Annuities come in two basic flavors. Everything else is just a variation of those two flavors. No, they are not vanilla or chocolate in flavor. Annuities are simply considered either immediate or deferred.
With an immediate annuity, the annuity buyer is expecting to receive an immediate income. An immediate annuity is the most basic vanilla type of annuity. You make one lump-sum contribution. It is converted into an ongoing, immediate guaranteed stream of monthly income for a specified period. Buyers can choose monthly, quarterly, or annual income.
Withdrawals may begin within a year. An immediate annuity is also known as a single-premium immediate annuity (SPIA) or an income annuity.
Think of an immediate annuity as a little like getting your weekly allowance or your monthly paycheck. Remember the good old days when your parents gave you a weekly allowance? I am hoping you were fortunate enough to get one! Then later, you started working and received a salary. In adulthood, until you turn sixty-five, you receive a steady paycheck every two weeks. In retirement, you know to expect to receive social security check. Social Security works very much like an immediate annuity. Immediate annuities provide a steady stream of income just like your allowance, paychecks, and Social Security checks.
However, your Social Security income likely needs to be supported by investment income from liquid investments. This is where an immediate annuity can come into play. What if you could receive a guaranteed amount of money every month (like your allowance) and know you had a predictable income to support you in retirement? People often buy immediate payment annuities to supplement their retirement income, such as Social Security, for the rest of their lives.
Downsides to immediate annuities.
So, what are the downsides to an immediate annuity? The annuity is a life-only income payment, meaning if the annuity recipient is alive, the income continues. The payments stop at death, even if the person dies one month after receiving their first payment. Most people reject that payment method because of their fear of loss. They do not want to risk losing their deposit upon their death.
Variations of immediate annuities.
But that is where the variations on immediate annuities come into play. An immediate annuity with survivor benefits can provide 25%, 50%, or even 100% at death to the survivor. Of course, there is a cost for this feature, but it provides for some certainty there is no loss of the initial investment. There are variations like a period certain annuity or an endowment refund annuity.
Another variation is the Delayed Income Annuity (DIA). The DIA pushes the first payment out several years.
Who would want a DIA? Perhaps someone sells their business at age 60, and the payment structure is over ten years. When this person is 70, their income stream from the sale of their business is gone. What if they purchased a DIA that would begin ten years later? Their first payments begin when the last proceeds from the sale of their business end. They now have an income that is guaranteed.
So, what is a deferred annuity? It is exactly what it sounds like. With a deferred annuity, the client defers making the ultimate decision on payouts until some later date. Once annuitized, it transforms the deferred annuity into an immediate annuity. You can choose to receive deferred annuity payments for a term, for example, 25 years. Alternatively, you can choose to receive payments until the end of your lifetime. The annuity company will tell you how much you would receive per month. That amount depends on the balance and the payment choice you select. Keep in mind that the longer you set up payments for, the lower your payments will be.
Deferred annuities, like immediate annuities, come with lots of extra choices. For example, there are fixed, indexed, and variable deferred annuities. The basic structures are the same, except for the investment part.
- A fixed annuity guarantees interest of a set amount for a predetermined time. Returns are tied to the interest rate performance of the insurance company’s general account.
- An indexed annuity is a fixed annuity. The interest rate is tied to the returns of a stock market index. For example, it is common to see indexed annuities tied to the S&P 500 Index or Nasdaq-100 Index.
- A variable annuity fluctuates with the returns on the underlying mutual funds in which it is invested.
There are several benefits to annuities. Some benefits are guarantees, safety, and predictable performance. Another advantage is that taxes on deferred annuities are only due upon the withdrawal of funds.
Tax advantages of annuities.
The immediate annuity has a tax advantage by virtue of the annuity exclusion ratio designed by the IRS. The exclusion ratio is the percentage of an investor’s return that is not subject to taxes. The exclusion ratio works this way. With each payment, one part is considered a return of principal. Another part is considered interest. Part of every payment an annuitant receives is regarded as a return of principal, which is not taxed. For example, perhaps 40% of the payment is excluded from consideration as income for tax purposes. This exclusion allows the client to spread out the burden of paying taxes over several years. The exclusion ratio applies to non-qualified annuities and not qualified.
The deferred annuity defers tax payments until money is redeemed from the annuity account. If the money stays in the annuity it is shielded from taxation. The deferred annuities have features where the client can withdraw a part of the annuity, usually up to 10%, which supplies liquidity and still shields the balance of money inside the annuity account. Monies that came out of a deferred annuity are currently considered to be interest and therefore taxed as ordinary income rates.
Annuities can provide some attractive yields. In an immediate annuity, the only meaningful way to calculate a yield is by determining how many years a client outlives their initial investment. If an individual has longevity on their side, an immediate annuity could provide some attractive long-term returns.
In the case of deferred annuities, companies can pay higher rates for your monies because there are significant penalties for early withdrawals. This allows the insurance company to plan on the funds being in their possession for a prolonged period. Therefore, they can attract more deposits by offering more attractive rates than alternative savings options like Certificates of Deposit(CDs).
Where can I find the experts on annuities?
How do you decide what annuities may be best for you and your clients? We can help identify the best type of annuity for your client. You can find out more about annuities and all their variations by calling EMG Insurance Brokerage. We know it is essential for advisors to access quality products, expert advice, and cost-effective solutions.
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Director of Annuities
EMG Insurance Brokerage