchaser should carefully consider the investment objectives, risks, charges and expenses of the variable annuity and the underlying investment options carefully before purchasing. To obtain a prospectus that contains this and other information call your financial services representative for a prospectus. Read the prospectus and underlying investment prospectus carefully before you invest or send money.
Typically, the purchaser can choose among several subaccount options (stock, bond and/or money market sub-accounts). Money may be transferred into and out of the various subaccount options without incurring taxes. This makes it possible to respond to changes in investment objectives and risk tolerance. Although a variable annuity may offer the potential for higher rates of return than a fixed annuity, it is subject to market fluctuations and carries greater risk inherent in fund investments so that when redeemed, the value may be less than the original amount invested. Like fixed annuities, variable annuities are also subject to early withdrawal penalties and taxes upon distribution and surrender charges if not held until the surrender charges are eliminated. Variable annuities can offer tax deferral, lifetime income and death benefits. Variable annuities have riders that may be available at an additional cost.
Purchasing a single-premium annuity is done in a lump sum, and is an attractive option for an individual who wants to begin experiencing the benefits of tax-deferred accumulation as quickly as possible. Alternatively, a flexible-premium annuity can be chosen if the purchaser prefers making payments in a series of installments.
Distribution or Payout Phase
In general, distributions from a deferred annuity can take place in two ways. The owner can either annuitize (enter the payout phase) or take withdrawals from the contract during the accumulation phase of the tax-deferred annuity contract.
Keep in mind, some important restrictions apply to withdrawals from annuities. During the accumulation phase of the contract, many products will permit withdrawals up to a certain percentage of the account balance – usually 10% of the accumulated value – without incurring surrender charges or penalties, depending on the contract. However, keep in mind that taxes will be applied to the earnings amount withdrawn.
There are also IRS penalties for early withdrawal that parallel those of other tax-advantaged retirement vehicles. Except in cases of hardship, such as death or disability (as defined by the IRS), withdrawals from an annuity taken before the age of 59-1/2 (and in the absence of a contract that has already entered the distribution phase under a lifetime payment arrangement) may trigger an additional 10% federal income tax penalty on the earnings that are withdrawn. The moral: plan carefully when setting up an annuity and fund it with money that is not going to be needed until the contract permits payments after you reach age 59-1/2.
During the “payout” phase, an owner may withdraw money in a variety of ways. A lifetime annuity may permit a certain level of income for the rest of the annuitant’s life, however long or short that might be. This “guarantee” is subject to the claims-paying ability of the issuing insurance company. This option appeals to people who are worried about outliving their assets. Like anyone else on a fixed income, though, purchasers of lifetime annuities will find that inflation may reduce their purchasing power. Annuity owners may want to consider delaying the start of lifetime annuity payments for as long as possible.
Annuity payments also can be set up over a certain period, where the payments will continue for that specified period regardless of whether the annuitant lives or dies. In the event of death, the payments will be paid to the contract’s beneficiary for the remainder of the period.
Annuities offer many advantages, including flexibility in payments, payout options and, above all, the benefits of potentially accumulating tax-deferred earnings. A qualified financial advisor can help determine whether an annuity is consistent with your financial objectives.