Most people think annuities are simple: you hand over a lump sum payment, agree to wait a certain amount of time, and then you start receiving monthly checks. But annuities are complex investments that come in many different packages. They can offer tremendous benefits if set up correctly and provide a steady stream of income during retirement.
If you are thinking about an annuity, here are 10 things to know before you buy.
1. Deferred Annuities Offer Tax-Advantaged Savings For Retirement
A deferred annuity has two parts: the accumulation phase and the payout phase. In the accumulation phase, your money sits and grows over time, building up the value the longer you wait. You are in control of when you decide to start drawing income from the annuity. Therefore, you are also in control of when you will start paying taxes. During the payout phase, you will likely be in a lower tax bracket than during your working years, allowing you to keep a larger portion of your income.
2. There Are Ways to Reduce The Taxes You Pay
One of the potential drawbacks of a deferred annuity has to do with the way you withdraw money and the taxes owed on the payments you receive. Essentially, you are receiving earned interest first, which is taxable, before being paid back your principal, which is tax-free. A way around this is to convert a deferred annuity into an immediate deferred income or immediate income annuity. With these types of annuities, the monthly payment you receive is a mix of principal and interest, so only a portion of the payment is taxable.
3. You Can Switch Out Of One Annuity And Into Another
If you decide that your current annuity no longer fits your needs, under most circumstances you can switch into a different annuity without any tax consequences as a “1035 exchange.” For example, if you invested in one type of annuity in your 40’s or 50’s and now find that in your retirement years you prefer a fixed-rate annuity, you can make the switch, and as long as you had your original annuity long enough, there would be no surrender fees.
4. A Life Insurance Policy Can Be Swapped For An Annuity
If you have a cash-value life insurance policy that is no longer needed, you can use a “1035 exchange” to switch the life insurance policy into an annuity tax-free. As an example, if you convert a life-insurance policy into an income annuity, your policies’ cash value immediately becomes a stream of income when converted. And by converting to an annuity, you decide how long you want to receive that income by setting the terms of the annuity.
5. Red Flag: Fixed Index Annuities Have Some Drawbacks
The allure of a fixed index annuity is strong. You get to participate in the gains from a rising stock market without any worries of losing money in down markets. But the upside gains are capped, and depending on those caps, you may be losing a considerable amount. For example, a fixed index annuity may have a 6% cap rate. If the index gains 5% in a year, you may get all 5% credited to your account. But if the index gains considerably more, like 10%, you would only get 6% since your gain is capped. The annuity could also carry a participation rate, meaning you’ll get even less of the actual index gain. Be sure to read the fine print and shop for the best deal.
Come back to The Capitalist tomorrow for part 2 of the list.