By Richard A. McGrath, CIC, LIA
Are you confident that your retirement savings will last for the remainder of your lifetime?
In the past, “defined benefit” pension plans provided income to recipients for as long as they lived. Combined with Social Security income and personal savings, it was usually more than enough to live on.
As people began to live longer, though, defined benefit plans became too expensive to maintain. Instead of retiring at age 65 and living to 70 or so, people began living to 80, 90 or even longer.
Employers could not afford to provide for 20 years of retirement, so most shifted to “defined contribution” plans, such as 401(k) plans, which provide matching contributions and tax advantages – but employees have to fund their retirement and manage their investments.
Some have saved enough to fund their retirement, even if they live long lives. Most have not. But there is an investment that can provide regular income for as long as you live, while also providing tax advantages and the potential to leave a legacy to your heirs – an annuity.
Benefits of Annuities
An annuity is a contract between the buyer and an insurance company, in which the buyer contributes a lump sum or series of payments and, in return, can receive regular payments for life.
Like qualified retirement plans, taxes are deferred on any growth within annuity accounts. Earnings withdrawn are subject to taxation and, if taken prior to age 59½, may be subject to a 10 percent federal tax penalty. Withdrawal within the first five to seven years may also result in a surrender charge, which is typically 7 percent. However, many annuities offer a free withdrawal amount per year as well as declining surrender charges.
An annuity can be purchased with pretax dollars, reducing your taxable income by the amount contributed, if it is used to fund a qualified retirement plan or IRA. When you begin receiving distributions from the annuity, they will be subject to taxation as income. The benefit is the ability to defer taxes until retirement, when your income may be subject to a lower tax rate.
Unlike many retirement plans, annuities may offer death benefits, and there are generally no limits on the amount of money that can be invested in them.
The amount of income an annuity produces is based on how much is invested, the life expectancy of the annuitant (the owner or the person for whom the annuity is purchased) and the return on investment of funds within the annuity.
Types of Annuities
There are many types of annuities, and when considering the features you want for your annuity, be sure to have a good understanding of the added cost, so you can make an informed decision about whether those features are cost effective.
Investors can choose between fixed annuities, which guarantee both the principal and a specific return, and variable annuities, in which the value fluctuates based on the performance of the underlying investment accounts. The guaranteed principal and return from a fixed annuity are based on the claims-paying ability of the issuer. Variable annuities have the potential to produce higher returns, but they are subject to market risk, so payments are not guaranteed.
A fixed index annuity offers both protection of principal and an opportunity to have interest crediting linked to the performance of a market index. In addition to fixed and variable annuities, annuities may offer either deferred or immediate payments.
An immediate annuity provides an immediate income stream in return for a lump-sum payment. Some immediate annuities allow policyholders to withdraw the cash value of the annuity in case of an emergency. Some also attempt to address market volatility by guaranteeing minimum payments or by adjusting payments annually instead of monthly, as is typical with variable annuities.
Annuities can also be designed with many different payout options. The simplest annuity is a single-life annuity, in which the owner receives income throughout his or her lifetime.
Those who want their annuity to provide not only for their retirement, but for their survivors can purchase an annuity that provides a death benefit. A refund life annuity provides the beneficiary with a lump-sum payment benefit, based on the current dollar value of any unpaid units. Other annuity variations can guarantee payments for five, 10, 15 or even 20 years. A joint and survivor annuity continues to provide lifetime income to a survivor after the death of the owner, typically at a rate of 50 percent, 75 percent or 100 percent of the original level.
Before deciding which type of annuity is best for you, determine whether you need an annuity. An annuity is advantageous for long-term investments, but do not invest money in an annuity that you expect to need in the near future, as the money may be subject to a surrender charge if you withdraw it.
Your insurance agent or financial advisor can help you determine whether an annuity is right for you and, if so, what kind of annuity would best meet your needs.
Richard A. McGrath, CIC, LIA is President and CEO of McGrath Insurance Group, Inc. of Sturbridge, Mass. He can be reached at firstname.lastname@example.org.
This article is written for informational purposes only and should not be construed as providing legal advice.