Provided By Anthony Ferrara, Senior Financial Advisor at Larson Financial Group
Investopedia sums it up well: “An annuity is a contract between you and an insurance company in which you make a lump sum payment or series of payments and in return obtain regular disbursements beginning either immediately or at some point in the future. The goal of annuities is to provide a steady stream of income during retirement.”1
What is the Difference Between an Immediate and a Deferred Annuity
Annuities are a contract with an insurance company to receive a fixed amount of financial benefits for a set period or until death.2 There are several types of annuities products, which can tend to lead to some confusion.
An immediate annuity is a contract that is purchased with a single lump sum payment and in exchange pays a guaranteed income that starts almost immediately.3 These type of annuities can be appealing for physicians as they draw within a year or so of retirement because it can essentially protect the principal on a portion of your investment accounts in the event of a sudden market downturn.
With a deferred annuity contract, money is paid in gradually and the payouts start at a later date. The time period where the investor contributes money is known as the accumulation phase, and it’s important to note that their funds are highly illiquid during this time. Once the accumulation phase has concluded, the annuity phase begins when the investor begins to receive periodic payments from the insurance company. However, these payments are only guaranteed by the financial status of the insurance company. They are not insured by the FDIC or SIPC.
As its name implies, a variable annuity’s rate of return is not stable, but varies with the stock, bond and money market subaccounts that you choose as investment options. There is no guarantee that you will earn any return on your investment and there is a risk that you will lose money. Because of this risk, variable annuities are securities registered with the Securities and Exchange Commission (SEC). The SEC and FINRA also regulate sales of variable insurance products.4
Why Do People Typically Choose a Variable Annuity?
- On the contract’s cash value growth
- Maintaining tax deferral on cash values transferred from unnecessary life insurance contracts
Transference of Risk:
- Insurance companies may provide certain guarantees on the annuities growth. For purposes of this article, we will examine variable annuities. Growth guarantees on variable annuities can be utilized through living benefit riders (which comes at an additional cost).
- Help fulfill other insurance needs such as funding long term care or providing a death benefit to an heir which may come at an added cost.
Fees Associated with Variable Annuities
- Mortality and Expense Risk Charge (M&E): Fee included to compensate the insurance company for various risks it assumes under the annuity contract.
- Administration Charges: For record keeping and other administrative expenses.
- Annual Maintenance Fees: These are typically for annuities with a cash value under $50,000
- Rider Charges: an optional guarantee available on annuities; the insurance company charges a fee or % for the guarantee based on the value of the account.
- Separate Accounts (Internal Investments) Charges: Covers the underlying fund expenses.
- Surrender Charge: Charge imposed by the insurer for early distribution or surrenders (also called a Contingent Deferred Sales Charge). Normally, 10% of the cash value of the annuity can be taken out each year with activating a surrender charge.
Taxes Associated with Variable Annuities
- Ordinary Income Tax on the Gains
- 10% penalty tax for distributions before age 59 ½ (for non-qualified annuities)
- ACA Medicare Tax of 3.8% (if annual income exceeds $250,000)5
- Estate Taxes: Balance of the annuity is included with the valuation of the gross estate if anyone besides the spouse is named as the beneficiary.6
- Death Benefit Tax: Beneficiaries owe ordinary income tax to the extent death benefit exceeds cost basis.7
- State Premium Tax Charge: If you live in one of the eight states that apply premium taxes to clients’ deposits into annuity contracts.8
How Can Annuities Provide an Additional Income Stream During Retirement?
There are two predominant risks that could threaten the financial well-being of retirees:
- The risk of outliving one’s savings and facing financial ruin
- The risk that bad investment performance will reduce the value of the retiree’s portfolio
The goal is to transfer some of the retirement income risk to the insurance company. Average life expectancies have continued to increase, making it more challenging than ever to save for retirement.9 Annuities are a unique product that, upon annuitization of the contract, can provide a steady cash flow during retirement years
Annuities have many benefits when used appropriately. A deferred variable annuity with a living benefit rider may act as a hedge to a person’s portfolio during prolonged periods of poor stock market performance, like the bear markets of 2001 or 2008 that negatively impacted retirement savings accounts.
For younger physicians, an annuity may not be appropriate as locking money into an illiquid product may hamper their ability to meet emergency needs or buy a first home. That said, individual circumstances do vary and a good financial advisor can help you sort through the pros and cons to your situation. If you recently started your career in medicine, you should consider maxing out your 401(k) plan and employer contributions first. In addition, some annuity purchasers are deeply concerned about asset protection issues and if you live in a state that offers protection to annuity values, it may be a suitable option for you.
There are a few other possible scenarios where exploring annuities might make sense. For one, you may come into a large sum of money, such as an inheritance, and you may want to defer the taxation that is normally associated with an investment portfolio. If you have an older annuity with outdated features and higher fees than what is currently available, you can replace it with a newer annuity with more favorable terms.
Sometimes there are surrender charges associated with the exchange of newer products, but if your annuity has been in-force a five to seven years, the surrender charges may be minimal or non-existent. There may be cases where the value of an enhanced benefit on the existing contract could be lost by transferring to the new contract. Typically, there are surrender charges for a certain period associated with the new product. Depending on your circumstances, this may negate any benefit. A good financial advisor can help you understand and sort through these issues.
To sum it up, annuities are complex products. It is highly recommended that you work with an advisor held to a fiduciary standard that is capable of explaining the features (and fees) necessary for accomplishing your financial goal. Always read the annuity’s prospectus before purchase and make sure you understand exactly what you are paying and what you are receiving in return.
- Dave Anthony “What is an Annuity?” (November 2016). http://www.investopedia.com/ask/answers/12/what-is-an-annuity.asp
- U.S. Securities and Exchange Commission “Variable Annuities: What You Should Know” (April 18, 2011). https://www.finra.org/sites/default/files/InvestorDocument/p125846.pdf
- Marie Beerens “Come Watch the Unraveling of the Annuity’s Mysteries” (March 17, 2017). http://www.investors.com/etfs-and-funds/personal-finance/unraveling-the-mysteries-of-the-annuity/
- Financial Industry Regulatory Authority “Variable Annuities: Beyond the Hard Sell” (June 2012). https://www.finra.org/sites/default/files/InvestorDocument/p125846.pdf
- Barbara E. Weltman “How Are Variable Annuities Taxed?” (September 15, 2015). http://www.investopedia.com/articles/personal-finance/091515/how-are-variable-annuities-taxed.asp
- Zacks Investment Research “Do Death Benefits From an Annuity Become Part of the Estate Value?” http://finance.zacks.com/death-benefits-annuity-become-part-estate-value-1338.html
- Zacks Investment Research “Annuity Death Benefit Tax Implications” http://finance.zacks.com/annuity-death-benefit-tax-implications-11031.html
- Darla Mercado “Beware State Premium Taxes on Annuities” (June 18, 2014). http://www.investmentnews.com/article/20140618/FREE/140619928/beware-state-premium-taxes-on-annuities
- James Xiong, Ph.D., CFA; Thomas Idzorek, CFA; and Peng Chen, Ph.D., CFA “Allocation to Deferred Variable Annuities with GMWB for Life” (February 2010). Journal of Financial Planningl
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