Annuities

An annuity is an investment which an individual makes to grow principal and optionally insure a lifetime income. There are different types of annuities with different annuity rates. These are Indexed annuity, Variable annuity, Fixed annuity, Immediate Annuity, Deferred Annuity and Retirement annuity. Equity Indexed annuities grow depending upon a predetermined annuity rate or any stock market index. It is a good source of investment if the stock market is in an upward cycle. In an indexed annuity the principal is guaranteed and the profits are locked in. As a result investors do not lose their money. The annualized rate of return for these kinds of products can be anything between 4% to 9%.  The annuity rate of return is typically higher than a traditional fixed annuity.

A variable annuity allows an investor to grow investments in portfolios. The annuity rate of return is not fixed. This is one of the most preferred methods of annuity investments because the money is invested in conservative stocks and the payments are tax deferred. Investors can choose the method of payouts. The expected rate of return for variable annuity is 7%-10%.

Fixed income annuities come with a time frame of 5 to 15 years. This type of annuity is more suited for conservative investors to ensure that their principal is guaranteed. The insurance companies which manage the fixed annuities place the funds in Government securities or in bonds of stable companies. At present rates one can expect a return of 4.70% on an investment of US$100, 000 for a 15 year rate of return. Another form of annuities that is gaining popularity is Immediate annuities. As the name suggests an investor in these structure start receiving payments on their investments as soon as it is made. The rate of return on immediate annuities depends on many factors such as age, gender, investment amount, and type of pay-out.

The next type of investment in annuity is deferred annuity. In this type of a arrangement the investor benefits from tax benefits on the investments made.  The withdrawals from a deferred annuity are made after retirement to enjoy the golden years of one’s life.  The returns from deferred income are taxable. A fixed deferred annuity will give a steady rate of return. Investors can choose the mode of investment in the scheme. The rate of return of a deferred income scheme will depend on the investment corpus, starting age of the investment and whether the payout is in a variable or fixed mode. The average rate of return that an investor can expect from a deferred annuity is between 3%-5%.

The most common and oldest kind of annuity is retirement annuity. People invest in these types of investment vehicles to ensure that they get a steady return after their retirement.  In this type of instrument, investors can choose between a fixed annuity rate and a variable return. Investors can also roll their investments in 401Ks, IRA and other CD’s into a retirement annuity. Investors have been investing in annuities to safeguard their future incomes. The annuity rate of return can be lesser than other investments such as equities or foreign exchange. However they will always remain as the favorite investment vehicle to ensure long-term returns.

To check current annuity rates, consult the immediate annuity calculator and the fixed annuity calculator.

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Long-term care insurance may be an important (even necessary) part of your financial plan. But you may be reluctant to buy a policy whose premiums can rise. Plus, if you never require long-term care, the money that you had spent on premiums simply vanishes.

Still, you may want the financial security that long-term care insurance provides. There is another way to get long-term care coverage - by combining it with a life insurance or deferred annuity policy. These combination policies could make long-term care insurance more financially attractive.

Here’s a brief summary about how they work. Long-term care insurance is added as a rider or as an additional benefit to a life insurance policy or deferred annuity contract. Premiums for many of the life/long-term care insurance combo policies are usually paid up front.  While this can be a significant outlay of funds at the start of the policy, the one-time premium payment for both life and long-term care insurance does provide protection from rising long-term care insurance premiums down the road. In contrast to the life/long-term care policy, the long-term care coverage on a deferred annuity will typically be based upon a percentage of the annuity assets (based, among other things, upon the insured’s age and health).   

One of the combinations of life and long-term care insurance provides current life insurance benefits to the policyholder if long-term care is required. The money to pay for long-term care expenses comes from reducing the policy’s death benefit. So if you have a $500,000 death benefit and incur $70,000 in long-term care expenses, the nationwide average cost of a year of nursing home care  the death benefit will decrease to $430,000.

As previously mentioned, another way that long-term care coverage can be combined with life insurance or a deferred annuity is to include long-term care insurance as a rider to the base policy. For example, a $100,000 life policy with a long-term care insurance rider may pay lifetime benefits up to $200,000.  These policies typically require annual premiums for the long-term care coverage, in addition to the initial premium payment. Many long-term care riders are guaranteed renewable. Assuming the insurer is financially sound, the annual premium on many policies remains constant throughout the life of the policy (subject to the insurer’s claims-paying ability). 

The insurance company will look at your family health history and any pre-existing conditions that you may have. In the case of a life/long-term care plan, the potential death benefit and long-term care expenses will be considered. Therefore, an annuity-based combination might be more appropriate if your health makes it difficult to buy life insurance. The money in the annuity can then be used for long-term care expenses, or passed to a beneficiary. 

Please note, however, that annuities are long-term investments designed for retirement purposes. Withdrawals of taxable amounts are subject to ordinary income tax, and if taken prior to age 59½, a 10% federal tax penalty may apply. Early withdrawals may be subject to surrender charges. Guarantees are backed by the claims-paying ability of the issuer.

Would a combination life/long-term care policy work for you? It depends on your individual needs and financial situation. With many different combinations to choose from, find a retirement advisor that can evaluate your options.

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Could underestimating your longevity mean you’ll run out of retirement money?

At age 65, the average life expectancy is 81.8 years for a man and 84.8 years for a woman. At age 75, the average life expectancy is 85.5 years for a man and 87.6 years for a woman. Note that as you grow older, you’re expcted to live longer!  With recent advances in medical science, it’s no longer a stretch to think that you could live to be 100. In fact, the US Census Bureau projects that by 2050 there will be nearly one million centenarians.

No one wants to die sooner, so that’s great news. The problem: If your retirement plan doesn’t recognize the possibility of a long retirement, then you could potentially outlive your money. But read on for a solution.

Consider the following hypothetical example. Assume you’re 64 years old and earn $60,000 per year. You plan to retire next year at age 65. You’ve accumulated $1,000,000 in retirement savings, which you think will return a hypothetical six percent per year throughout your retirement. And, you have a $60,000 annual retirement need (excluding Social Security). If you have a 15-year retirement from ages 65 to 80, you’ll have no shortfall in retirement funds; in fact, you’ll end up with almost $696,000 to pass on to your heirs. On the other hand, if you have a 30-year retirement from ages 65 to 95, you’ll run out of money at age 83 as the table below illustrates. Of course, this example  is hypothetical and for illustrative purposes only. It is not meant to represent the performance of any particular product.

Source: Burling Bank. Assumes $1,000,000 in retirement savings has already been accumulated; another $60,000 is added. The money grows at a hypothetical 6 percent pear year; $60,000 (in today’s dollars) in withdrawn each year. This example above is hypothetical and for illustrative purposes only. It is not meant to represent performance of any particular product.

Because the risk of outliving your funds is real, annuitization may be an option.  Annuitization is the process of converting your assets into an income stream.  For example, maybe you plan to leave your heairs$250,000.  You could turn that $250,000 into an income stream you cannot outlive with an immediate annuity.  For example, a femaelage 70 could invest $250,000 into an immediate annuity and get $1765 a month for life – an income she cannot outlive.  To see the amount you can receive, use the immediate annuity calculator.

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If you bought a fixed deferred annuity a few years ago, you may be looking at the end of your initial annuity rate guarantee, and the renewal annuity rates could be lower than they were when you first made the investment.  Some fixed annuities leave you no option other than accepting the current one-year rate, or transferring the annuity to another one so you can lock in a new, long-term annuity rate guarantee.    

However, a one-year annuity rate lock may not be such a bad idea. You could earn a reasonable return and wait until next year to see where interest rates have gone before deciding to renew for another year, or explore other options.  

If your contract surrender period has ended and the renewal annuity rates are low, the annuity company might offer you a new multi-year (usually five to 10 year) annuity rate guarantee period. This could be their way of trying to keep your business rather than lose you to another insurance company. You could, however, possibly face a new round of surrender charges by doing this.  (Surrender schedules and rates vary among companies.)

It might also be time to take money from your annuity through annuitization (payments over a fixed period or life) or annuity withdrawals of interest.
    
Fixed annuities are designed for long-term investors. Ordinary federal income taxes and a 10% tax penalty often apply to annuity withdrawals and surrenders taken prior to age 59½. However, you can consider “exchanging” your annuity to another company for an annuity that offers a better renewal rate history or more multi-year rate guarantee options. Assuming that all requirements of Internal Revenue Code §1035 are satisfied, you can exchange your old annuity and you will not owe any federal income taxes or penalties on the exchange.  Surrender charges could still apply depending on your existing contract’s terms. Therefore, you would want to consider the comparative fees, surrender charges, and surrender schedules of the contracts prior to making an exchange for a higher annuity rate.   

Before you make any changes, review your company’s annuity rate renewal history. This will show you the rate that the company paid past clients as their renewals came due. You need to ask for this. This could also indicate how well the company paid its existing annuity holders as compared to the annuity rate it paid to attract new investors.    

If you are not clear on the renewal options you might have on your annuity, you can check Comparative Annuity Reports to see the annuity rates that various companies pay. You may also want to look at annuities that lock in the rates for the entire contract term. This way you will know where you’re going to be at the end of the fixed-rate guarantee period.  (All annuity rates and guarantees are subject to the insurer’s claims-paying ability.)

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Ever since their inception back in 1982, IRAs have been offered by virtually every type of financial institution, from banks to brokerage firms to insurance companies. They are, in fact, the only possible avenue available for many retirement savers who do not have access to corporate or self-employed plans. Virtually any type of investment can be used inside an IRA, with the exception of life insurance, commodities futures, collectibles, and some kinds of coins.

However, just because an investment is permissible within an IRA does not necessarily mean that it is beneficial. There has been much debate over whether annuities are appropriate retirement investment vehicles inside IRAs, or any other type of tax-deferred retirement plan for that matter. The main argument against doing this is obvious: why put an investment that is already inherently tax-deferred inside of an account or plan that is also tax-deferred? Because, of course, there is no such thing as “double” tax-deferral; money that has been deferred from taxation once cannot be deferred again! Yet a great many insurance companies and agents enthusiastically promote annuities within IRA accounts.

The insurance industry would be quick to respond that investors seeking guaranteed rates of return will get higher yields from fixed annuities than other vehicles offering similar risk. The industry might also point out features such as the ability to annuitize or a 10% annual withdrawal feature that does not exist in other fixed income alternatives. In the case of variable annuities, they offer a range of insurance and money-management features that are not included in other investments. Options such as periodic portfolio rebalancing, systematic investment plans, and living and death benefits are standard features in all modern variable annuity contracts. The asset allocation features normally found in these contracts can generally only be matched by professional money management firms, which can be inaccessible for most IRA or other retirement plan participants.

In other words, there is more to an annuity than tax deferral. Consider the entire range of benefits that any opportunity offers and do not judge it on one single feature. Do keep in mind that variable annuities are subject to insurance-related costs (mortality and expenses) and investment management fees associated with the underlying investments.

The best way to decide if a variable annuity makes sense in your IRA is to see a side by side comparison with the mutual funds that match the variable annuity sub-accounts.  Ask your retirement consultant for a spreadsheet comparison.

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Fixed annuities guarantee your income based on current interest rates. Facing a long retirement horizon, you may want to consider relying a little on the markets to enhance your annuity income. An equity-index annuity offers that chance, but you must understand how it works.

Equity-index annuities  combine features of traditional insurance products (guaranteed minimum return) and traditional securities (where the return is linked to equity markets). Depending on the mix of features, an equity-index annuity may or may not be a security. In fact, the typical equity-index annuity is not registered with the SEC (but may be in the near future and become classified as a security).

Here’s how they work:
During the accumulation period – when you make either a lump sum payment or a series of payments – your insurance company credits you with a return based on changes in an equity index. The S&P 500 is a typical index although some equity index annuities may be based on indexes such as EAFE, he NASDAQ 100 or the Wilshire 5000.

The insurance company typically guarantees a minimum return of 90% of the premium plus a minimum interest rate. With an equity index annuity,  surrender charges can last for several years, and it is possible to lose money if the investor cancels the policy in the early years or does not earn index-linked interest. If there is no increase in the underlying index during the designated term, investors receive only the minimum guaranteed rate minus expenses and withdrawals prior to age 59½ are subject to 10% penalty.

After the accumulation period, the insurance company will make periodic payments to you unless you take your contract value as a lump sum.

Understanding how the interest rate used in your contract is linked to the equity index determines what advantage you really get over a fixed annuity. Consider these procedures in the linking process:

Participation Rates: The participation rate determines how much of the index’s increase will be used to compute the index-linked interest rate. For example, if the participation rate is 75% and the index increases 10%, the return credited to your annuity would be 7.5% (10% x 75% = 7.5%).

Interest Rate Caps: Some equity-indexed annuities set a maximum rate of interest that the equity-indexed annuity can earn. If a contract has an upper limit, or cap, of 7% and the index linked to the annuity gained 7.5%, only 7% would be credited to the annuity.

The Margin, Spread, or Administrative Fee: The index-linked interest for some annuities is determined by subtracting a ‘fee’ percentage from any gain in the index. This fee is sometimes called the “margin,” “spread,” or “administrative fee.” An annuity with a “spread” of 3%, will credit a return of only 7% if the index gained 10% (i.e. 7% = 10% - 3%).

The method of indexing the index change will affect your return too. A couple of indexing methods are:
Annual Reset (or Ratchet). This method credits index-linked interest based on any increase in index value from the beginning to the end of the year.

Point-to-Point. This method credits index-linked interest based on any increase in index value from the beginning to the end of the contract’s term.

Know the features of any equity index annuities you consider to see their impact on your annuity’s potential return.  Use the fixed annuity calculator to get an estimate of your future value at different interest rates.

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If you are going to need long-term care at some point in the future, and have no insurance of any kind to pay for it, then you may be seriously considering spending down your assets in order to qualify for Medicaid. If this is the case, then converting some portion of your non-exempt assets into an annuity may be a viable strategy.

Of course, if this is what you intend to do, then an immediate annuity with an irrevocable payout option must be used. The payout must be irrevocable because the entire contract will be valued with the owner’s assets if the owner has the power to change the payout terms.  In order to have the annuity be exempt to quality for Medciaid, the payout must be set up a a lifetime payout based on the Medicaid life expectancy tables.

But while the transfer of assets into the contract will effectively exempt them for Medicaid purposes, care must be taken to ensure that the income stream paid out by the annuity does not exceed the amount allowed under the Medicaid spend-own rules. If this should happen, then the irreversible payment schedule would leave you with no way to reduce the income from the contract. You would thus become ineligible for Medicaid–permanently.

As an example, assume that you have chosen to enter a nursing home that costs $3,000 per month. Therefore you transfer enough assets into an immediate annuity to pay you a hypothetical income of $675 per month for the rest of your life. But you also receive Social Security income of $700 per month, which brings your total income to $1,375 per month. Unfortunately, prospective Medicaid recipients become ineligible for coverage if their monthly income is above a certain level in certain states–those states that use an income cap. For a single person living in an income cap state, the maximum amount of earned income is $1,326 . However, the specific amount of income will vary from state to state, as some states use the federal Social Security Income limits and other states impose a mandatory income cap below this amount.  But since you are over the $1,326 limit and have no power to reduce either source of your income at this point, you have effectively forfeited any chance of receiving benefits. Worst of all, your monthly income is also much too low for you to be able to pay your nursing home expenses. Therefore, if you choose to convert your assets into an immediate annuity, be absolutely certain that your income level will be acceptable once you begin receiving payments. Failure to do so could place you directly between the hammer and the anvil.   The income cap states are AL, AK, CO, DE, ID, MS, NE, NM, SC SD, and WY.

Assume however that you are not in an income cap state.  Then, assuming no other issue would preclude you from getting Medicaid benefits, the State would pay your $3,000 nursing home bill and also take your monthly income of $1375 a reimbursement.  So what good is the annuity?  If you name the beneficiary of the annuity as a family member and also select the return of premium option, your heirs will recover any of your original premium paid to the annuity company should you die before monthly payments equal your original annuity premium.

But be careful–the handling of this varies form state to state.  Some state now have a rule that the State must be named as beneficiary of the annuity or it will not be exempt.  Other state have estate recovery rules so they can place a levy against the annuity.  Check your state’s rules closely before using an immediate annuity for Medicaid planning and get advice from an elder law specialist.

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While fixed annuities provide both safety and tax-deferred interest accrual for millions of retirement savers, fixed annuity owners cannot avoid taxation indefinitely. This is perhaps their chief disadvantage, as all interest income that is distributed from an annuity is taxed at the annuity owner’s top marginal tax bracket.

However, there are three instances in which one can gain some relief when taking distributions from fixed annuities. The first scenario applies to small (or large) business owners who declare an operational loss for the year on their tax returns. As long as the business is not considered a passive activity, the loss can be used to cancel out other types of income, such as investment income. For example, if a shopkeeper realizes an operating loss of $15,000 in a given year, then he or she could take a $15,000 fixed annuity withdrawal that same year and credit the loss against the income, thus effectively making the withdrawal tax-free.

Another good way to exempt your fixed annuity distribution from annuity taxation is to designate a qualified charity as the beneficiary on the contract. After you pass away, the charity will then receive the proceeds of the annuity, with no income or estate tax liability.

A third way to avoid taxes with your fixed annuity is to use the proceeds to pay for long-term care expenses. Medical expenses that exceed 7.5% of a taxpayer’s adjusted gross income are fully deductible on Schedule A of the 1040. The majority of long-term care expenses can easily exceed that amount, often running in excess of $40,000 in a single year. Even by itself that kind of expense will qualify a taxpayer to itemize, regardless of whether he or she would be able to do so otherwise. For example, a married couple filing jointly would have to have itemized deductions in excess of $10,300 in order to claim them. But a $40,000 long-term care bill will put most filers far over this threshold. If a couple hypothetically has an adjusted gross income of $32,500, then 7.5% of that is $2,437.50. Therefore, all long-term care expenses in excess of that amount, or $37,562.50, would be deductible on Schedule A of the 1040. So if they took out a $40,000 fixed annuity distribution to pay the expenses, over 90% of the income would be sheltered.

If you are looking for ways to reduce taxation from your fixed annuity distributions consider that this is a question of overall tax planning.  Our retirement income calculator might help.

Note: Income from deferred fixed annuities is taxed as ordinary income and withdrawals prior to age 59½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims-paying ability of the annuity company.

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For some time, insurance buyers have been able to buy annuities or life insurance that included a long-term care insurance. Here is how the policies generally work. In many cases, some of the earnings from the cash value in the life policy or the cash value of the annuity are used to pay premiums for long-term care insurance protection.  A hypothetical example might look like this:

Our hypothetical investor, a 65-year-old man, pays a premium of $50,000.  He obtains a life policy with a death benefit of $74,718.  He also gets long-term care insurance amounting to $149,436, to be used at a rate of $3,133 monthly, when the policy owner qualifies for long-term care benefits.  So far, this may look attractive because there are no annual out of pocket premiums—the only payment is the single payment of $50,000. Additionally, assuming that there are no prior withdrawals or payments for long term care insurance benefits, the insurance company will guarantee the $50,000 which can be withdrawn at any time . |

The $50,000 cash value is credited with interest each year at a gross and guaranteed minimum rate of 4%.  But from the accumulated cash value, deductions are made to pay for the life insurance and the long-term care insurance. Currently, the deductions from the policy to pay for the long-term care insurance are taxable to the policy owner because the IRS views them as payments from the life policy (and because this policy was purchased with one large premium, IRA classifies it as a modified endowment contract and taxes the first withdrawals as ordinary income). 

Good news.  The Congress would like everyone to have long-term care insurance protection so that as of January 1, 2010, these combination policies where a life policy or annuity is funding the long-term care insurance will no longer generate taxable income to the owner.  The change applies to policies purchased after 1996. However,   through 2009, owners of these combination policies will need to make the tax payments each year.  Also, one may consummate a tax-free exchange of an annuity or life policy after 2009 for one of these combination policies.

If you have been interested in long-term care insurance protection without annual out of pocket costs, these single premium annuity or life policies may be the answer.

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Retirees often want to know how quickly they can get to their money in case they need to cover extraordinary expenses such as a medical emergency, or a home or auto repair. This need for liquidity may cause them to avoid and insurance annuity. However, when you look closely, you will see that insurance annuities can possibly provide access to funds that can accommodate many circumstances.

For instance, what if you need to take out money before the insurance annuity matures?  Most annuity companies will let you remove a portion of your account’s value each year without paying a withdrawal charge. This is usually 10%, and once the surrender charge period expires, you will be able to withdraw as much as you want without paying any penalties to the issuer. But an insurance  also can allow for other circumstances.

Suppose you are worried about money for future long-term care or a medical emergency. Some annuity companies will give you penalty-free access to your funds if you have to go to a nursing home or come down with a critical illness.
And what about income?

If your situation changes and you need income from your insurance annuity, you will have the opportunity to annuitize the contract and receive payments for a fixed period or life. This option is available after one year of buying the insurance annuity. Once you annuitize the contract, the annuity is not considered includable for Medicaid qualification purposes in some States (the income could be, however).

What happens when you die? Will your survivor get the money he or she might need?

The annuity company will transfer the account’s value to your designated beneficiary without any surrender charges, penalties, or probate fees in almost all cases (you can check this in the contract first).

Do you think that there is a chance that creditors might come after your money? Many states’ laws protect insurance annuities from creditors.

So before you decide that insurance annuities do not offer the ease of access that you might need to your funds, look at the complete picture. Examine what you might need this money for—what situations would you consider potential emergencies? It is possible that an annuity company has just the right option for you.

Get your free copy of the booklet on insurance annuity.

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