Annuities and IRAs

Annuities have been in existence for well over two hundred years.  Annuities allow you to accumulate tax-deferred funds for retirement and receive a guaranteed income, if you desire, for life or a specified period of time.  There are several different types of annuities: IRA, Roth IRA, Education IRA and traditional annuities.

While annuities are similar to CDs offered by banks they have three primary advantages: tax deferral, avoidance of probate, and a guaranteed income (optional) for a fixed period of time or income for life. Below are reasons to invest in annuities:

  • You need tax-deferred growth.
  • You need your principal and interest guaranteed – less risk than the stock market.
  • You need to safely create wealth for your heirs.
  • You need your heirs to avoid probate upon your death.
  • You need an increased death benefit.
  • You need stock market linked gains without the downside risk.
  • You have money designated for inheritance.
  • You do not need more than 10% of the principal liquid annually.

There are many features with annuities. They can be classified by:

  • Nature of the underlying investment – fixed interest or variable and equity-indexed
  • Primary purpose – accumulation or pay out (deferred or immediate cash flow)
  • Nature of payout commitment – fixed period, fixed amount, or lifetime
  • Tax status – qualified (IRA type) or non-qualified
  • Premium payment arrangement – single premium or flexible premium

Individual Retirement Annuities or IRA’s are popular and include options for tax-deductible investment and tax-deferred interest.  You invest money in an IRA, up to the amounts allowable under the tax law. These investments are termed “contributions.” In many instances, an income tax deduction is available for the tax year for which the funds are contributed. The contributions, as well as the earnings and gains from these contributions, accumulate tax-free until you withdraw the money from the account. You therefore enjoy the ability to generate additional earnings, unreduced by taxes on these earnings, each year the funds remain within the IRA.

The withdrawals of the funds from the IRA are termed “distributions.” Distributions are subject to income taxation in the year in which you receive them.  There is a tax penalty for withdrawing your IRA funds prior to an assumed retirement age of 59 1/2. This tax penalty is 10 % of the distributions received by you before age 59 1/2, unless certain exceptions apply.  When IRA’s were established, the assumption was that your income tax bracket would be lower after retirement than while working.  As we become a wealthier society, this often is not the case.  Therefore, the Roth IRA was established as an alternative.

The Roth IRA has been in existence since 1998.  The Roth IRA provides no deduction for contributions, but instead provides a benefit that is not available for any other form of retirement savings: if you meet certain requirements, all earnings are tax-free when you or your beneficiary makes withdrawals. Other benefits include avoiding the early distribution penalty on certain withdrawals, and eliminating the need to take minimum distributions after age 70½. This means your earnings can continue to grow tax-free. The chief advantage of the Roth IRA is obvious: the ability to have investment earnings completely escape taxation. The advantage comes at a price, though: you do not get a deduction when you contribute to the Roth IRA.

An education IRA, allows a contribution of $500 annually.  The money grows tax-free and has preferential tax treatment upon distribution to the beneficiary who uses it for authorized education expenses. These plans are very restrictive on who can contribute to them, the amount of total contributions allowable each year, and the limitations on what exact education expenses qualify.

Traditional annuities are savings vehicles similar to CD’s, but the investment income is not taxable until you withdraw money. This tax deferral is also true of IRAs; however, unlike these products, there are no limits on the amount of principal you can put into an annuity. Moreover, the minimum withdrawal requirements for annuities are much more liberal than they are for IRAs.  You can own an annuity as an investment whether or not you participate in an employer’s retirement plan.

Fixed annuities guarantee a minimum interest rate and a minimum benefit.  The focus of a fixed investment is on safety of the principal and stable investment returns.  Fixed rate annuities are most similar to a bank CD, but typically pay a higher minimum interest rate and offer greater security.  You receive the interest return whether the market is up or down.  These are a secure and safe, no-risk investment, which makes them poplar.

Equity Indexed Annuities guarantee an annual minimum interest rate (typically 3%) or the turn from a stock market index, such as Standard and Poor’s 500, reduced by certain expenses.  If the index rises enough during the year, a greater return than the minimum is credit to the contract owners’ annuity account for that period.  If the stock market index does not rise sufficiently or even declines the lower minimum rate is credited.  This vehicle provides the benefit of a higher return in a strong economy with the security of a guaranteed minimum.  These products often offer a bonus of 5-10% the year you invest with a minimum contribution of $50,000 or more.

Annuities have your choice of payout, immediate or deferred.  Immediate annuities allow you to convert a lump sum of money into an annuity so that you can immediately receive income. Payments generally start about a month after you purchase the annuity. This type of annuity offers financial security in the form of income payments for the rest of your life. In other words, you cannot outlive it.  You pay taxes only on the portion of your immediate annuity payments that is considered earnings. You are not taxed on the portion that is principal. The principal is the initial deposit made with funds that have already been taxed.

Deferred annuities are good for long-term retirement planning because income taxes are deferred until you withdraw money, unlike a 401(k) or an IRA, there are no limits on your annual annuity contributions, and there is a death benefit. If you die before collecting on the annuity, your heirs get the amount you contributed, plus investment earnings, minus whatever cash withdrawals you made. Like immediate annuities, deferred annuities can be fixed or variable.

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