Uncle Sam wants us to save for retirement. That’s why fixed annuities have special features and tax benefits. Where there are tax benefits, there are usually strings attached. Annuities are no exception.
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So you want to know about fixed annuities? Here’s everything you ever wanted to know, and maybe a little more.
First Things First.. What’s an Annuity?
Annuities are policies issued by insurance companies. They pay a regular guaranteed income for life or a period of years. You buy an annuity policy by making a single payment or a series of payments.
- Deferred annuities accumulate money for a period of time before the policy pays income.
- Immediate annuities start paying income right away.
- Traditional qualified annuities are part of a pension plan or IRA. They are purchased with before-tax dollars.
- Roth-qualified annuities are part of a Roth IRA or pension plan. They are purchased with after-tax dollars.
- Non-qualified annuities are personally owned and paid for with after-tax dollars.
Owners, Annuitants, and Beneficiaries
An annuity policy is a contract between the insurance company and the owner, who has the sole right to the values and payments in the contract. The owner decides who the annuitant and beneficiaries are. The age and sex of the annuitant are how the insurance company determines the amount of income.
The annuitant and owner don't have to be the same. The beneficiary receives the proceeds at the death of the owner or annuitant. The insurance company issues the policy and has to honor the promises in it. Guarantees in the policy are only as good as the financial ability of the insurance company to pay claims.
How Does a Fixed Annuity Work?
The values of a fixed annuity are guaranteed by the insurance company.
- The Cash Value: Payments made accumulated at the interest rates applied
- The surrender value: Cash value minus any charges for cashing in the policy
- The annuity payout factors: The rate applied to calculate annuity income
- Minimum interest rate: Applied to the cash value
Fixed annuities often have current interest rates and annuity payout factors higher than the guarantees. The current rates change regularly.
What If the Insurance Company Goes Bankrupt?
Insurance companies that sell fixed annuities are regulated by each of the 50 state insurance departments. These departments have financial standards for licensed companies. Each state has guarantee funds to reimburse policyholders if the insurance company fails.
The limits for each state are different. Financial ratings of insurance companies are available from A.M. Best, Fitch, Moody’s and Standard & Poor.
|Highest Ability To |
|Medium Ability To |
|Lowest Ability To |
|A.M. Best||A++ to A-||B++ to B-||C++ to C-|
|Moody’s||Aaa to Aa||A to Baa||Ba to Caa|
|S&P||AAA to A||BBB to B||CCC to C|
|Fitch||AAA to AA-||A+ to BBB-||BB+ to CC|
What Are the Features of a Fixed Annuity?
- Competitive risk-free returns: Fixed annuity interest rates are generally higher than CDs or savings accounts. Your purchase payments are invested in the insurance company's general account. The rate of return you get is based on their portfolio of US government and highly rated corporate bonds. The insurance company absorbs any market risk. Rates are offered for periods of 1, 3, 5 or 10 years. Rates can never be below the guaranteed rate in the policy.
- Partial withdrawals: You can withdraw up to 10% of the cash value free of any surrender penalties. Penalties and taxes still apply.
- Guaranteed lifetime income: You can select from 6 or more income options. All of them are guaranteed.
- Tax-deferred growth: Unlike CDs or savings accounts, the growth in a fixed annuity is not taxed until you begin to take income or other distributions.
- Long-term care benefits: Some fixed annuities offer long-term care benefits at an additional cost
- Creditor protection: Most states offer annuities some form of creditor protection. In some cases, these are unlimited protections.
How Much Does a Fixed Annuity Cost?
- Front end sales loads: The front end sales load is deducted from your purchase payment. Most products on the market today don’t have a front end sales load.
- Surrender penalties: Most fixed annuities charge a fee if you cash in your contract, or withdraw more than 10% of the cash value. Surrender penalties decline to 0 over a period of years, usually not more than 10.
- Market value adjustments: The insurance company pays a fixed rate of return and absorbs any market risk. If you cash in your contract early, the insurance company loses money if interest rates are rising. The insurance company profits if interest rates are declining. The market value adjustment will be a cost or a bonus depending on interest rates.
- Rider fees: Optional riders like long-term care benefits have a cost. The fee is usually a percentage of the cash value.
How Do I Get Income from a Fixed Annuity?
The income from a fixed deferred annuity is determined by the account value. The income from a fixed immediate annuity is determined by the purchase premium. The option you select will also affect the income amount. The chart below outlines the income options. Once an income option is selected, there is no access to account values.
Guaranteed Income Options
|During Lifetime||At Death||Advantages||Disadvantages|
|Life||Pays income for annuitant’s life||None||Highest income||No refund of unused principle|
|Life and 10 Years Certain||Pays income for life. Not less than 10 years||Balance if death occurs before the end of 10 years||Protection for beneficiaries||Lower income|
|Life and 20 Years Certain||Pays income for life. Not less than 20 years||Balance if death occurs before the end of 20 years||Protection for beneficiaries||Lower income|
|Life wIth Cash Refund||Pays income for life. Payments are at least the specified refund amount||Balance of refund amount||Protection for beneficiaries||Lower income|
|Period Certain||Pays Income for a specified number of years||Balance of payments||Useful for certain planning purposes||Outliving income|
|Joint & Survivor 100%||Pays income for longer of two lives||No further payments at 2nd death||Surviving spouse continues to receive income for life||Lower income|
How Is a Fixed Annuity Taxed?
Tax treatment for traditional qualified annuities, Roth-qualified annuities, and non-qualified annuities is different.
The chart below summarizes tax treatment of fixed annuities.
|Contributions||After-tax. Unlimited||Pre-tax. Limits for IRAs and qualified plans apply.||After-tax. Limits for IRAs and qualified plans apply.|
|Surrender||Gain is taxed at ordinary rates.||All proceeds taxable||Tax-free|
|Annuity Income||Partially taxable at ordinary rates||100% taxable at ordinary rates||Tax-free|
|Withdrawals||Withdrawals are gain first. Gain is taxed at ordinary rates.||100% taxable at ordinary rates||Tax-free|
|Loans||Loans are considered withdrawals. Gain first is taxed at ordinary rates.||IRA loans not permitted. Pension plans may have exceptions for home purchase and loans repaid in 5 years.||IRA loans not permitted. Pension plans may have exceptions for home purchase and loans repaid in 5 years.|
|Death Benefits||Gain is taxed at ordinary rates. Proceeds will be taxed as "gain first"||Rules for inherited traditional IRAs and qualified plans apply.||Rules for inherited Roth IRAs and plans apply.|
|Sales||Proceeds in excess of basis taxed at ordinary rates||N/A||N/A|
|Penalties||10% for withdrawals before age 59-1/2||10% for withdrawals before age 59-1/2||10% for withdrawals before age 59-1/2. Penalty for withdrawals prior to end of the 5th year|
What Happens to the Money In a Fixed Annuity When You Die?
If you die during the deferral period, your beneficiary will receive the account value. If you die during the distribution period, the income option determines what the beneficiary will receive.
Is a Fixed Annuity Right for Me?
Fixed annuities are financial tools. Whether they are right for you depends on the job you want them to do. Here are some considerations:
- Tax-deferred growth is a major benefit of annuities. Is tax control important to you? Can you benefit from tax-deferred growth?
- Fixed annuities offer competitive risk-free returns. Are you a conservative investor? Are you looking for an alternative to CDs or savings accounts?
- Fixed annuities have surrender and tax penalties. Do you have adequate resources for emergencies and other short-term needs?
- Fixed annuities can guarantee income for life. Do you want a fixed guaranteed income for life instead of income that may benefit from market returns?
- Fixed annuities can offer long-term care coverage. Do you need long-term care coverage?
What Should I look for in a Fixed Annuity?
The first concern for any type of annuity is the financial condition of the insurance company. The primary rating services that cover insurance companies are A.M. Best, Moody’s, Standard & Poor, and Fitch. Each has differences in their methodologies and rating designations.
The rating each service assigns reflects their opinion about the insurance companies’ ability to pay claims. Look for high-quality ratings from at least 2 of the 4. Rates on fixed annuities change frequently. Make sure you have a rate comparison from several companies.
The surrender period should never be longer than the rate guarantee. Is it a market value adjustment (MVA) policy? The MVA can have a positive or negative effect if you withdraw money or surrender the policy early.
Fixed annuities can be an important part of your retirement plan. While they have many features and benefits, they are not for everyone. Talk to your independent insurance agent. They can help you decide if a fixed annuity is right for you.
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Advisor’s guide to annuities John Olsen
Fundamentals of Investments Wilson & Hopkins
NAIC Buyers guide to deferred annuities
IRS PUB 575
IRS PUB 410
Fitch Ratings Definitions
Moody’s Moody’s rating scale and definition
S&P Global Understanding Ratings
A.M. Best Why An A.M. Best Financial Rating Is Important
The American College of Trust and Estate Counsel State Survey of Asset Protection Techniques
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