What is an Annuity?
In simple terms, annuities are insurance contracts that allow for money to grow in a tax-advantaged manner. Annuities can also be used to guarantee an income stream for an entire lifetime. There are Deferred Annuities, Fixed Indexed Annuities, Variable Annuities and Income Annuities. The different types are discussed below in detail.
What is a Deferred or Variable Annuity?
Deferred annuities are primarily used to grow your money in a tax-advantaged manner. This means that no taxes are paid on the principal or interest earned in the annuity as it grows over time. This basically means that the interest rate being earned compounds over time, meaning that the interest earned also earns interest over time. This is the best possible way to grow money over time. Taxes are only paid when you take money out of the annuity, and it is only paid on money that was not taxed (known as “qualified funds”) going into the annuity on the contract date. This is the difference between “qualified” and “non-qualified” funds. Qualified funds are money that has not been taxed as income, such as any money used to fund any type of retirement account. Non-qualified funds are money that has already been taxed as income. Once you understand the difference between the two types of funds, it’s easy to understand how the money is taxed when you take it out of the annuity. The easiest way to remember is qualified = untaxed money; non-qualified = taxed money.
There are several different types of deferred annuities; the two main categories are fixed or variable. A fixed deferred annuity earns a fixed interest rate that is guaranteed by the insurance company. The principal in a deferred annuity is protected by the financial strength of the issuing insurance company. This is very important because there is no FDIC protection as with a bank Certificate of Deposit (CD) or bank account. Again, the only protection of your money is the strength of the insurance company you buy the annuity from. This really is not so bad because insurance companies are so much better run and financially positioned than banks, and history confirms this fact. Until the AIG fiasco of 2008, there was never the question of what happens if my insurance company goes out of business? None ever had, it was that if there was ever a financial problem or slowdown at one insurance company, another company always came in and bought up the ailing company. This has all changed now and your best protection is to only deal with highly-rated (rated “A” or better) companies by the well known rating companies such as S&P and Moody’s.
A variable deferred annuity is invested directly in the stock market, so the growth rate depends on the performance of the invested securities. There is no protection of your principal with a variable annuity because this type is invested in the stock market and would therefore be subject to market risk. Usually, the younger you are the more tolerant you are to risk because you have more time to recover from a downturn and benefit from a surge. As you get older and near retirement age, the less risk tolerant you become. The main risk is a big loss. If your funds have a 50% loss in the market, which many people had in 2008 and 2009, you’d need to have a 100% gain to recover and get back to where you were! This becomes almost impossible for most investors.
How do Fixed Indexed Annuities work?
A fixed indexed annuity (FIA) is a type of deferred annuity contract that was developed several years ago in an attempt to maximize the growth rate of the contract while still guaranteeing the protection of your principal. Remember, as you earn a higher interest rate on your money, the risk to your principal increases also. A FIA tries to provide both, a higher interest rate than a traditional fixed annuity and principal protection not found in a variable annuity.
The way that this is accomplished is that the contract is tied into one of the major stock market indexes like the S&P-500 or the NASDAQ-100. As these indexes increase, the increases are added up, and as they decrease, the decreases are added up. At the end of the year, the total increases and decreases are all added up (subject to caps, see below), and if positive, that’s your interest rate for the year. If the total is negative, you’ll earn the minimum interest rate (e.g. 1%) that’s guaranteed in the contract.
The way a FIA does this is to cap your growth to a predetermined amount, usually around 2% per month. Any growth above this cap level goes to the company. This allows the company to guarantee that in the event of negative stock market growth (i.e. loss); your principal would still earn the guaranteed minimum rate of 1% or so. This allows you to partake in market growth while protecting your principal from market loss. FIA’s provide a great combination of growth and protection not found anywhere else.
What is an Income Annuity?
Income annuities are guaranteed income streams that are again guaranteed by the financial strength of the issuing insurance company. You can have an annuity pay income over your entire lifetime, or for a specific number of years (“period certain”) or a combination thereof. A person buying an income annuity would give the insurance company a specific amount of money and in return, the insurance company would start to pay the person a specific amount of money at predetermined time intervals, e.g. monthly or yearly, for the duration of the contract. The main benefit of lifetime income annuities is that no matter how long you live; your income stream would never end, thus protecting you from outliving your money. The longer you live, the more money you will be paid, even if the company ends up paying you more than you gave them originally. If you die before the company pays you what you originally gave them, you can arrange as part of the contract for your beneficiaries to receive at least the amount you originally paid the company plus interest. The real protection here is if you live a very long life! This needs to be a part of every seniors’ retirement portfolio.
Free book on Establishing a “Worry-free” Retirement
For a limited time, we are offering a free book on developing a “Worry-Free Retirement.” All you have to do is go to our “Smart Money” website and request the book. The information in this book could help you save thousands of additional dollars towards your retirement. There is no cost or obligation to this offer so hurry, supplies are limited and the offer will end when we run out.