The Firm Update – Annuities

In the previous blog post, Charley addresses how a cash flow analysis is implemented within our Dynamic Wealth Design. There are many investment vehicles that may assist with accomplishing one’s retirement goals.  Here, we will review annuities.

An annuity is a contractual agreement between an individual and an insurance company. Individuals transfer money to an insurance company for the opportunity for an income stream in the future, this stream of payments may be for a specified period of time or the remainder of the annuitant’s life. This article will address some of the basics of annuities and how they may be the right fit for an investor’s financial needs.

Annuity contracts have two phases, the accumulation phase, and the distribution phase. During the accumulation phase, investors fund an annuity contract either in a lump-sum payment or through periodic premiums. These assets grow tax deferred and no taxes are due on any growth or interest within the account until distributed. When investors begin to withdraw assets from an annuity this is known as the distribution phase.

When beginning distributions, annuities have two options for the onset of payments, immediate or deferred. An investor may decide they would like to receive payments immediately and will exchange a lump sum of money for payments that begin right away.  This is referred to as an immediate annuity. Investors may also decide to defer payments to a date further down the road, this is referred to as a deferred annuity. Once distributions begin interest and, or growth within the contract are taxed as ordinary income. Annuity products can be especially favorable for retirement savings as they grow without the burden of annual taxes on growth.

For tax purposes, annuities are treated similarly to an IRA, and withdrawals from an annuity before the age of 59.5 would incur a 10% penalty. Annuities may be funded with pre-tax or after-tax dollars. Those funded with pre-tax dollars are referred to as qualified annuities and those funded with after-tax dollars are referred to as non-qualified annuities. Unlike many after-tax accounts, non-qualified annuity accounts grow tax deferred and any potential growth within the contract will be taxed as ordinary income when distributed. Investors will always receive their original non-qualified investment, or cost basis, back tax-free. Different than many other after-tax accounts, such as a brokerage account, these do not receive a step up in cost basis at the death of the owner.

There are a few types of annuities available to investors and each have different risk levels and investment options. These options include fixed, variable and indexed annuities.

  • Fixed annuities – protect one’s initial investment and will pay a fixed rate of return over the term of the contract.
  • Variable annuities – offer investors underlying investments from which they can choose. These products have the highest upside potential but also may lose value if the underlying investments do not perform well. Variable annuities carry “market risk” and the value of the contract may be higher or lower depending on the performance of the underlying investments.
  • Indexed annuities – are a hybrid of fixed and variable annuities with characteristics of both. They protect the initial investment and offer the opportunity to participate in the potential growth of an underlying index, such as the S&P 500.

There are also different term lengths available for annuity contacts; these may range from one to ten years or more. The selected term period is referred to as the “surrender period”. During the surrender period, there is a surrender charge if the investor decides to take their full investment out of the contract. However, it is common for insurance companies to allow a 10% distribution of the contract value each year with no surrender penalty. After the surrender period the contract holder/investor may:

  • Annuitize the contract and receive payments for a fixed period of time or the rest of their life
  • Transfer it into another more competitive annuity product (or IRA account if funded with pre-tax dollars)
  • Leave it within the contract

Annuities are not suitable for all investors and should be thoroughly evaluated with a financial professional. Annuities address longevity risk for investors, or the possibility of outliving their savings. They can be powerful tools for retirees if utilized correctly.  Invested assets in annuities are illiquid and subject to penalties, they are not typically recommended for those younger clients with liquidity needs. If you have any questions about your current annuity or would like to explore the possibility of incorporating one within your financial plan, please reach out, the Normandy team would be happy to assist.

As always, thank you for your continued confidence and trust.  We are here to be of service.

Best regards,

Derek Landis, CFP®


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Derek Landis