It can provide reliable, guaranteed income, but it can sometimes be costly
Are you planning for retirement? Or do you want to change your portfolio? Regardless of your situation, you have many options to help you save money for the future. If you have a job, you may be able to contribute to a company 401 ( thousand), which is a retirement account provided through your employer. Other options include individual retirement accounts (IRAs), Roth IRAs, and health savings accounts (HSAs), which allow you to save money for medical expenses or a defined annuity during retirement.
These annuities come in many different shapes and sizes and are often offered through insurance companies and investment firms. Some investors use them to supplement existing investment retirement resources. But is a fixed annuity the right choice for you? This article outlines some basic fixed annuities, what you should know about payouts, tax implications, and other considerations.
KEY TAKEAWAYS
- A fixed annuity promises to pay a guaranteed interest rate on the investor’s capital contribution.
- The type of fixed annuity with deferred or immediate payments determines when payments begin.
- Annuity investments are tax-free until they are withdrawn or as income, usually during retirement.
- Annuity payments are taxed at normal rates.
What is a fixed annuity?
A fixed annuity is a contract between an investor and an insurance company. Investors, also known as annuity beneficiaries, fund the annuity in exchange for a guaranteed interest accumulation rate period and a predictable income stream repayment period over the life of the annuity.
Investors can use a one-time payment to refer to money during the accumulation phase or make smaller payments over time. Income is paid by the issuer based on the owner’s age, account balance, interest accrued at the agreed rate, and other key factors.
Fixed annuities aren’t the only ones available to investors. Variable annuities, in contrast, are compared to mutual funds and other market-based securities of the buyer’s choice, and their value fluctuates accordingly.
Because variable annuities do not guarantee payments, many risk-averse investors opt for fixed annuities for retirement. Their slow growth is the price investors pay for fixed rates.
Immediate and Deferred Fixed Annuities
Income from a fixed annuity can be immediate or deferred. With an immediate annuity, the buyer makes a one-time payment to the insurance company. The payout begins almost immediately and usually lasts for the rest of the person’s life.
Immediate annuities are often attractive to retirees or those nearing retirement who worry that their resources may be exhausted. Immediate annuities are also an option for those who make a huge one-time profit, such as an inheritance or profit from selling a business, and hope to turn it into a source of income.
A deferred annuity, on the other hand, begins paying out at some point in the future chosen by the buyer. With a deferred annuity, the annuity beneficiary either makes a one-time contribution, a series of contributions over some time, or both. 1 These annuities are for people who are a few years away from retirement and don’t need an immediate income.
Fixed annuity payment
When investors want to receive benefits from an annuity, they notify insurance companies. An insurance company’s actuary calculates the number of periodic payments. This calculation includes many factors, including the dollar value of the account, the age and life expectancy of the annuity beneficiary, the likely future returns on the account’s assets, and whether the annuity is intended to provide income to the spouse upon the death of the annuity beneficiary.
Generally, the longer an annuity beneficiary waits, the larger the payout will be. Most annuity beneficiaries choose to go through joint and survivor annuities for the rest of their lives and the lives of their spouses. Once both are dead, insurance companies usually stop paying out entirely.
If an annuity beneficiary lives a long time, they may get more value from the annuity than they paid. However, if they die too early, they may earn less than they pay. Nonetheless, both scenarios achieve the annuity’s main selling point: income for the rest of your life, whether it’s long or short.
Annuities may also include additional provisions, such as a guaranteed number of years of payment. With this option, if the annuity beneficiary and their spouse die before the guarantee period ends, the insurance company will pay the remaining funds to their heirs. In general, the more clauses included in an annuity contract, the smaller the monthly payment will be.
How Fixed Annuities Are Taxed
Most annuities offer tax benefits. If the annuity is tax-deductible, contributions to the qualifying annuity are tax-free until the annuity beneficiary begins earning income from it. As with IRAs and other retirement accounts, tax-deferred income can grow and compound more quickly over time than it would be if money were put into a regular taxable account.
Once payments begin, annuity beneficiaries will have to pay their ordinary income tax rate instead of the capital gains rate, which is usually lower. The same goes for most retirement accounts. 3 However, annuity beneficiaries may be in lower tax brackets by then, and many are retired.
Annuities are more expensive than many other retirement investments, and any withdrawals you make in the early years may be subject to surrender fees.
Special attention items
Annuities, whether fixed or variable, have their drawbacks. They tend to be expensive compared to mutual funds and funds of certificates of deposit (CDs). Annuities are usually sold through an agent, whose commission costs are passed on to the buyer. The annual payout of an annuity is also quite substantial, often more than 2%. Any special riders usually have an added fee.
Since there are many deferred annuities, annuity beneficiaries may be required to pay a surrender fee if they withdraw funds during the first few years of the contract, usually 6 to 8 years or more. 5 Early distributions may also be subject to tax penalties until the annuity beneficiary reaches age 59 & 12;
However, most annuities have provisions that allow 10% to 15% of the penalty-free amount to be withdrawn from the account for emergency purposes.
Anyone who needs annuity funds before regular payments should read their contracts carefully and consider consulting a knowledgeable financial advisor.
Annuities and the COVID-19 Pandemic
Virtually everyone has been affected in some way by the GFC COVID-19 pandemic, including retirees and non-retirees alike. US federal and state governments extend unemployment insurance benefits through stimulus checks. But there are also provisions for those seeking relief from retirement accounts.
The $2 trillion Pass Coronavirus Aid, Relief, and Economic Security Act includes exemptions for those who need to withdraw up to $100,000 from retirement resources by the end of the 2020 tax year without facing early withdrawal penalties. This provision does not carry over to 2021, meaning anyone who withdraws from their retirement account in 2021 is liable for a 10% penalty.
In addition to the 10% penalty, withdrawals from retirement accounts for the tax year 2021 are also subject to that year’s income tax.
Some states have also extended a grace period for consumers who have shown difficulty paying annuity contracts because of the pandemic. For example, insurance companies must offer consumers an opportunity to pay late premiums to pay their annuities in New York under an order issued by Governor Andrew Cuomo.
Bottom line
Annuities are just one of many options for your retirement portfolio. You can buy contracts through insurance companies or investment companies. Fixed annuities, more specifically, can provide you with some protection because they offer investors a guaranteed interest rate. The money can be paid in one lump sum or on a recurring monthly basis. The payment amount will vary based on your age, account amount, and life expectancy. But keep in mind that these vehicles have certain tax implications and you must pay your normal income tax rates. If you’re hesitant to jump into an annuity contract, consider talking to a retirement expert to see if it’s right for you.
