While
they are best known for providing guaranteed income during retirement, Fixed Annuities
can be purposed for tax deferred accumulation.
They are designed to protect your principal from downside loss and can
be funded from after-tax money or pre-tax accounts such as IRAs and 401Ks. Additionally, distributions made for Qualified
Long-Term Care expenses are entirely tax-free.
Are
Annuity products a safe investment?
Not all Annuities are equal
when it comes to protecting your principal from investment loss.
Variable Annuities are the
least safe, as contract funds typically
are invested directly into equities and other assets that can fluctuate widely in
value. Variable Annuities offer a potentially
rewarding upside, but their suitability is limited to investors who can
tolerate the risk of losing their invested principal.
Investors seeking growth
and safety of principal have better options with Fixed Deferred Annuities. Two popular products are Multi-Year
Guaranteed Annuities (MYGAs) and Fixed Indexed Annuities (FIAs).
MYGAs offer a contractually guaranteed interest
rate for a fixed period, such as three years or five years. Interest earnings grow fully tax-deferred when
no distributions are made (when money is withdrawn, gains are taxed first prior
to return of principal). “Surrender Charges”,
or fees, generally apply for early termination; however, most MYGAs allow penalty-free
withdrawals during the guarantee period.
Such withdrawals may be limited to certain thresholds such as: 10% of
account value each year, accumulated interest earned, Required Minimum
Distributions (RMDs on Qualified Annuities), or other terms as specified in the
Annuity contract.
When choosing a MYGA
product, it is important to review all contract guarantees and terms including how
funds are disbursed if the Annuitant (person insured by the Annuity) dies before
the end of the accumulation period. Some
MYGAs pay a death benefit equal to the full account value without any surrender
penalty.
When the guarantee period
ends, consumer-friendly tax laws allow accumulated funds to be rolled over without
tax consequence into a new Annuity contract (this is known as a 1035 exchange). The customer has other options as well, such
as annuitizing the payout over a specified number of years (or for lifetime) or
receiving a lump sum payment. As noted
above, distributions are taxed first on gains. In the case of a Qualified
Annuity, or IRA-type account, the entire distribution is taxable since none of
the contract funds had been taxed previously.
FIAs, like MYGAs, are Fixed Annuity contracts that
accumulate interest on a tax-deferred basis; and they often are designed for a
longer time horizon compared to MYGAs.
The main difference, though, is that FIA contracts base investment
returns on the performance of a selected Index such as S&P 500. Unlike direct investment in equity or bond
markets, FIAs generally are protected against investment losses. In exchange, only
a portion of Index growth is credited to the Annuity contract when the Index increases
in value. Index measurement for interest
crediting purposes often is on a one-year point-to-point basis with an annual
reset for the next year.
When purchasing an FIA, it is important to
review all terms including contractual surrender charges, availability of
penalty-free withdrawals, the portion of Index gain credited to the contract, guarantees
regarding annuitization (payout) of funds in the future, and how the death
benefit is calculated.
FIAs are especially attractive in times of a
mature bull market, since history shows market corrections occur and the
downward trend usually is short-lived.
For example, consider an investor with $100,000 who purchases an FIA
contract participating in a stock Index, and with downside protection, rather than
investing directly in the Index itself.
If the underlying Index were to drop 20% in the following year, the FIA
contract value is still $100,000 and has not suffered any of the 20% market
loss which could take years to recoup.
Investing in a MYGA vs.
FIA Contract
Purchasing a MYGA contract makes the
most sense when there is a shorter timeline for needing access to funds and/or
the investor wants to know exactly how the investment will grow. MYGAs can be compared to Bank Certificates of
Deposit (CDs), which operate similarly in that an interest rate is guaranteed
for a specified period. Currently, MYGAs
are available with much higher credited rates compared to Bank CDs; and, as
noted earlier, Annuity contracts grow on a tax deferred basis unlike most investments
including Bank CDs.
Purchasing an FIA contract is most suitable
when the investor has a longer time horizon and would like some exposure to
market upside but without risk of losing principal. The long-run return on FIAs tends to be higher
than investments in MYGAs; and there is no need to worry about a steep market
loss during the contract period.
Annuity Tax Advantages
Annuities can be purchased
with non-qualified or tax-qualified funds. With Non-Qualified Annuities, the amount invested
comes from after-tax money; and only investment gains are taxed when money is withdrawn. With Qualified Annuities -- like traditional IRAs
-- the entire amount of money withdrawn is subject to taxation as the
investment was funded initially with pre-tax dollars.
Tax deferral inherent in
both Non-Qualified and Qualified Annuity products helps to accelerate asset
accumulation through “Triple-Compounding”, which includes earning interest on
the principal, interest on the interest, and interest on what would have been
paid to taxes.
Distributions from an Annuity
during the accumulation phase are taxed on what is known as a last in, first
out (LIFO) basis. This means withdrawals
from an Annuity are made on earnings (gains) first, and the owner is taxed at
regular income rates on the payments until all earnings have been distributed.
It should be noted that for
people under the age 59 ½, withdrawals from an Annuity may be assessed a 10%
penalty applicable to the taxable portion of the withdrawal.
Annuity Tax Advantages for Qualified Long
Term Care Expenses
Fixed Annuities also can be
purposed to protect against the high cost of Long-Term Care services. One well-known product is a “Hybrid”
Annuity/Long-Term Care Insurance policy, which can be funded with a single
premium that buys a base policy plus a continuation of benefits rider to pay Long-Term
Care expenses for additional time if the base funds are exhausted. Limited health underwriting applies, so
applicants who are not in good health may not be eligible to purchase a Hybrid
product.
With Hybrid Annuities,
distributions for Long-Term Care services are not subjected to a surrender
penalty and are income tax free. This
would not be the case if paying for these costs from IRA or 401(K) assets.
Non-Underwritten
Fixed Indexed Annuities with a “Boost” benefit for Long-Term Care
Insurance carriers also
have begun offering non-underwritten Fixed Indexed Annuities featuring a “Boost”
to income payout amounts when the annuitant cannot perform Activities of Daily
Living (ADLs) or has cognitive impairment.
Here is an example of one company’s product design:
- Wellness
Withdrawals can be triggered if you or your spouse cannot perform at least
two of six Activities of Daily Living.
These withdrawals serve to double your guaranteed monthly payout
and are available for up to five 5 consecutive policy years.
- Investment
performance with the Annuity can be tied to the Barclays Atlas global
diversified index, as well as S&P 500 (funds can be allocated in any
proportion between the two).
- Penalty-free
withdrawals can be taken for any reason up to 5% of the account value each
year beginning on the first policy anniversary.
Summary
All Fixed Annuities offer safety
of principal, tax-deferred growth, and innovative product designs not available
with most other investments. With Fixed
Indexed Annuities, investors can participate in the upside of equity markets while
avoiding the risk of losing invested principal.
