Babe Ruth was known for his talent in baseball but he was definitely not known for his prowess with regard to his money. In fact, his lavish lifestyle was the target of many critics. However, he did hit a financial ‘home run’ when the stock market crashed in 1929 because the majority of his cash was invested in annuities, which insulated him from the downturn of the stock market.
How is it possible that an investment tool can be tied to stocks, bonds and mutual funds, but be risk free? Before investing in annuities it’s important to understand the basics. Annuities generally have a fixed monthly premium that is paid in. After a certain period of time you will start to receive periodic (usually monthly) payments, and these payments can be set to continue for a certain period of years or for the remainder of your life or your spouse’s life. If you pass away early your assets will be paid out to your beneficiary.
Types of Annuities
There are two main types of annuities: immediate and deferred. Their names make them fairly self-explanatory. Immediate annuities begin making monthly payments to you when the initial investment is made. Deferred annuities are the most common type of annuity. Payments are made into the annuity for a period of accumulation and then at a designated time (usually retirement) payments begin to be paid out. There are a few variations of deferred annuities, below is a list of some of the most common.
- A fixed annuity earns a fixed rate that is set at the time the plan is initiated. The monthly payments that are paid into the annuity are also fixed. The accumulated funds are typically invested in government securities or high grade corporate bonds.
- A variable annuity grows in the same way that a mutual fund grows and can increase or decrease based on the ups and downs of the market.
- Equity indexed annuities are tied to a stock index (like the S&P 500 or Dow Jones). When the stock markets perform you will receive a portion of that gain and if the stock market goes down you will be insulated. The monthly premiums are fixed and can never change.
As the value of your annuity grows the amount is tax deferred. When you take your money out of the annuity you will be taxed on the earnings at ordinary income tax rates rather than capital gains rates. Ideally you will be taking the money out after retirement when you are in a lower tax bracket.
With most annuities there are surrender charges if you withdraw amounts early, or for more than the designated amount. The surrender periods are stipulated in the plan at the time that you initiate it. With most annuities the surrender period is 7 years and the charge usually decreases over the 7 year period. There are many plans that offer bonuses for longer surrender periods. Typically the bonuses are 3% - 5% for adding 1 to 3 years. There are Annuities without penalties which are sometimes referred to as having a level load. These annuities may allow you to withdraw interest earnings or up to 15% of the accumulated value. It’s important to note that any amounts withdrawn from an annuity may be subject to a 10% federal tax if you are under retirement age and ordinary income tax. In an attempt to lure customers away from their current annuity company many insurance companies offer bonus credits for switching to one of their products or performing a 1035 exchange.
Most annuities offer a death benefit where the beneficiary (usually a spouse) can receive either the accumulated value of the account or a continuation of the monthly payouts for the rest of their lives.
Fees and Charges
With annuities there are several fees and charges that you should be aware of. The fees that are charged include mortality and expense, underlying fund expenses, and administrative fees. These fees are charged on the accumulated value and ultimately decrease the value of the account. You can find a description of the charges in the prospectus for any variable annuity that you are considering.
Annuities offer an interesting way to combine tax advantages, death benefits, and retirement while mitigating the risks of down markets. Given the roller coaster that was witnessed in the stock market over the last few years this could be an attractive option for some people. There are some heavy fees, taxes, and charges associated with early withdrawal so an annuity is a great long term investment strategy. Because of the tax deferral benefits Annuities are a great option for individuals that have maxed out the contributions to their IRA or 401(k). As always, consult a professional before investing in annuities.