Tuesday, July 5, 2016
Saving For Retirement: What Do You Know About Annuities?
The money placed in an annuity will go directly to a beneficiary when you die. It is a trust of sorts. No need to go through probate, because it is handled like a life insurance policy. Wills are contestable, trusts are not. No attorney fees here. Just a check to your beneficiary.
The purpose of an annuity is to provide income that will outlive you. No one wants to be alive when their money runs out. Money placed in an annuity grows with interest that is tax deferred. So, this means that you do not have to pay taxes on the interest until you draw the money out of your annuity years later. At that point, you only pay taxes on the amount gained from interest, not the principal.
Since this is the case, generally speaking, you fund an annuity with money that you will not need to use for several years. Years ago, most all annuities were set up in a way that the money you placed in them was left there for at least 10 years. These days, there are annuities available for 1, 3, 5, 6, 7, 8, 10 years or more options.
Why the "years left in" requirement? The insurance company that holds your annuity will use the interest they make on your money to invest in stock accounts. In this way, they make money on your money. They need you to agree to leave your money in the annuity in order for them to make their money.
In exchange for using your money, they promise you a base interest rate that your money will make for you. So in effect, they are sharing with you the money they made off your money. As your money grows over time, your annuity gains value so that when you are ready to use your money, you will have more than you originally deposited.
There are basically 3 types of annuities: Traditional Fixed, Indexed and Variable annuities. Traditional Fixed annuities guarantee a fixed interest rate during the agreed upon term or years that your money remains in the annuity. Lately, that figure has been ranging from 2% to 3%. Compared to a traditional bank savings account with only .5% interest gain, this number may sound good to you.
An Indexed annuity interest rate is tied to the S&P 500. The interest rate may rise and fall according the changes in the financial world. Usually, however, there is a base guaranteed rate. There is a possibility for higher gain with this type, but there is also a possibility that your money may lose value if interest rates fall very low. This is also true with a Variable annuity.
Variable annuities may begin earning very high interest rates, such as 5%, 7% or even 9%. But if the market crashes, your money could lose value. Your money in these annuities is invested in the stock market, some in general accounts and some in more volatile accounts. The potential for higher gain is there, but the potential for loss is there too. Agents selling Variable annuities must possess a securities license as well as a life/health license.
If you have money that you can afford to lose, then Indexed or Variable annuities might be the way to make some higher amounts of money. If you are like most people that are saving for their retirement, money is precious and there is no desire to lose any of it. A Traditional Fixed annuity will likely be the better choice.
Let's say for example, that you had $20,000 to put into a fixed annuity. Let's say, you agreed to leave the money in the annuity for 7 years. Let's say that you were promised by the insurance company a 3% interest rate. The first year, your money would make $600. If your money was in a bank savings account, it would only have made $100 at .5% interest.
Also, you would have to pay income taxes on that $100 at the end of the year. Whereas, if your money is in an annuity, you would not have to pay any taxes on it until you draw the $600 out in 7 years. Now, in the second year that your money is in the annuity, $20,600 is now gaining 3% interest. So at the end of year 2, you now have gained $618, making a total of $21,218 in your annuity account.
At the end of year 2 in a bank savings account with .5% interest, you now only have $20,200.50. Now, with the end of year 3 upon you, your fixed annuity now has $22,266.54, but if your money had been in a bank savings account, you would only have had $20,301.50. I think you get the idea. There is a much greater rate of increase with annuities.
However, the downsides to an annuity is the lack of liquidity for most. This means that you must agree to leave your money in the annuity for the agreed upon time or else there is a penalty. Usually, the penalty ranges from 10% to 7%. That's a pretty big loss should you need to get your money out. So, it isn't recommended to put your money into an annuity unless you are pretty sure you won't need it for the specified time.
United American insurance company has an annuity available that is fully liquid or will not impose a penalty when you draw out your money. The interest rate at present is 3% with a 6 year term. AIG presently is offering 2%, but you can draw out 12% each year without a penalty. North American is offering 2.2% with a 10% penalty if you draw out more than the year's annual interest gained.
Let's say you put $200,000 into an annuity when you were 58 years old for a 7 year term with 2.45%. When you are 65 years old and ready to retire, you would have $236, 926.55. You basically made $36, 926.55 in those 7 years. That's pretty awesome! You would not have made a fraction of that amount in a bank savings account.
Now comes the point in time when you are ready to annuitize your money. At the end of the 7 years, you will receive a notice from the insurance company that you may annuitize your money or leave it in there if you wish. There will be a new interest rate at this point that they will offer you. You may choose to get your money in a lump sum or annuitize.
Annuitizing your money means that you will begin receiving monthly payment amounts until your money is all gone or you are dead. You choose how to annuitize your money. You can receive a set amount each month until its gone. Of course, now you begin to pay taxes each year on the interest portion of the amount that you are drawing out. But likely, you will be in a lower income tax bracket because you are retired.
If you die during this period, your beneficiary with receive the rest. You can alternatively choose to have a monthly amount paid to you as long as you live. If this is your choice, the insurance company will figure your life expectancy at this point and then divide those years into the money and promise to pay you until you die.
They are taking a risk here and so are you. If you live longer than your money, the insurance company continues to pay you until you die, even if your money runs out. If you die sooner, the insurance company keeps the rest. Maybe I've seen too many John Grisham movies, but this concept has always made me nervous.
There are a few different options at this point for annuitizing your money and your agent would likely discuss them with you before writing your policy and then go over them in detail when the time comes to annuitize. An annuity is a legal contract with an insurance company and there is a bit of paperwork involved: applications, disclosures, replacement statements, etc.
Only a licensed agent in your state can write such a policy for you. Be sure to check out your agent's qualifications, licensing, etc. and the insurance company's financial strength and ratings before entering into such a contact.
There are definite advantages and benefits to annuities. There is more money to be made in preparation for retirement, but the money needs to come from a place where it is not needed for daily living expenses or even needed for occasional rainy days or emergencies.
Suzanne Lender is a licensed insurance agent in the states of Tennessee, Arkansas and Florida.