Annuity

What is an Annuity?

An annuity is a contract between you and an insurance company where your earnings are allowed to grow and compound but taxes are deferred to the future. This feature affords powerful benefits to aid in accumulating assets for retirement and other long-range financial objectives.

Reichek Financial Services can help you set up an Annuity as a part of your complete financial plan.The word annuity literally means "series of payments" and when you purchase an annuity, the issuing company contracts to provide an income stream or payments for a predetermined period of time. Whether these income payments start within the first year of the contract or at some time in the future, determines what type of annuity you own.

Two Main Annuity Types

#1: Immediate Annuity

If you own an immediate annuity, your stream of payments start right away (technically, anytime within 12 months of purchase). You make choices of whether your payments are guaranteed for a specific number of years or for your entire lifetime. The insurance company figures the payment amount based on your purchase price and your life expectancy.

#2: Deferred Annuity

Deferred annuities have two phases: the accumulation phase, where your money grows for a while, and the payout phase. During the accumulation phase, your money grows tax-deferred until you begin to take money out in the payout phase. Funds can be withdrawn as a lump sum or as a series of payments. The owner determines when to take money out and and therefore, when to incur tax liability. Having control over when taxes are due and how the money is taken out are some of the key reasons annuities are so popular.

The payout phase starts when you decide to take money from your annuity. Typically, this is during retirement when income and therefore tax rates are usually lower. Depending on individual needs, lump sum (sometimes called cash-out or full surrender) and partial withdrawals are available. The choice to convert your deferred annuity into a series of payments ( called "annuitization") is available as well and is typically exercised by people afraid of out living their funds. Various "Settlement Options" are offered and the annuity owner selects the one most appropriate for them.

Think of an annuity like an umbrella. Money placed under the umbrella is treated differently when considering the tax consequences.

  • Money used to initially buy an annuity is called the premium, it's your original purchase price or principal amount. Since you paid taxes on the money when you earned it it is not subject to taxation ever again. This is true as long as your purchase is not part of a qualified retirement program such as an IRA, 401(k), TSA or 457 plan.
  • Monies placed in an annuity earn interest or receive dividend income or capital gain distributions. These "earnings", are not taxed in the year in which they are earned unlike "earnings" in a savings account, mutual fund, certificate of deposit. The "earnings" grow and compound tax free until withdrawn.
  • There are no penalties on distributions in the following circumstances:
    • Made on or after the death of the owner of the annuity.
    • If the taxpayer becomes disabled
    • Made after you are 59 1/2.
    • Made as part of a series of "substantially equal periodic payments" (not less than annually) based on the life expectancy of the owner or joints lives (or joint expectancies) of the owner and his or her designated beneficiary.
    • Made under a single premium immediate annuity with a starting date no later than one year from the annuity purchase date.
    • Made under certain annuities issued in connection with a structured settlement agreements.

Avoid Probate

Should premature death should occur, the accumulated values within your annuity can be transferred to your beneficiaries. This avoids the delay, expense, publicity and, frustration of probate. Although like most assets, the annuity is included in your taxable estate. Beneficiaries will usually have settlement options of their own, ranging from the lump sum payment option, or a guaranteed monthly income.

What is a Fixed Annuity?

A Fixed annuity, sometimes just referred to as a tax-deferred annuity, is a contract between the owner and an insurance company for a guaranteed interest bearing policy with guaranteed income options. The insurance company pays interest currently but you don't pay taxes on the interest until you make a withdrawal or begin receiving an annuity income. Your annuity contract earns a competitive return that is very safe. Interest rates are usually guaranteed for the first year and then change periodically based on fixed income market conditions, much like rates for a CD.

Tax-Deferred?

Tax-deferred means delaying paying taxes on interest earnings until a future point in time. You continue to earn interest on the money you're not paying in taxes. You can accumulate more money over a shorter period of time, which ultimately provides you with a more income.

Savings Advantages

Many people today use tax-deferred annuities as the basic building block of their overall financial plan rather than more traditional savings accounts or certificates of deposit. Although CD's and Annuities are somewhat similar there are significant differences between them. The fact that annuities allow for the deferral of the taxes due on the interest earned until the interest is withdrawn is probably the most important difference. By deferring taxes with a tax-deferred annuity, money compounds faster because interest is earned on dollars that would otherwise been paid to the IRS. Later, if you decide to take a monthly income, your taxes can be less because they will be spread out over a period of years. Additionally, when taken as income in retirement, annual incomes are usually less resulting in the applicable tax being levied at lower tax brackets. Annuities, like Certificates of Deposits, have a penalty for early surrender, however most annuity contracts have a generous "free withdrawal" clauses.

Tax Advantages

There are NO taxes due while your money is compounding. You may also pay less tax on occasional withdrawals because you can control the tax year in which the withdrawals occur, and you pay taxes only on the interest withdrawn. Tax deferral lets you have control over an significant expense - your taxes. Any time you control an expense, you have more ability to minimize it's impact. The longer you can defer this particular expense, the greater your gain when compared to the gain you would make with a fully taxable account.

The Tax-Deferred Advantage

To illustrate the increased earnings capacity of tax-deferred interest, compared below to fully-taxable earnings. $30,000 at 6.0% will earn $1,800 of interest in a year. A 28% tax bracket means that approximately $504 of those earnings will be lost in taxes, leaving only $1,296 to compound the next year. If these same earnings were tax-deferred, the full $1,800 would be available to earn even more interest. The longer you can postpone taxes, the greater the gain.

Compare the Return

$107,297 Accumulated in a Tax-Deferred Annuity
$71,966 Accumulated in a Taxable Account

The Difference:$35,331
Note: That at an annuity's guaranteed rate of 4%, the return after 25 years would be $66,646.

Safety

Your tax-deferred annuity is very safe. A qualified legal reserve life insurance company is required to meet its contractual obligations to it's policy/contract holders. These reserves must, at all times, be equal to the withdrawal value of the insurance companies issued annuity contracts. State laws also require set levels of capital and surplus to further increase policyholder protection, in addition to legal reserve requirements. "Legal reserve" refers to stringent financial requirements that must be maintained by an insurance company to protect the funds paid in by all policyholders. These reserves must be at all times, equal to the withdrawal value (principal plus interest less early withdrawal fees, if any) of every policy in force. State insurance statutes also mandate that life insurance companies must keep certain minimum levels of capital and surplus, affording additional policyholder protection.

Tax Documents - 1099's

Taxes are not withheld while your annuity is compounding; it is totally tax-deferred. When a distribution is requested (random withdrawals or annuitization), taxes are withheld at that time - unless you elect differently. You can elect that no taxes be withheld at the time you request a distribution. Since the interest is tax-deferred, a Form 1099 is not required while your money is compounding. Only when your earnings are distributed (random withdrawal or annuitization) is a Form 1099 be sent, reflecting the actual amount of interest distributed to you.

When Does My Money Mature?

Annuities do not "mature" like bonds or Certificate of Deposits. Principal and interest automatically earn interest until withdrawn or you reach age 100. You choose whether to let your money continue to grow, make withdrawals, or begin receiving an annuity income at any time.

What is the Penalty Tax and When Does it Apply?

An IRS imposes a penalty, currently 10%, which must be paid on any withdrawal of interest or non-previously taxed premiums made prior to age 59 1/2.

 
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