In our last blog Annuities Part 1, we took a look at the main types of annuities. In part 2 we are going to look more closely at what each of these annuities do, and what role they play in one’s finances.
Before we begin, an important distinction must be made, and that is the relationship between the owner and annuitant. The owner is the person who arranges and pays for the annuity while the annuitant is the person whose health and life expectancy the annuity is based on. While often times the owner and annuitant are usually the same person, there are situations where they are not. For the scope of this blog we will assume that the annuitant and the owner are the same person. It is important to note that most withdrawals before age 59-1/2 result in a 10% penalty as well as income tax on interest earnings.
In our last blog we listed the 8 main types of annuities:
- Single Premium Immediate Annuity (SPIA’S)
- Delayed Income Annuity (DIA)
- Qualified Longevity Annuity (QLAC)
- Fixed Annuity (FA)
- Fixed Index Annuity (FIA)
- Structured Annuity
- Variable Annuity (VA); and
- Equity Indexed Annuity (EIA).
- Single Premium Annuities (SPIA’s)
- What they do: With SPIA’S the owner pays an insurance company a single payment in return for a guaranteed stream of income for life or for a guaranteed length of time or both. The income payments vary in amount depending on the features selected. Whether paid annually, semi-annually, or monthly the annuitant receives an income stream in return. Part of the income is a return of premium and the other part is interest earnings. The interest earnings are considered income to the owner and therefore taxed as income.
- Delayed Income Annuities (DIA’s)
- What they do: DIA’s are the same as SPIA’s except income payments are delayed resulting in higher income payments. Generally speaking, the longer the time is delayed the higher the income payments.
- Qualified Longevity Annuity Contracts (QLAC’s)
- What they do: QLAC’s are more complex in that they deal with a person’s retirement money and the suspension of the Required Minimum Distribution (RMDs). RMD’s generally mandate you begin taking distributions from retirement accounts at age 70-1/2. It is a government rule. In the case of QLAC’s a portion of the RMD can be delayed to age 85 with the goal of reducing taxable income.
- Fixed Annuities (FA’s)
- What they do: Fixed annuities are similar to Certificate of Deposits (CDs) in that they pay a stated interest rate. They differ in that fixed annuities are not taxed every year on interest earnings. CDs’ interest earnings are taxed every year. Early withdrawals can result in paying a penalty (fixed annuities) or surrendering interest earnings (CDs).
- Fixed Index Annuity (FIA)
- What they do: Fixed Index Annuity (FIA) is an insurance contract purchased for safety of principal with greater potential interest earnings than a CD or fixed annuity. The money is typically divided between several indexes. The most common being the S&P 500 index. While the money is not invested into the stock market it does however track the stock market to determine, up to a limit the amount interest that will be credited to the account. Each year the insurance company will look at where the index started and where it ended. Typically, if the index ends higher the owner is credited interest on the amount of increase. If, however the index ends lower the owner will not be credited interest but they will not incur a loss nor a gain.
- Who they are for: Are primarily for those who seek safety of principal and higher potential interest earnings than compared with CDs and Fixed Annuities.
- Structured Annuity
- What they do: Structured Annuities fall within the legal industry. Created by a court order to spend down a settlement amount for the victim’s benefit. Designed to ensure the money is not misspent and/or to ensure guaranteed income. They typically use immediate annuities for this purpose.
- Variable Annuity (VA); and
- What they do: Variable Annuity is an investment contract with an Insurance Company. The money is not invested with the insurance company. It is why the owner of the variable annuity contract assumes the investment risk. The money is typically invested into several subaccounts. Subaccounts are like buckets where money is divided into. Those subaccounts are investments comprising mutual funds or exchange traded-funds (ETFs). Usually there are twenty plus subaccounts for an owner to invest into. From conservative to aggressive investments all dependent upon the owner’s risk tolerance. Because Variable annuities are issued by insurance companies, there are different forms of insurance the owner can attach to the variable annuity, called riders. One such example is the ‘Guaranteed Minimum Death Benefit’. This rider states that if the owner were to die and the account value is lower than the premium payment minus withdrawals (net premiums) the beneficiaries will receive no less than the net premium. Effectively recovering the owner’s net investment even if the account value is lower. As long as the account value has at least one dollar left in it. For simplicity’s sake I will end here but there are numerous forms of insurance that can be attached to a variable annuity contract.
- Who they are for: Those who seek tax deferral. Money grows tax-free. No income taxes are paid on earnings until money is withdrawn from the contract. Those who seek to outpace inflation. Those who want to invest and receive guarantees on their money at the same time.
- Equity Indexed Annuity (EIA)
- What they do: EIA’s are like index annuities except the owner actually invests money into a stock index. Equity index annuity’s most common stock index is the S&P 500. Where they differ is that the account is subject to losses. They offer the owner the potential of a higher rate of return than an index annuity while providing a measure of protection from decreases in the stock index chosen. The insurance company may offer to absorb the first 10% or 25% of losses with the owner absorbing the rest thereafter. Another way this is done is the insurance company will wait until the owner has absorbed the first 10% of losses with the insurance company absorbing the rest.
- Who they are for: They are for those who want a higher rate of return than an index annuity and are also willing to expose themselves to potential investment losses.
Certificates of deposits (CDs) typically offer a fixed rate of return if held to maturity, are generally insured by the FDIC or another government agency, and may impose a penalty for early withdrawal.
Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Guarantees are based on the claims-paying ability of the issuer. Withdrawals made prior to age 59½ are subject to a 10-percent IRS penalty tax, and surrender charges may apply. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. The investment returns and principal value of the available subaccount portfolios will fluctuate, so the value of an investor’s unit, when redeemed, may be worth more or less than the original value. Optional features available may involve additional fees.
Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest