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THE BASICS OF MONEY MANAGEMENT SOURCE
Confused About Annuities?
You're not alone. Many people have difficulty understanding them.
The main reason for all the confusion: Annuities may be single or
flexible-payment; fixed or variable; deferred or immediate. No matter
the type, annuities are financial contracts with an insurance company
that are designed to be a source of retirement income. This pamphlet
will help you decide if an annuity is right for you and help you to
choose the type of annuity that best meets your needs.
You can purchase an annuity in two ways:
Make one lump-sum payment to purchase a single-premium
annuity. If you want to contribute more money at a later
date, you will have to purchase another annuity.
Make ongoing contributions to a flexible-payment annuity.
You can contribute money at regular or even irregular intervals
anytime you want.
Fixed vs. Variable
There are two basic types of annuities you can buy-fixed and
Fixed annuities earn a guaranteed rate of interest for a specific
time period, such as one, three or five years. Once the guarantee period
is over, a new interest rate is set for the next period. This guarantee
of both interest and principal makes fixed annuities somewhat similar to
Certificates of Deposit (CDs) purchased from a bank. Unlike a typical
CD, however, an annuity is not backed by the Federal Deposit Insurance
Corporation (FDIC); its security is directly related to the financial
health of the insurance company that issues the annuity.
Variable annuities typically offer a range of investment or funding
options. These funding options may include stocks, bonds and money
market instruments. The return on variable annuities can go up or down.
Your principal and the return you earn are not guaranteed; they depend
on the performance of the underlying investment options. If the funding
options you choose for your annuity perform well, they may exceed the
inflation rate or fixed annuity returns. If they don't, you may lose not
only prior earnings, but even some of your principal.
Some variable annuities offer, in addition to a range of investment
options, a fixed account option that guarantees both principal and
interest, much like a fixed annuity. This gives you the option of
dividing your money between the low-risk fixed option and higher-risk
vehicles such as stocks, all under the umbrella of just one annuity.
Many variable annuities offer asset allocation programs to help you
decide where to invest your assets based on your circumstances.
Variable annuities also allow you to transfer money from one account
to another without triggering a taxable event. In other words, if you
transfer money to a different funding option within your variable
annuity, you will not have to pay taxes on any earnings you have made.
Tax-free switching lets you re-allocate money to suit changing market
conditions, without worrying about the taxes.
Fixed and Variable
Variable annuities usually have more features and higher fees than
fixed annuities. With some fixed annuities, contract expenses – such
as maintenance and contract fees – are taken into consideration when
the company declares periodic interest rates or determines the payment
amount. Surrender changes may also apply.
Variable annuity fees are more complicated. They may include an
annual contract charge that covers administrative expenses and surrender
fees, as well as a mortality and expense risk charge. Variable annuities
charge this latter fee to guarantee the death benefit, the availability
of payout options and the level of expenses.
In addition, a variable annuity has fees for the management and
operating expenses of the funding options in which your money is
invested. These charges pay for everything from the fund manager's
salary to the costs of printing the fund prospectus.
For a variable annuity, all important information will be explained
in the prospectus that describes the variable annuity contract. The
prospectus must be given to you when you are considering the purchase of
a contract with after-tax dollars. Read it carefully before you invest
or send money and be sure you understand exactly what your expenses will
Deferred vs. Immediate
While you can put money into a deferred annuity with a single
payment or flexible payments, immediate annuities are usually purchased
with a single payment. When you receive payments also differs. Just as
the names imply, you get money earlier from an immediate annuity and you
delay getting money from a deferred annuity.
This easy quiz will help you determine whether you should consider
an immediate or a deferred annuity. Answer the following statements:
1. Saving for retirement is one of my main goals.
2. I do not want to touch my principal or interest until I
am at least 59˝ years old.
3. I contribute the maximum deductible amount to my IRA,
401(k) or 403(b).
4. I need an investment that will earn tax-deferred interest
for many years.
5. I am retired or very near retirement now.
6. I have a lump sum of money and I want to begin drawing an
income from it.
7. I want immediate return from my investment.
8. I want to receive a steady monthly check for the rest of
If you answered yes to questions 1 through 4, a deferred annuity may
be appropriate for you. If you answered yes to questions 5 through 8,
you're more likely to need an immediate annuity. A financial advisor or
qualified insurance agent can help you decide if an annuity is the right
retirement savings vehicle for you.
Deferred annuities can be a great way to accumulate money for
retirement, if you want retirement income beyond what you will receive
from Social Security or your pension plan. They are particularly
effective if you have many years before retirement. Your money grows tax
deferred, which means you pay no taxes on earnings until you begin to
withdraw your money.*
*Note: Unlike a nonqualified
deferred annuity purchased with after-tax-dollars, an IRA receives tax
deferral under the provisions of the Internal Revenue Code. Therefore,
there is no additional tax benefit in purchasing a deferred annuity.
If the tax-deferred aspect of a deferred annuity is important to
you, make sure the expenses do not outweigh the tax benefits. This can
be a tough judgment call, but a good guideline is that if the expense
charges are more than 1.5% greater than a comparable financial vehicle
and your time horizon is less than 10 years, a deferred annuity may not
be the option for you. Consult a tax advisor for assistance in making
A deferred annuity is not a vehicle for money you may need for
current expenses. If you withdraw income before age 59˝, the IRS will
usually apply a 10% penalty in addition to ordinary income tax, similar
to the penalty for early IRA withdrawals. What's more, your insurer may
impose its own early withdrawal penalty, also known as surrender fees,
if you cash in your deferred annuity within a specified period. These
fees, similar to withdrawal penalties on a CD, usually cease seven years
after your date of purchase. Often there is a separate surrender fee for
each payment. So, a new payment may have a 7% fee if you take the new
payment out right away, while a 10-year-old payment may have no
surrender fee. The fee will usually decrease and be eliminated over
time. Keep in mind, however, you can often withdraw small amounts (e.g.,
10%) annually without any penalty from your insurer, but the IRS penalty
may still apply. The IRS views all withdrawals as income, which are
taxable, until all income has been paid out.
If you switch annuities, you may also incur withdrawal charges from
your current annuity. If a salesperson advises you to change annuities
despite the fact that you will be penalized, make sure you know the
reason. Do the benefits of the new annuity – such as a higher interest
rate, better investment choices or greater flexibility – offset the
withdrawal charges? Be sure the salesperson isn't benefiting from the
switch at your expense. If you decide to exchange one annuity for
another, be sure to request and complete the appropriate forms provided
by your insurance company to ensure that the transaction will be treated
as a tax-free exchange under the federal income tax law (Section 1035 of
the Internal Revenue Code).
Withdrawing Money from a Deferred Annuity
When you're ready to start withdrawing money from your deferred
annuity, you will need to choose how to receive your money. You can take
it all out in a lump sum, take it as needed, or receive it in a steady
stream of periodic payments – so-called "annuitizing." If
you annuitize, you can receive a stream of income that is guaranteed to
continue for the rest of your life, no matter how long you live. And,
the tax liability can be spread out for the rest of your life too. Some
of the earnings are included in each payment and are taxable, meanwhile,
any earnings continue to accumulate tax-deferred on the remaining
principal and earnings that have not yet been distributed. So, receiving
distributions as periodic payments after retirement may further reduce
your income tax liability, if you are in a lower tax bracket. Some
annuities also provide you with an option to have a set amount,
determined by you, automatically withdrawn and deposited directly in
your bank account during a regularly scheduled period, such as monthly.
You have many options on how you receive your money, each with its own
tax ramifications. Consult your tax or financial advisor to tailor a
plan for your particular needs.
Why Buy a Deferred
There are a number of good reasons to consider a deferred annuity as
part of your financial retirement plan:
You postpone paying income taxes on any earnings until you
withdraw money, typically during retirement, when you may be in a
lower tax bracket. All earnings grow tax-deferred.
You can put in as much money as you want. Unlike
Individual Retirement Accounts (IRAs), there is no IRS restriction
on the amount that can be contributed annually to deferred annuities
with your after-tax money. You can, however, use a deferred
annuity to fund your traditional or Roth IRA, in which case you
would operate within IRA limitations.
You can provide death benefits to your heirs. If you die
prematurely, your annuity can offer a death benefit to your
beneficiaries without the costs and delays of probate. Your
beneficiaries will never receive less than what you have contributed
(less any withdrawals). In addition, a spouse who inherits an annuity
before distribution has begun can step in as the new owner of the
annuity and the tax deferral continues until amounts are withdrawn. If
distribution payments had begun, the benefits would generally have to be
distributed to the beneficiary at least as rapidly as through the method
in effect at the time of the annuitant's death. Taxation will continue
to apply to those proceeds. Generally, a beneficiary who inherits an
annuity before distribution begins can request a lump sum distribution
without penalty but will be subject to full taxation on the accrued
interest or gain on the contract.
Immediate annuities can provide dependable financial security: a
stream of income payments guaranteed to continue for the rest of your
life or for a period you select. If you are about to retire, an
immediate annuity may be a good place to put a large lump sum of money
accumulated for retirement through another savings or investment
vehicle. You also can convert your deferred annuity into an immediate
annuity to start receiving income.
To purchase an immediate annuity, you make a one-time payment, and
distributions typically begin within a month. Immediate annuities can be
fixed or variable, just like deferred annuities. The income payments you
receive from fixed immediate annuities are based on the amount you
contribute, your age and the interest rate environment at the time of
purchase. The payments to you will not change. The payments from
variable immediate annuities fluctuate based on the performance of the
investment options you choose. Although payments may go up or down,
variable annuities are designed to provide income that can rise over
time to help you keep pace with inflation.
The principal in an immediate annuity is not readily accessible. If
you need more money than the income provided by the immediate annuity,
you can minimize this drawback by keeping some of your retirement funds
in a liquid account, such as a savings account or money market fund.
There also is a chance you may lose some of your principal. If you
choose an income for life option with no refund guarantee, and you
should die before your principal is all paid out, the balance of your
principal and any earnings will go to the insurance company rather than
to your heirs. Fortunately, annuities offer several guaranteed payout
options. For more information see Options with Guarantees.
When selecting the investment options for your immediate annuity,
keep inflation in mind. You want investments that will keep pace with
inflation. Variable annuities can let you participate in stock market
growth, historically shown to be one of the best ways to combat
inflation over the long term. However, the downside is that payments can
drop if the market drops. Not only is this unnerving, but obviously it
will make it harder for you to budget. If you still want the potential
for higher payments, consider dividing your retirement savings between
fixed and variable options to provide fixed payments, as well as growth
Why Buy an Immediate
Among the reasons to consider an immediate annuity are the
An immediate annuity is a financial vehicle that can
provide guaranteed income for life.
The income payments you receive can supplement your other
income sources, such as Social Security and pension payments, which
may not provide enough income by themselves.
You choose how often to receive your income payments.
Whether monthly, quarterly, semi-annually or annually, there's a
payout plan to fit your particular needs.
You pay income taxes only as you receive your payments.
When you receive income payments, you will be taxed on the portion
of the payments that is earnings. The portion that is principal,
which represents your initial deposit made with money that had
already been taxed, is not taxable.
You may lessen your financial worries. Financial
management can be a burden in your retirement years. Because you
don't know how long you'll live, it's hard to be sure your resources
will last as long as you need them. If you withdraw too much of your
nest egg, your future income can suffer or you may run out of money
entirely. If you are too thrifty when it comes to spending your nest
egg, your level of living may suffer. Immediate annuities can remove
some of these burdens by providing you with a predictable fixed
payment for life, so you can concentrate on enjoying your
You can choose from a number of options for receiving income from an
Lifetime Income for You. You can opt for income, guaranteed
by the insurance company, for the rest of your life. Payments cease upon
Lifetime Income with a Guaranteed Period. You will receive
income for life. If you die before the guarantee period is over, your
beneficiaries will receive the remaining number of payments.
Lifetime Income for Two. You can opt for income guaranteed
for the rest of your life and the life of another person, such as your
spouse. Guaranteed income for two people is known as a joint and
survivor option, which guarantees that income payments will continue for
the life of the primary owner and a second person. The guarantee is made
by the insurance company issuing the annuity.
There are many other options which can be explained to you by a
financial advisor or insurance representative. These options can usually
be mixed and matched to provide an ideal income plan for your needs. For
example, say you and your spouse retire at age 65 with 10 years left on
your mortgage. You could choose the option to have income for two people
with a 10-year guaranteed period, so that if you both die before the
guarantee expires, the payments would continue until the end of the
10-year period to pay the mortgage for your heirs.
Before You Buy an Annuity
Consider the Following:
The money contributed to an annuity may be in post-tax dollars. When
you contribute after-tax savings to an annuity, you can put in as much
money as you like. Before you put after-tax savings into an annuity, it
may be advisable for you to put the maximum pre-tax amount into a
retirement plan such as your IRA, SEP, 401(k) or 403(b). Also note that
annuities may fund an IRA, SEP, 401(k), 403(b). When an annuity is used
to fund these vehicles there are contribution limits that apply, and
federal tax laws generally require that you begin taking minimum
distributions by April 1 of the calendar year following the year in
which you reach age 70˝. Failure to do so will result in a tax penalty
of 50% of the amount of the shortfall. Additionally, once money is in
your 401(k) or 403(b) plan, you generally cannot make withdrawals before
age 59˝ except for special circumstances, such as severance from
employment, death or disability. If you meet an exception, withdrawals
are generally subject to a 20% federal income tax withholding in
addition to regular income tax and a 10% early withdrawal penalty for
Expenses can vary. Make sure that the annuity contracts you consider
have competitive fees. Independent rating services such as Morningstar
both publish reports that compare variable annuity fees. Your local
library may have copies. While cheaper doesn't necessarily mean better,
if a contract is too expensive it could offset gains from the
All earnings from annuities are taxed as ordinary income.* If your
ordinary income rate at retirement is higher than the current capital
gains rate for other investments, you would actually pay higher taxes.
You do, however, have a tax deferral on any earnings. With some other
investments, you could be subject to ordinary income as well as capital
gains taxes annually, even if you have not cashed in the investment,
which can reduce the value of your earnings.
* Tax regulations are subject to change.
Some Questions to Ask
If you've decided that an annuity makes sense for you, here are a
few key questions to ask yourself before signing up:
1. Have you done some comparison shopping and considered all
of your options? Because annuities are long-term savings
vehicles, you'll want to make sure the company you pick will be around
at least as long as you will. And, as you learned in the previous
discussion, different annuities offer a wide range of choices, prices,
features and flexibility.
2. Does the rate on a fixed annuity look too good to be true? You
want a competitive interest rate at renewal time. If the company is
offering bonus rates (a higher interest rate for a set period of time)
make sure the underlying interest rate and the company selling the
annuity are financially viable. Once the bonus rate term expires, there
is no guarantee going forward that renewal rates will be competitive. Be
especially careful if you are exchanging annuities.
3. What are the annuity's surrender fees and how long are they
in place? If the surrender fee is high (typical fees are around
6-7% and decline over a period of approximately five-to-seven years),
you could feel locked into a contract from which it will be costly to
4. What is the track record of the funding options offered in
a variable annuity? Don't be swayed by last month's top
performer. Look for strong returns over a three-to-five-year period or
more. Newspapers such as Barron's
and the Wall
Street Journal – available in your local public library - publish
rankings of various funding options on a regular basis. The history of
various funding options also can be found in Morningstar
publications, available in larger libraries. Remember, past performance
is not a guarantee of future results.
5. Does a variable annuity offer multiple funding options in
case you change your investment strategy a few years down the road? Look
for a range of funds to diversify your retirement savings as your needs
6. Will your ordinary income tax rate be greater than the
current capital gains rate when you begin to take distributions
(possibly at retirement)? If so, you may pay more in taxes by
choosing annuities over another investment that would be taxed at the
capital gains rate. Keep in mind, however, that your money in an annuity
is accumulating on a tax-deferred basis. By selecting an annuity, you
avoid paying yearly ordinary income tax on the earnings while your money
compounds and grows.
7. What is the insurance company's rating? While
anyone who is properly licensed to sell insurance products (e.g., banks,
brokers, agents) can sell annuities, the annuity contract is issued by
an insurance company. So, you'll want to consider the company's rating.
Is it financially secure, with a good claims paying record? While this
is most important for fixed annuities, it is relevant to any guarantees
(e.g., death benefit) in a variable annuity as well. Checking up on an
insurance company is easy at your local library, or you can contact your
state's Department of Insurance. A.M.
& Poor's and Moody's
all rate the financial stability of insurance company general accounts. Morningstar
evaluate and report information on variable contracts only. Variable
annuities are rated by independent sources such as Lipper
Analytical Services, VARDs
It's a good idea to choose an annuity from a company that gets high
marks from at least two independent rating sources.
Getting Started in Annuities
Gordon Williamson, John Wiley & Sons $19.95
Creating Retirement Income
Virginia B. Morris, Lightbulb Press Inc. and the National Association
for Variable Annuities $14.95
Pamphlets from the Federal Government
The quarterly Consumer Information Center Catalog lists more than
200 helpful federal publications. For your free copy write Consumer
Information Catalog, Pueblo, CO 81009, call 1-888/8-PUEBLO, or find the
catalog on the Net (http://www.pueblo.gsa.gov).
Related Life Advice® pamphlets
See other Life Advice® pamphlets on related topics: Building
Financial Freedom, Choosing a Bank, Choosing a Financial Advisor,
Financial Planning for College, Inheritance, Investing for the First
Time, Mutual Funds and Planning for Retirement. To order up to three
free pamphlets at a time, call 1-800-Met-Life, that’s 1-800-638-5433.
Life Office Management Association (LOMA)
2300 Windy Ridge Parkway
Atlanta, GA 30339
National Association for Variable Annuities (NAVA)
11710 Plaza America Drive
Reston, VA 20190
The National Insurance Consumer Helpline can answer questions
about annuities at 1-800-942-4242. The helpline also will send you a
free booklet called A Consumer's Guide to Annuities, which lists basic
terminology and outlines the difference between types of annuities.
If you're on the Net, check us out. We're part of MetLife Online. (http://www.metlife.com).
Here are books which are available directly from Amazon.com
that may be of interest to you. Click on the title to go directly to Amazon
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