When creating a safe- growth strategy within their retirement plan, many investors will turn to fixed annuities. That’s because these financial vehicles offer guaranteed growth rates, principal protection and tax-deferred growth. And while it’s rarely used, fixed annuities also offer the option to annuitize, or create a systematic and regular income that you can count on.
Even within the realm of fixed annuities, though, there can be many different options to choose from. Because of that, it is recommended that you first have a good understanding of how fixed annuities work, and how they may – or may not – be a good fit for you.
In their most basic sense, fixed annuities represent a contract between an individual and an insurance company that guarantees a safe rate of growth. They are most commonly used as a multi- year, guaranteed, safe money alternative to CD’s and bonds, and they carry also the option to turn into an income stream in the future.
With a fixed annuity, premiums are typically paid as a lump sum and are intended to last many years. Contract lengths vary, and the initial premium may be made with cash / non qualified funds, or with qualified funds, such as an IRA, 401K or an employer-sponsored retirement plan.
Additionally, there are types of fixed annuities that permit contributions over a period of time. These are a great safe growth saving vehicle.
The money inside a fixed annuity offers a fixed rate of return that is set by the offering insurance company, and the funds grow on a tax-deferred basis.
This means that there is no tax due on the gain that takes place inside of the annuity until the time of withdrawal, which allows the money to grow and compound more – sometimes much more – than a comparable taxable investment. Because of this, fixed annuities are often used as a good, safe CD alternative.
Most fixed annuities will allow you to “lock in” an interest rate for a fixed period of time, such as three, five, or seven years – regardless of what happens in the market. These are known as MYGAs, or multi-year guaranteed annuities. With an MYGA annuity, you can count on this pre-determined rate – and, once that time period has elapsed, you can usually renew the contract for another set period of time.
Depending on the annuity, you may obtain additional benefits. Almost all annuities allow for withdrawals of 10% of the contract value per year without penalty. Additionally most have penalty-free withdrawals for a terminal illness and/or the need to reside in a nursing home. There may also be a death benefit paid out to a named beneficiary in certain situations. Some annuities include these benefits at no added charge, while others may have small rider fees. Be sure to read the fine print.
Most people who are retired or approaching retirement will purchase fixed annuities for the safety and protection of principal they offer.
Fixed annuity rates vary with the market. Fixed annuity premiums are typically invested in an insurance company’s general account, which is comprised of vast holdings of safe assets like bonds, commercial mortgages, and other safe instruments. The insurance company’s asset managers know with relative certainty from year to year what their yield on this general account will be, and therefore, the carriers can make multi-year rate commitments to annuity buyers and ensure profitability.
For example, let’s say that the insurance carrier offers a certain minimum rate of return on a fixed annuity. In this case, the insurance company is then able to project what the accumulated contract value will be over a period of time.
Because fixed annuities are a type of insurance contract, they provide some of the same tax benefits, such as safety of principal and tax-deferred growth of earnings. In fact, tax will only be paid either when the annuity’s earnings are withdrawn, or if the contract is annuitized (i.e., converted to an income stream). The insurance company also guarantees that the principal will be safe, no matter what occurs in the market.
Once the annuity’s initial guarantee period has expired, the rate may be renewed for another set period of time, or alternatively, it may be adjusted based on the prevailing yield that has been earned in the insurance company’s account.
This account is the same “pool of money” that backs up the return on fixed indexed annuities – hence the FIA name. Yields in this market generally range from 3% to 3.75% – however, they are always changing. In some instances, insurance carriers that have a lower credit rating may offer higher “teaser” rates of 4% or more. But be careful before you commit to a higher yield before you read all of the annuity’s fine print.
One reason for this is because the higher rate may only last for a short period of time, and when it comes time to renew, you could be stuck for the long term with a much lower rate than you anticipated. On top of that, most annuities impose surrender charges if you withdraw more than 10% of the contract’s value within a certain period of time. (This is known as the annuity’s surrender period). In this case, it could be quite costly for you to get out of the annuity if it doesn’t perform the way you had anticipated it to.
In any case, it is highly recommended that you work with an annuity specialist who has a good relationship with a number of insurance carriers in the market. That way, once your objectives are determined, the agent can go out into the market place and find an annuity that works well for you.
Although annuities may seem to offer similar benefits from one to another, the truth is that the benefits you get from an annuity can vary a great deal. That’s why it is important to first determine your specific needs, and then fit an annuity that can best match.
Some of the key factors in choosing the right fixed / multi-year guaranteed annuity include the:
If you already own an annuity, and it isn’t meeting your objectives, you could consider exchanging it for another annuity. In this type of transaction – which is referred to as a 1035 exchange – you can exchange one annuity for another income tax-free.
According to the IRS, a 1035 exchange is a type of replacement transaction – and as such, it must follow certain guidelines. In this case, for instance, you may not directly take receipt of the money from your current annuity and then place it into the new product. Rather, the funds must pass directly from one annuity to another. That is how the transaction attains its tax-free status.
Based on IRS regulations, you can directly transfer, tax-free, a life insurance policy for another life insurance policy, an annuity for another annuity, or a life insurance policy to an annuity. However, you may not exchange an annuity for a life insurance policy.
There are a number of factors that should be considered before you move forward with a 1035 annuity exchange. For instance, be sure to fully evaluate the new benefits that you may receive as versus what you are currently getting. You also need to be mindful of any surrender charges that you may incur on your current annuity.
The taxation of annuity income or withdrawals is dependent upon whether the annuity is qualified or non-qualified. For example, if the funds that you contributed into an annuity have not yet been subject to tax (such as those from a traditional IRA or 401k plan), then 100% of the money that you receive will be taxed.
However, if the money that you contributed to the annuity has already been taxed, then only the portion of your income or withdrawal that represents gain will be subject to taxation. The portion that represents a return of your contribution will be received tax-free.
In addition to taxes, you could be required to pay a penalty to the IRS if you access your funds before you turn age 59 ½. In this case, an additional 10% “early withdrawal” penalty will be incurred on the funds you withdraw.
Most deferred fixed annuities will allow you to access up to 10% of the contract’s value penalty-free during the surrender period. A surrender period is a set period of time after you have purchased an annuity where you could incur a penalty for withdrawing funds from the account.
Annuity surrender periods can last for just a few short years, or they can last for 10 or more years, depending on the annuity. Typically, the amount of the surrender penalty will decrease over time until it finally reaches zero.
There are both pros and cons to consider before purchasing a fixed annuity.
Some of the key benefits to owning a fixed annuity can include:
- Safety of principal
- Guaranteed rate of return
- Predictable stream of income (possibly even for the remainder of your lifetime)
Some of the items to consider before moving forward with the purchase of a fixed annuity, however, are:
- Lower rate of return (as versus that of equity-related investments)
- Liquidity (particularly during the annuity’s surrender charge period)
Fixed annuities can provide you with both protection of principal, as well as a steady return over time. And, depending on your specific goals, fixed annuities can also provide a fixed stream of income, possibly even for the rest of your life.
It is important to keep in mind, though, that any annuity represents a longer-term financial endeavor. With that in mind, be sure that the funds you contribute to an annuity will not be needed in the future for emergencies.
Knowing what your short- and long-term financial objectives are before you purchase an annuity can help you to narrow down the options that are best for you. In addition to the annuity itself, it is also important to check the credit rating of the offering insurance company.
This can help you in determining the financial strength and stability of the insurer, which in turn, can have an impact on its income guarantee. Most insurance carriers are rated by A.M. Best, Standard & Poor’s, Fitch, and/or Moody’s. These ratings can typically be found on the insurance company’s website, or by checking with an annuity specialist.
Other items to consider when purchasing a fixed annuity include the interest rate provided by the carrier (both the initial rate, and the renewal rate), as well as the annuity’s surrender charge period.
Although fixed annuities can provide a number of tax and income-related benefits, they can also be somewhat confusing products. Because of that, it is always best to first consult with an annuity specialist before you make a long-term commitment.
At DCF Annuities, we scour the market place to find the right annuities for our clients. We aren’t stuck offering products from just one insurance company – and because of that, we can match you with the very best option for your specific needs and objectives.
Want to learn more about how you can obtain tax-advantaged growth in a safe money environment? If so, just contact DCF for more details.
Reach out to us if you’d like to:
- Schedule a 1-on-1 video call to discuss your specific needs and situation
- Ask questions about products, carriers, or DCF Income Payments
- Discuss how a DCF Income Payments and newly-issued annuities may (or may not) fit into your portfolio