For Some People.. Annuities Are A Great Idea

An Annuity Can Be A Safe, Smart Choice for Wealth Protection…
If You Know What to Look Out For

By Teresa Kuhn JD, RFC, CSA


While a properly structured and optimized Bank on Yourself™ policy is always the cornerstone of every financial plan I design, I do occasionally have clients who wish to add another popular safe money product to their portfolio-the annuity.


Baby boomers nearing retirement, having seen huge chunks of their life savings drained away during the current recession, have driven annuity sales to all time highs in their bid to find safe havens for their wealth. 

Annuities are also becoming more popular with younger people, especially those who have inherited money and seek tax benefits or wish to avoid putting money in the stock market or otherwise expose their money to risk.

Annuities come in a wide variety of “flavors” and are more complex than many other types of money vehicles. Their vast array of fees, rules, and other restrictions can be confusing and a bit overwhelming.  It is in your best interest to consult a professional money manager when deciding to add any financial product to your portfolio, but especially annuities.  


A little education and consultation with a professional will ensure that you don’t wind up with an annuity which is unsuitable for your particular situation.
Before you make that consultation appointment, however, it makes a lot of sense to learn all you can about these safe money products so you will know what questions to ask and avoid making financial mistakes from which it will be difficult to recover.

In this article, I will give you a brief overview of annuities and how they work.  However, I strongly suggest that anyone considering purchasing an annuity take the time to further his or her own education.  

Don’t get all your advice from TV and don’t allow the slick annuity company sales brochures to influence you. This is an important decision that can and will impact your financial future.
Do your due diligence by visiting consumer websites, government sites, and libraries, attending seminars and webinars, and speaking with experts.

Many employers and state governments offer free financial counseling to retirees and those about to retire.  Take advantage of every resource available before you buy anything.

How do annuities work?


Simply defined, an annuity is an insurance product designed to pay out income over a period of time. 

Typically, you agree to make a series of payments or one lump sum payment to an annuity issuer.   

In consideration for those payments, the company agrees to make periodic payments to you for a definite time period or an indefinite period (until death) in one of two ways:

Deferred annuities allow you to pay either monthly installments or lump sum payments This account grows on a tax-deferred basis until you start receiving payments at a later date.  While the tax deferred status of these annuities is often touted as a desirable benefit, there are potentially adverse tax consequences later on of which you need to be aware.

In contrast, an immediate annuity begins paying benefits the same year as when you deposit your money. Payment amounts vary based on factors such as age, gender, and total amount invested.

What are the types of annuities and which one is best? 

Some companies like to market annuity products which feature various whistles, bells, and options designed to convince consumers to choose that company’s offerings over those of another.

Some of these options are designed to address certain inherent issues while others are simply marketing devices which add to the perception of value, but do little to truly improve the product.

It’s important to understand the features of any annuity at which you are looking and determine whether or not that feature is a true improvement.

Customization aside, there are essentially only three real types of annuities:

Variable annuities allow the buyer to choose how their account is invested from a variety of options, including mutual funds.  This type of annuity’s rate of return is by necessity tied to the performance of the investment options a person selects, as well as the amount of deposits made.     

Some people choose this kind of annuity because of  its’ supposedly greater growth potential.  However, you could wind up with a lot smaller payments should the stock market falter.  Variable annuities carry with them the additional burden of not being able to forecast with any degree of certainty how much money you will get when the time comes to receive payments.

With a fixed annuity, the annuity company contracts with the purchaser to pay no less than an agreed-upon interest rate while the account is growing; and the purchaser agrees to make periodic payments of specified amounts.  

The types of annuities do present a potential problem in that low interest rates at the time of purchase can make for mediocre results, especially considering the fact that most fixed annuities do not adjust for inflation.  

However, choosing a fixed annuity with income riders, such as those I recommend to my clients, does address this shortcoming.

Fixed annuities do make it much easier to predict the amount of income one can expect in retirement ,especially ones which are customized  to take into account the wealth erosion caused by inflation.

 Indexed annuities provide investment returns based on fluctuations in a particular index, such as the S&P 500.  Unlike variable annuities, indexed annuity contracts stipulate a minimum contract value, regardless of the performance of the index.  These are often referred to as “guarantees.”  

The tax man cometh…be prepared

The tax benefit of a variable annuity is often its strongest selling point – yet in

real life it is usually a cruel illusion. Most people would never buy variable annuities if they really understood the way these investments are taxed. It’s true that capital gains, interest and dividends can build up inside an annuity on a tax-deferred basis. But when you take money out, by definition your first withdrawals are your gains – which are all taxable as ordinary income. Only after you have taken out all your earnings and paid tax on them can you start taking out your own money, on which there is no tax. – financial writer Paul Merriman

While understanding how much in income taxes will be taken from any money vehicle is essential to getting the most out of that vehicle, many people with whom I speak are startled to learn of the potentially negative tax implications of their savings and investment choices.

For whatever reason, they never stop to consider how taxes could possibly wreck their entire financial plan, especially when it comes to annuities.

After all, one of the biggest reasons people purchase annuities is because their accounts grows tax deferred, meaning that tax is pushed off until the time you start taking out payments, as is the case with other long term investment plans,  such as 401 (k)s.

It’s funny that when I ask people the question, “Do you think taxes will go up or down in the future?” the response is almost always, “Of course, they are going up -the economy is a mess and they’ll need money.”  

Yet, strangely, people considering the purchase of a variable annuity, indexed annuity, or mutual fund often rave about its’ tax deferred status without recognizing the potential hit their nest egg may take if they are unprepared when the tax man comes to call.
 

Part of the reason for this disconnect I am sure has to do with an ever-changing, convoluted tax code that is difficult to interpret, even for people who are trained to do so. 
Part of it is that some financial experts mislead people into thinking that they will always be in a lower tax bracket when they retire- so why worry?

The truth, however is that many investment and savings plans, including some types of annuities are fraught with potentially negative tax issues.

It is also true that many seniors retire only to find themselves in a HIGHER tax bracket, instead of a lower one.

Tax issues are further obscured to people because of the inclusion of long-term type investment options within ,for example, the variable annuity.  

Because they are acting with a view to the long term, people often assume that the annuity will be taxed at capital gains rates, which are currently 15%. (but I feel are destined to increase in the future.)  

Unfortunately, that is not true- annuities are actually taxed  at personal income tax rates which means that while your contributions themselves are not taxed, any earnings generated by them are taxed at your normal income tax rate.   

This could prove costly because a lot of people wind up in higher tax brackets closer to retirement age.  

Another thing to bear in mind is that, while there is no limit to annuity contributions as there are in other tax-deferred accounts (401 (k) plans, for example), there is the same 10% penalty  associated with withdrawing your money from an annuity before age 59 and ½.

Additionally, if you plan on leaving your annuity to a beneficiary, go over the potential tax issues that that beneficiary will encounter with a tax attorney or other tax specialist. 


Fees and expenses

Just like other types of financial options, annuities do have fees associated with them. 
While most of these fees and commission are legitimate, it is worthwhile to train yourself to look carefully at them to determine the impact to your future wealth. 

Arguably,  the fee to which you should pay the most attention and which has the most potential to damage your net worth is the surrender charge.  

A surrender charge is the annuity company’s version of an early withdrawal penalty.

While the typical annuity product charges between 7 and 8 percent of the investment over a period of around 6-8 years, there are products being sold with much longer surrender charge periods (some as long as 17 years!) and much higher rates (10 percent and more)

You never know when some unexpected life challenge will require you to access your money. It is vital that you know EXACTLY how much the surrender charge will be and how long the surrender period is.

Commissions are another factor when assessing the true cost of your annuity. Sales people are sometimes given commissions as high as 10 percent for the initial investment, plus they receive ongoing commissions as the account is growing.  

While not always true, the fact that your annuity salesperson is getting a high commission can be indicative that the product may not be as cost-effective as you want.

Depending on the type of annuity, you could also be charged an annual fee or fees. These fees could add as much as an additional 2% a year to the cost of your annuity.  

When comparing annuities, be sure to take a cold, hard look at the associated fees and have your advisor do some serious number-crunching for you.

Other things of which you should be aware

• Always check out the issuing company for stability and claims-paying ability.
• Before doing changing from one annuity to another, be sure to do a thorough analysis of surrender charges (if applicable), sales commissions, fees, and potential tax liability.
• If you are using an annuity as a way to create an inheritance for a beneficiary, be sure to consult with a financial planner to find the best kind of annuity for that purpose

 In conclusion, I’d like to say that Living Wealthy Financial Group believes an annuity properly designed and implement by one of our professional advisors, is a great way to diversify your portfolio and create a steady stream of money that you won’t outlive.

To learn more about safe money strategies that make sense for you, visit our other websites:

www.ibankonme.com
www.ibankonme.blogspot.com

www.livingwealthyradio.com

Or, call us with your questions or to make a confidential appointment with one of our qualified advisors.

800-382-0830