By Boyce F. Lowery, CLU, ChFC
For the last couple of months, we have been discussing annuities. We looked at why some advisors shy away (not why you might think) as well as the different types of annuities that are available. Today we are going to wrap things up by identifying some of the advantages and disadvantages of annuities and the most appropriate uses for them.
Taxation of Annuities
One of the great benefits of annuities can be their tax treatment. However, the tax status of an annuity depends on where the funds were derived to fund the contract at the outset. Annuities can either be qualified or non-qualified. A qualified annuity simply means that the annuity was funded with pre-tax dollars as a part of a retirement plan that meets certain IRS requirements. One could fund an IRA with an annuity or simply roll funds from a qualified retirement plan to an annuity contract. Conversely, non-qualified annuities are funded with after-tax dollars.
With a non-qualified deferred annuity, you accumulate earnings on a tax-deferred basis. You don’t have to pay any taxes on value increases until you begin to receive payments or make withdrawals. With a qualified deferred annuity, all distributions, including withdrawals and annuity payments, are taxed as ordinary income. When a Roth IRA is used for holding an annuity, any withdrawals or periodic payments would be free of income tax so long as the rules of a Roth IRA are followed. Regardless of the type of annuity, the contract owner can be subject to a 10% tax penalty for any distributions made before age 59½. However, there are ways to avoid this penalty with the help of an informed advisor.
With a non-qualified deferred annuity, you will pay taxes on the earnings when received but not on your original principal that was used to fund the annuity. Non-qualified deferred annuities are taxed on a “last in, first out” basis, meaning the most recent money to accumulate in the account is the first distributed. So, the earnings are distributed first, before the principal. As such, the initial withdrawals taken from a non-qualified deferred annuity will be taxable until only the principal is left, at which point distributions will be tax-free. However, if a deferred annuity is non-qualified and is subsequently “annuitized,” a portion of each payment will be deemed a return of principal and not subject to taxes. Annuitization is the process of converting accumulated funds in an annuity contract into a series of periodic income payments. Annuities may be annuitized for a specific period of years, a fixed dollar amount as long as the funds with interest will last or for the life of the annuitant, with or without a period certain.
Immediate (Income) Annuities
Unlike deferred annuities, immediate annuities start paying out right away. If the annuity is funded with tax-qualified money, then the entire payout from annuitization is taxable, as are any withdrawals that might be allowed.
Non-qualified immediate annuities benefit from the Exclusion Ratio. This simply means that a portion of the systematic payout (annuitization) is considered a tax-free return of the annuity owner’s principal amount and a portion is considered taxable earnings. The ratio is calculated by dividing the principal portion of the accumulated annuity funds by your life expectancy.
For example, let’s say you fund an immediate annuity with $50,000, the lifetime payouts are $4,000 a year and your IRS-calculated life expectancy is 20 years. Your tax-free portion of the payments is $2,500 a year ($50,000/20) and the remaining $1,500 of each distribution would be considered taxable earnings until the full $50,000 of principal is paid.
Potential Downsides to Deferred Annuities
There are some potentially negative aspects of deferred annuities. For one, they often come with a surrender charge for an early withdrawal that exceeds the stipulated penalty-free amount. The surrender charge amount is determined using a declining percentage typically spread over a 5-year to 10-year period from the annuity purchase date.
There are also potential changes in interest earning potential due to changes in earning caps or non-guaranteed interest rates. That isn’t a concern with multi-year guaranteed annuities. Finally, annuities are not FDIC insured. Rather than being guaranteed by the FDIC, the funds in an annuity are guaranteed by the insurance company that offers it. If the insurance company fails, then protection is limited to State Guaranty Fund Limits.
Potential Downsides to Immediate (Income) Annuities
Typically, an immediate annuity cannot be unwound, meaning once the payments begin, the payments are locked in as stipulated in the annuity contract. There are some immediate annuities that do offer the ability to make some limited changes to the contract after payments begin, but this is not the norm.
Some immediate annuities offer increases in payments over time through the use of an inflation feature. However, these annuities will have payments at the outset that are typically less than payments from annuities not offering an increase for inflation.
Immediate annuity payments are not flexible, meaning if you have a need for a lump sum of cash, the immediate annuity will not be the place to look. However, there are businesses in the marketplace that will purchase an immediate annuity from the annuity owner for a lump sum of cash.
When You Should Consider an Annuity
There are a number of reasons why you may want to consider an annuity as a part of your retirement portfolio. Despite the “cons” discussed above, annuities can offer many important benefits. Annuities, other than variable annuities, may be appropriate in the following situations:
- You want to minimize or completely avoid market risk while potentially earning a higher return than other “safe money” choices.
- You desire guaranteed minimum accumulation values with the potential for higher returns.
- You need a guaranteed income stream that you cannot outlive. Use of this strategy would guarantee that you will never run out of money, a common fear for many retirees.
- You want guaranteed lifetime income so that you can be more aggressive with other financial vehicles without fear of running out of money.
- You desire the benefit of tax deferral (non-qualified annuities).
- You want to avoid probate.
How We Can Help
As you can see, like all financial vehicles, there are both advantages and disadvantages to annuities. That is why it is important to educate yourself and work with an unbiased financial professional when considering an annuity and how it might fit into your planning.
If you are looking for safety of principal, returns similar to or better than other fixed-income instruments, tax advantages, or lifetime guaranteed income, then an annuity may be a good solution for you. We at Suncrest Advisors are independent financial professionals and we can help you analyze your own unique situation to see if an annuity makes sense or if other financial vehicles might be a better option. Call us today at 888-827-0146 for a free consultation.
Boyce Lowery is a 40-year veteran and established expert in the insurance industry. As the managing partner of Suncrest Advisors, he, his partner, and their associates all aim to provide financial security and peace of mind to business owners, executives and professionals, and high net-worth individuals across the United States. Along with more than four decades of experience, Boyce is a Chartered Life Underwriter® (the premier designation for insurance professionals signifying specialized knowledge in life insurance and estate planning) and a Chartered Financial Consultant® (known as the advanced financial planning designation). To learn more, visit http://suncrestadvisors.com/ or connect with Boyce on LinkedIn.