Annuity Education

Fixed indexed annuities can be very useful investments. As the name implies, FIAs are fixed annuities linked to the performance of a stock market index (often the S&P 500). Because of this stock market exposure, they can sometimes bring conservative investors very nice returns – often, considerably better returns than CDs, bonds, or money market accounts. They really aren’t designed to outperform the stock markets; they are designed to outperform the fixed markets.

Principal protection and a chance to benefit from market gains. During the accumulation phase of an FIA, you have the opportunity to benefit from stock market gains while your principal is protected against stock market losses. The annuity contract usually guarantees you a minimum rate of interest on your purchase payments while the annuity is growing; the insurance company involved will credit you with either the minimum return stated in the contract or a return based on the performance of the linked index.

Tax-deferred growth, an income stream, and often a death benefit. Most FIAs give you all the features of a fixed annuity: your earnings are not taxed, and when the distribution phase of your annuity starts, you can receive periodic (usually monthly) income payments. (Sometimes you can take the entire value of your annuity as a lump sum at the end of the contract term. It is your withdrawals that are taxed.) There is often a guaranteed minimum death benefit payable to your beneficiary when you pass away.

No annual contribution limit. If you need to put away more retirement savings NOW, the contribution limits on IRAs and 401(k)s can be frustrating. Would you rather have a retirement account you can only put $5,000 or $6,000 in annually, or an account to which you can contribute as much as you want? FIAs (and other types of annuities) have no contribution ceiling, and there are no IRS-imposed income limits above which you cannot contribute.

Guaranteed minimum income benefit (GMIB). A GMIB ensures that the annuity payments that come your way are at least a specified minimum amount, even if your investment subaccounts perform poorly (the insurer picks up the slack). How is the minimum payment amount figured out? It is based on the insurance company’s estimation of the future value of the initial annuity investment.

Guaranteed minimum withdrawal benefit (GMWB). If the principal of your variable annuity shrinks due to a market downturn, you can use this rider to recoup the amount of your entire initial investment. If you own a variable annuity with a GMWB with a 10% withdrawal rate, you can withdraw 10% of your entire investment each year until the initial investment amount has been recouped. That’s useful if the value of your annuity should decline. If you started your variable annuity with a $200,000 investment and it is now worth $180,000, you can use the 10% GMWB to withdraw $20,000 of the original principal amount each year until the entire $200,000 is recovered thanks to the guarantee set by the insurance company.

Guaranteed lifetime withdrawal benefit (GLWB). This means guaranteed income payments for life. Let’s say your variable annuity has an account balance of $100,000 and is structured to pay out $5,000 a year for 20 years. With a GMWB for life, you will continue to receive $5,000 a year from the insurer even if you have recouped the original principal and even if the account value falls due to poor investment returns.

Guaranteed minimum accumulation benefit (GMAB). A GMAB gives you the confidence of knowing that after a set period of years, you will have at least X dollar amount of assets in your variable annuity. Usually, the GMAB is established for the end of a 10-year period, i.e., in ten years, the insurer guarantees that your annuity contract will be valued at a minimum of $100,000, even if the market drives the actual value down.

A tax perk that needs to be publicized. In 2010, you will be allowed to withdraw money from a certain kind of annuity without paying taxes as long as you use it to pay for qualified long term care coverage. All baby boomers - especially those in the highest tax bracket - can thank the Pension Protection Act of 2006 for this new, fortunate development.

A tax-sheltered exchange into a hybrid annuity? Sure. The Pension Protection Act also allows you to make a 1035 exchange into a hybrid annuity starting in 2010. So you can exchange an annuity you have now for one with an LTC rider that would permit you to withdraw the entire value of the annuity to pay qualified long term care costs - tax-free and penalty-free.

Immediate annuities provide “immediate” income. There are two phases to an annuity: the accumulation phase and the income phase.

With a deferred annuity, assets grow during the accumulation phase. Then, at a certain date, the income phase begins – and payments are made to the annuity holder out of the accumulated principal.

Longevity has its rewards. If you know a little about the insurance industry, you know insurance policies and annuities are structured around projections of life expectancy. With an annuity, if you die sooner than expected, the insurance company won’t have to pay you as much income as projected. If you outlive their projections, they will have to pay you more. So the healthier you are, the more attractive immediate annuities are.

The after-tax advantage. If an annuity is purchased with after-tax money, the income stream comes with significant tax advantages.

Let’s compare and contrast here. In a deferred annuity, all earnings and investment results grow tax-deferred during the deferral phase. But when income phase starts and the tax-deferred earnings are paid out, the tax collector wants his fair share.

Since an immediate annuity is paying back both principal and tax-deferred earnings, a portion of each payment is considered to be income, and a portion is considered to be tax-free return of principal. The shorter the payout period, the greater the amount that can be excluded from tax.

Immediate annuities can be used in IRAs that require minimum distributions beginning at age 70 ½. These minimum distribution rates are designed to distribute out the entire balance of an IRA over a person’s lifetime. With longer lifespans, the tables the IRS uses for this calculation are fast becoming obsolete – and that raises the very real threat of outliving your IRA assets. However, if those assets are invested in an immediate annuity, a lifetime income stream can be assured and the IRS will accept that income stream amount as an acceptable minimum distribution.

A new perk: tax-free withdrawals to pay for long term care. With all this in mind, owners of hybrid annuities can thank the PPA for a new option. At the start of 2010:

  • • These nonqualified deferred annuities with added long term care insurance riders were now characterized as tax-qualified LTC insurance plans.
  • • As a result, all withdrawals from these hybrid annuities are income tax free so long as they are used for qualified long term care. So you can use the cash value of the annuity to cover the cost of LTC insurance premiums without triggering a taxable event.
  • • Annuity owners are now allowed to make tax-free 1035 exchanges into appropriate hybrid annuities with long term care riders.
  • • Additionally, an annuity owner can do a 1035 exchange for the cash value from any annuity into a single-premium qualified LTC insurance policy without incurring any gains.

In addition, the new freedom to make a tax-free exchange means that an annuity owner can now leave a current contract for a hybrid annuity that may provide a much greater pool of money someday to cover LTC costs. The possible downside: if you make that move before age 59½, you may incur fees, charges and/or penalties as a result. (Keep in mind also that annuity contracts are not “guaranteed” by any federal agency; the “guarantee” is a pledge from the insurer.)




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