Do you seek greater certainty in your retirement income strategies? The case study below shows how an index oriented option can help offer income guarantees and increase income success rates.
Are you ‘shopping’ for retirement solutions? You may have growth, guarantees, lifetime income, tax advantages and more on your list … but do you know annuities could offer you all?
Here is a “Retirement Shopping” video.
Meet Rick and Karen, both age 59, decided that they do not need the annuity for retirement and want to pass the value to their children at death. However, they want to maximize the money they can pass to their children and avoid passing a tax burden.
Enter annuity wealth transfer concept, this method helps people like Rick and Karen to minimize tax and leave more assets for their beneficiaries. See details below.
Fixed index annuities are long-term insurance products that can help consumers grow their assets, while protecting their principal in changing markets. By allocating a portion of their retirement assets to a fixed index annuity, consumers can reinforce their retirement savings foundation and help:
1. Generate higher growth and income than many fixed income instruments.
2. Protect against interest rate risk and bond market volatility
3. Guarantee more income for life
Below is a excerpt from an article at thinkadvisor.com, it advises financial advisors to give 2 perspectives about annuity:
“From an economist perspective, annuities are wonderful because they give you guaranteed income for as long as you live,” she explains. “But a lot of people see them as unfair because they think ‘I’m going to give this money to an insurance company. And if I live a long time, that’s great. But if I don’t, the return on investment might not look as appealing.”
What does she recommend advisors do to help their clients work through this type of thinking? Two options may help, she says. One is to walk through the reasons an annuity is like a pension plan, she says.
“If they think of an annuity is like their own personal pension that they’ve been contributing into for many years, it starts to feel a lot more palatable than if it’s just they handed $100,000 to an insurance company,” she says. “Just reframing [the idea] a little bit and getting people to think of it more like a pension than thinking of it as a financial product that you’re hoping to get a return on investment for can change the mindset.”
She also recommends “preconditioning” clients when they are younger, and earmarking a portion of retirement savings for an annuity.
“You do want to give people the option to back out if things have changed [by retirement], but laying the groundwork of a the plan, and [saying] ‘this is how we’re going to do this, and this money is earmarked to go into an annuity,” I think helps.”
In last blogpost, we discussed the reasons for exchanging life insurance policies to annuities. Now we will take a look at a case study.
Life Insurance to Annuity Exchange
Exchanging a life insurance policy for a NQ annuity is a permitted nontaxable exchange, provided the:
A Case Study: Joan Jumps from Life Insurance to Annuity
Joan, age 55, owns a permanent life insurance policy. It’s underperformed her expectations. She’s considered her reasons for ownership carefully and decided she no longer needs it.
If Joan desires income now, she could exchange the life policy for a single premium immediate annuity (SPIA). She would buy the SPIA with a $115,000 premium (the life policy’s cash value) and the SPIA would have a $160,000 cost basis. She would have an exclusion ratio of 100% and, provided she lives that long, would receive her payments tax-free for nearly 30 years (29.6 to be exact, representing her remaining life expectancy). Payments received after that point will be fully includible in her taxable income. In year 23 Joan would recover the total premium paid.
If Joan prefers income later, she could exchange the life insurance policy for a deferred annuity.
Finally, Joan can also add additional funds from her savings. By doing so, she’ll increase the monthly amount of protected lifetime income she’ll receive from the immediate or deferred annuity. Any additional premium would also be recovered tax-free from the annuity payouts.
Questions to Consider
Consider Your Options
Of course, you can always surrender the old policy. But, if there’s any gain in the policy, you’ll need to include that amount in your gross income on your tax return. There it will be taxed as ordinary income. Gain is generally determined by subtracting the total premiums you’ve paid (your cost basis) from the policy’s current cash value.
Even if there’s no gain in the policy, there may still be a good reason not to surrender it. If you’ve paid more into the policy than its current cash value, you’d be walking away with a loss that you can’t claim on your tax return. Exchanging a policy that’s “underwater” (i.e., its cash value is less than the total premiums paid for it) for a nonqualified (NQ) annuity can:
A life insurance policy might be underwater for a variety of reasons. One reason might be lower-than-expected interest rates on whole life or universal life policies. Another reason might be lower-than-expected subaccount values in variable life policies.
In next blogpost we will discuss life insurance to annuity exchange.
All annuities are bad
Annuities come in many varieties, designed to perform in different ways for different purposes. Yet there is a tendency to take a complaint about a particular type of annuity and its application to a certain situation, then apply it generally to annuities as a whole.
It’s a little like complaining that all cars are bad because a two-seater sports car can’t haul a load of bricks or a pickup can’t go from 0 to 60 mph in less than four seconds. Cars are useful; you just have to pick the right car for the purpose. It’s the same with annuities. They are useful; you just have to pick the right annuity for what you want help to accomplish.
Annuities lag market investments
This criticism is a favorite from those with businesses and interests tied to market investments.
But it misses both a central feature of annuities — the guarantee of income in the future — and the recognition of market risk inherent in other investments.
Sure, an equity portfolio can have impressive gains. But it can also fall flat on its face, depending on the stocks in the portfolio and the overall market. And other types of investments — fixed income, real estate, commodities — are also subject to market risks. Performance of those investments isn’t guaranteed and can sometimes even be negative.
By comparison, many annuities may offer a lower rate of return, but without the risk that typically underlies investments with higher rates of return. You are giving up the chance for a higher return in exchange for the guarantee.
Now, some annuities tie fund growth and payouts to market investments, introducing some market risk. Whether that type of annuity is suitable will depend on the individual.
Annuities are expensive
This criticism usually goes hand in hand with the market-lag complaint above. And it’s one of those that typically applies to certain types of annuities, yet paints the entire category with the same brush.
The overall complaint misses the point that an annuity isn’t so much an investment as a tool. And the more complex the tool — picture a multispeed, cordless, self-leveling drill/driver versus a simple hand-crank drill — the more it’s likely to cost.
Some kinds of annuities have very little or even no fees involved. But other types of annuities have fees related their investment structure. Additionally, some annuities provide riders, allowing the addition of certain benefits or terms to the underlying contract, at an additional charge.
And, of course, the cost of an annuity will vary from provider to provider. And, just like tools, people are sometimes willing to pay a little more to purchase from a brand with a reputation of reliability and quality.
Annuities involve surrender charges
Withdrawing money early from some annuities will typically trigger a surrender charge. This charge can vary in size and structure, depending on the annuity contract terms.
Critics point to such charges as being an unnecessary burden should someone need to access to the annuity principal if an unexpected expense arises.
Of course, withdrawing money from a certificate of deposit or a retirement account can also draw a penalty.
Money needs time to earn a return. That’s the nature of investment. In the case of an annuity, an insurance company needs to be able to count on the funds being there for an investment return over a certain amount of time, because it is guaranteeing payments to the annuity owner at a later date.
This is one of those areas where, if someone may need access to the funds in the short-term, an annuity may not be the best option. Or perhaps that person should look for an annuity offering lenient surrender charge or partial withdrawal terms.
Annuities are sold on commission
Some folks argue that the commission system adds to the expense of a financial product like an annuity.
But all financial products have costs tied to their creation, marketing, and management. And those costs are recouped either through fees, commissions, or a combination of the two.
For many consumers, paying a one-time commission is more economical than paying ongoing costs for buying and retaining a product, financial or otherwise. The choice, of course, is up to the individual.
An annuity is only as good as the company behind it
With the exception of government securities, this criticism can be leveled at any financial investment or vehicle.
True, many industries, including insurance, have some regulatory backstops. But such fallbacks can be time consuming and fall short of consumer expectations.
That’s why it’s important to look at the history and track record of the company backing an annuity. You should also look at its financial strength. Various rating agencies review insurance companies on a regular basis.
In addition, some people consider the basic ownership structure of an insurance company. Some believe the differences between publicly traded companies owned by shareholders versus mutual companies controlled by policyowners can be important.
We discussed beneficiary designation in last blogpost.
Joint Ownership Issues
As stated before, required minimum distributions must begin at the death of any owner which means that when the first joint owner dies, the annuity must begin making distributions. The only exception is if the surviving spouse was named beneficiary, they could continue the annuity without current distributions. There is no real benefit to joint ownership as it does not extend the life of the annuity and it can be a detriment to continuing the annuity when the first owner dies. Many individuals believe that since they own their other property jointly, they should also own their annuity jointly. The better way to go would be to have each spouse name their spouse the beneficiary rather than making both spouses co-owners. Naming the spouse as beneficiary would allow a better tax outcome.
Parent-Child Joint Ownership
If a parent purchases a joint annuity with their child, the parent and child will own equal shares. A withdrawal requires two signatures and distributions are made out to both parent and child. If the parent paid the premium, they have just made a gift to their child of half the value of the annuity. If the parent wants to make a withdrawal, one half the distribution will be taxable to the child regardless of who receives the money. If the child is under age 59½ then the entire amount distributed is subject to a 10% penalty. If the parent owns the annuity jointly with a child or grandchild, making the child the co-owner makes no real difference in postponing distributions and if the child dies before the parent, the parent would be forced to begin liquidating the annuity even if they had supplied the money.
In most cases, using joint ownership only hurts the ability to sustain tax-deferred growth. Most owners think joint ownership will allow the annuity to continue until the second death and that they will obtain additional tax-deferred growth. In actuality, it is just the opposite. When the first owner dies it can trigger the required minimum distributions. Do not set up joint ownership but to instead name the second spouse the beneficiary so you may continue the annuity uninterrupted if the owner dies.
Not only do annuities provide excellent investment vehicles, but they also provide tax-deferred growth. If you take two investment accounts with the same assets and one is taxable and one is tax-deferred, the tax-deferred account will always do better because it is not paying taxes until the money is distributed from the vehicle. Annuities are treated similarly to IRAs and qualified plans. The additional advantage of a non-qualified deferred annuity is that unlike a qualified plan or an IRA, no required minimum distributions need to be made during the life of the owner.
However, the tax deferral only applies as long as the owner is alive. Once the owner dies, the annuity must begin making post-death distributions to the beneficiary. Under IRC Section 72(s), upon the death of any owner, the annuity must begin to make post-death distributions to the beneficiary.
The Tax Reform Act of 1986 changed the joint ownership of annuity taxation rules to prevent using joint ownership to avoid taxation of the annuity over two lives. This makes annuities distributable whenever either one of the owners dies. If the other spouse is named as beneficiary, the taxation would then be postponed.
When a surviving spouse is named the beneficiary of the non-qualified annuity, they may continue the annuity in their own name. This is very similar to a spousal IRA rollover allowing the surviving spouse to continue to receive tax-deferred growth. The ability to continue the non-qualified annuity does not turn on ownership at all but on who the beneficiary is. If one spouse is the owner but names their spouse as the beneficiary, then the spouse who is named beneficiary can continue the annuity and continue to receive tax-deferred growth in the annuity.
In next blogpost, we will discuss joint ownership issues.
"Annuities 101," by Sheryl J. Moore, answers most of the basic questions related to various types of annuities, it can be found on WinkIntel.com.
In last blogpost, we discussed the first 2 FIA myths. Now we will bust the rest 3 FIA myths.
Myth 3: Fixed indexed annuities are not liquid.
It’s important to understand that annuities are a long-term retirement savings strategy. Except for some immediate annuities, most contracts begin payments on a fixed date many years in the future. So, if you withdraw money from an annuity before that date and during the withdrawal charge period, the withdrawal will incur a charge called a “surrender payment”.
In most cases, deferred annuities allow withdrawals up to a specified percentage of the contract’s accumulated value each year during the withdrawal charge period without any charges. Once the withdrawal charge period has ended, funds may be withdrawn without any charges. FIAs are designed to meet the need for long-term retirement savings and income, so one should have sufficient liquid assets to let the annuity funds sit.
Myth 4: Fixed indexed annuities are investments.
Fixed indexed annuities do not directly invest your money in any stock or equity investments. Instead, the annuity company credits a set, guaranteed return each year, with the potential for additional interest credits based in part on the performance of an external index. You should understand that FIAs are insurance products that are designed to help you manage certain financial risks associated with retirement such as volatile markets, interest rates and longevity.
Myth 5: Fixed indexed annuities are full of hidden charges.
Many types of annuities are available in today’s retirement marketplace. Some, like variable annuities, require explicit annual fees similar to mutual funds or managed money solutions. Unlike variable annuities, fixed indexed annuities do not directly participate in any stock or equity investments and do not charge the fees commonly associated with those investments.
With fixed indexed annuities, charges are typically imposed for discretionary actions like excess withdrawals or early surrender of the annuity contract; for optional features like supplemental guaranteed lifetime withdrawal and legacy benefits, or to support higher indexed interest crediting rates. These charges enable the insurance company to provide the guaranteed value promised to customers. FIAs have levers such as participation rates and caps that can limit interest crediting in return for providing guarantees, such as the protection of principal from market loss. Fees are not “hidden,” and must be fully disclosed prior to purchase.
A recent Secure Retirement Institute study revealed that Americans are largely confused about how to turn workplace savings into a guaranteed income stream. Only 1 in 4 consumers understood that money saved in workplace retirement plans could be used to purchase annuities.
Here are five common myths about fixed index annuities (FIAs). Once armed with the facts, you will be ready to make a more confident decision in adding FIAs to your financial plans.
Myth 1: Fixed indexed annuities are not tax efficient.
FIAs may be a valuable solution for those looking to grow their retirement savings because they are a long-term, tax-deferred product - annuities allow retirement savings to grow without being reduced by tax payments – another appealing reason to consider an annuity. In fact, annuity earnings grow on a tax-deferred basis until you begins taking withdrawals or surrenders the annuity.
Over time, you will have the potential to build more retirement savings than you would have been able to if your earnings been taxed as income. Keep in mind that there is no additional tax benefit associated with funding an annuity from a tax-qualified source like a 401(k) plan.
Myth 2: Fixed indexed annuities can’t keep up with inflation.
Income riders frequently offer payout options that are indexed to inflation, which may help annuity holders keep pace with the rising cost of goods and services. However, when you are considering annuities in retirement planning, you should factor in the inflation risk associated with a fixed annuity payout. Like any risk in retirement planning, there are ways to insure, hedge, offset or otherwise lessen the impact of a known risk.
In next blogpost, we will bust the rest 3 annuity myths.
In last blogpost, we discussed 3 drawbacks to fixed annuity products, now the next 4 drawbacks.
4. Limited Access to Cash
Fixed annuity products are not checking accounts. They do, however, allow the consumer to withdraw money from the contract in many ways but with restrictions. The three most common ways contracts allow access to cash are 1) by a partial withdrawal from the contract, 2) a full surrender of the contract and 3) by taking payments based on one of the contract’s options or riders. If the consumer takes more than a certain percentage of the contract’s value (usually 10%), they will be subject to a surrender charge. Most annuities come with a surrender charge schedule that requires the buyer to pay a fee if they surrender the annuity contract in a certain number of years (i.e., typically 6 to 10 years) from purchase. These fees can be significant. So, it is hard to back out of a contract once purchased. Overall, consumers should only put money into an annuity contract that is being invested or saved for the medium to long-term.
5. Additional Taxes for Withdrawals Prior to Age 59½
If withdrawals are taken from a fixed annuity contract prior to age 59½, in most cases, an additional 10% penalty or tax will be due on withdrawn interest earned. Remember, annuities were intended to create supplemental retirement income and withdrawals prior to age 59½ trigger this penalty. There are some exceptions to this rule and consumers should consult their tax professional to get the specifics.
6. No Additional Tax Benefit for Qualified Funds
If a buyer funds their fixed annuity purchase with pre-tax or qualified funds, they do not receive any additional tax deferral benefit for doing so. Qualified funds are already tax deferred by law and, thus, get no additional income tax benefit by being placed into a fixed annuity. Many consumers buy annuities using qualified money, however, to obtain the basic benefits that annuities offer that other savings products do not, such as guaranteed lifetime income.
One of the cardinal rules of saving and investing is not to buy a product you don’t understand. Annuities are no exception. Consumers need to be sure they understand the contract they are purchasing and its key features, benefits, costs and restrictions.
Fixed annuity contracts can be extremely valuable for the consumers who need them. They can provide guaranteed fixed rates of return, potential returns tied to investment market indices, protection of principal and guaranteed lifetime income in exchange for certain drawbacks or restrictions. They are a financial tool that can be used to create tax-advantaged returns and supplemental lifetime income. The key is for buyers to understand the drawbacks and to make sure the annuity products they buy fit their needs and risk tolerance.
Today’s fixed annuity products possess great intrinsic value (e.g., tax deferral, guaranteed income options, probate avoidance and others), but they come with drawbacks that a buyer must understand before committing their hard-earned cash.
Although these drawbacks are not deal breaker, they must be carefully considered before the products are purchased.
1. Interest Rates That Can Change Each Year
Most fixed annuity contracts (except for multiple year annuity products, where the interest rate is guaranteed for the entire surrender charge period) allow the issuing life insurer to set a new interest rate each year or period of years. This means that the interest rate the consumer receives can change during the surrender charge period. This is an implicit risk the consumer is taking when buying most fixed annuity contracts.
This impact of this drawback can be minimized by understanding the renewal rate history of the issuing life insurance company. Most all annuity companies will provide a documented record of their renewal rates as a historical indicator of how the carrier has treated consumers when setting renewal rates.
2. No Capital Gains Tax Rate
Income earned on fixed annuity contracts is treated as ordinary income and not as capital gain. For example, suppose a fixed annuity contract is purchased for $25,000 and the contract is fully surrendered 10 years later when its value is $50,000. Based on current tax law, the gain on the contract of $25,000 will be treated as ordinary income and taxed at ordinary income rates in effect at the time of withdrawal. The benefit of being taxed at likely lower capital gains rates is not available.
3. Contractual Bonuses That Come With Strings Attached
Many fixed annuity contracts are sold with what are advertised as first-year bonus interest of 3% to 5% for example. The buyer should know that for most contracts, to fully earn these bonuses, they will need to hold the contract for several years, or, in some cases, they will only get the bonus if they take an income stream from the contract.
Keep reading for the remaining drawbacks.
This USNews.com article has a great list of 16 Annuity related questions and more importantly, answers!
Given the low rate environment, Annuity is a great and much better alternative than many other safe products.
Economics research on retirement optimization has long shown that a lifetime immediate annuity can improve the efficiency of retirement income... yet in practice, the great "Annuity Puzzle" is that consumers still rarely purchase them (and fiduciary advisors often oppose them).
Here are some valid reasons to not use an annuity:
At the same time, here are some invalid reasons not to use an annuity:
Below is a flyer that discusses 4 factors that work against your retirement life, and ways to deal with these factors.
Are you looking for a solution that has principal protection with the potential for asset growth?
Meet Henry and Catherine
Below is a FIA accumulation solution offered by AIG.
In our last blogpost, we introduced an annuity product from Athene that offers 7-year point-to-point return period which is significantly lower than the common 1-year point-to-point crediting period. How longer crediting periods offer the potential for higher returns?
Please see the following flyer from Athene for a look-back study.
Athene developed Athene AccuMax 7 to specifically to meet rising demands for growth potential and protection from loss due to market downturns. An accumulation-focused fixed indexed annuity, AccuMax offers multi-year crediting strategies, attractive Participation Rates and zero risk of losing principal due to market loss. Plus, a suite of new features was designed to give clients added stability in volatile markets.
Below is a brochure of this product.
Q: I own an annuity with my husband as joint owner and joint annuitant. Is a Section 1035 exchange to an annuity in my name alone possible?
A: Probably yes, although since some uncertainty exists, the annuity companies involved in the transaction will likely not cooperate in the exchange.
Code Section 1035 allows for a tax-free exchange of a life policy for a nonqualified deferred annuity (NQDA) or for an exchange of one NQDA for another. Section 1035 itself does not provide much detail regarding valid exchanges. The lack of detail has caused taxpayers and carriers to rely on various regulations, rulings, and company practices to fill in the blanks regarding what is a valid exchange.
One thing we know for sure is that an exchange must be done directly between the surrendering and issuing companies—and the client must not personally take control of the money during the process. As a practical matter, that means both carriers must agree that the proposed transaction is a Section 1035 exchange. If one of the carriers does not believe the transaction qualifies, it will stop cooperating in the Section 1035 process, and the exchange will fail.
The other things we believe we know about Section 1035 exchanges are: • The policyowner must be the same both before and after the exchange.
• The insured must be the same both before and after an exchange of life policies.
• The insured must be the same as the annuitant on a life for annuity exchange.
• The annuitant must be the same both before and after an exchange of an annuity.
Based on what we think we know, an exchange described in the question does not appear to be a valid exchange—and thus it would be rejected. Why did we say such an exchange might be possible?
The answer is that another section of the Tax Code—Section 1041—says that transfers of assets between spouses are tax-free. If you mash together Code Sections 1035 and 1041, they make a pretty good case that the transaction described would be income tax-free.
However, since the IRS has never explicitly said such a transaction is tax-free, most carriers will reject combining the logic of both Code sections to achieve the desired tax result.
For people who seek a retirement income stream now from a selection of payout options, SPIA (single premium immediate annuity) is a good choice.
There are many benefits: Multigenerational income strategies. Non-spousal joint life payouts. Corporate and trust ownership. That’s just three benefits, there are more as the flyer shows below.
PFwise's goal is to help ordinary people make wise personal finance decisions.