Annuity investment planning

Those on a fixed income or living off their retirement savings often look for a safe, low-risk place to invest their money. They will often turn to annuities, which are sold through insurance companies. Basically, an annuity is a contract between you and the insurance company that stipulates tax-deferred earnings.

There are a number of insurance guarantees that come with annuities, including the option to “annualize” or convert the principal into an income stream for life. However, the fees are usually quite high, and the gains are taxed as ordinary income, not as long-term capital gains.

The FDIC does not insure annuities, even if they are sold through a bank. The security of your principal depends on the financial strength of the annuity provider. If the business fails, you may have $ 100,000 coverage from your state’s guarantee association. But these associations operate under state law and vary in what they cover and how much they pay.

Fixed rate annuities

With a fixed rate annuity, you pay the insurance company a certain amount of money. Then the insurance company guarantees you a certain periodic payment over the life of the annuity. This is often a way to earn an income stream for life. The goal of the insurance company is to invest your deposit and earn more money than they promised to pay you.

There are often higher interest rates on annuities than on CDs. But a fixed rate does not mean the same for annuities as it does for a CD. With a CD, the rate is fixed for the entire term of the CD. Fixed rate annuities do not have an expiration date. The rate is generally only guaranteed for the first year. The rate will then drop after the guaranteed period and then adjust annually.

You may be charged penalties if you withdraw money during the penalty period. You may have to pay an 8% penalty if you withdraw money in the first year. After that, the fine is generally reduced by 1% each year.

Annuities have tax-deferred features, so if you withdraw money before age 59½, you may have to pay a hefty 10% penalty to the IRS. Annuity earnings are taxed as ordinary income by the IRS no matter how much time you have invested.

Variable annuities

Variable annuities offer investors unique features, but they are quite complicated. They combine the elements of life insurance, mutual funds, and tax-deferred savings plans. When you invest in a variable annuity, you select from a list of mutual funds to place your investment dollars. Your options may include balanced mutual funds, money market funds, and various international funds.

Variable annuities have tax-deferred benefits and have income guarantees not found in other investments. For example, for a fee, your variable annuity will pay a death benefit.

Let’s see how this works. Invest $ 100,000 in a variable annuity. In a few years, the value of the mutual funds in your account has dropped to $ 75,000. If it were a pure mutual fund, your heirs would only receive the $ 75,000. With this annuity, your beneficiaries are guaranteed $ 100,000 if you die. If you have opted for death benefits, the market value of the annuity can be up to $ 125,000. Your beneficiaries would receive this amount.

Taxes are imposed in the same way as for fixed rate annuities. Profits are taxed as ordinary income. You do not want to use annuities within your 401 (k) or IRA. These plans are designed to accumulate tax-deferred money. You don’t want to pay the higher costs of an annuity when you can invest in a mutual fund that benefits you with less tax expense.

There are cases where the variables fit together well. If you’ve already reached the limit on your other retirement savings vehicles, you might consider a variable annuity. You are not limited in the amount you can invest in an annuity. Many allow you to turn your investment into an annual income stream, for a small fee. The insurance company will guarantee that you will receive income payments for a specified period or for life.

CD-type annuities

A CD annuity is a fixed rate annuity with a guaranteed rate that matches the penalty period. For example, you buy a 4% five-year CD annuity. If you keep the CD for five years, you will receive 4% per year. If rates go up, you are already stuck at the lower rate.

Insurance companies developed CD annuities to help prevent insurers from making empty promises to continue paying high interest rates after the guaranteed period. Rates were falling and customers were not getting what they expected. Clients began to pay a penalty to exit the investment.

Generally, higher interest rates are offered on CD annuities than traditional CDs. The investment is tax-deferred, but if you withdraw your five-year CD before age 59½, you’ll pay a 10% penalty on the profit to the IRS. Many contracts will allow you to take up to 10% of the balance or up to 100% of the interest annually without any penalty being charged by the insurance company.

Surrender charges for a CD-type annuity are similar to those for fixed-rate annuities. There is no FDIC coverage on the investment. Some CD annuities have escape clauses in which the company penalty is waived if the client allows payments to be made over a period of five years or more.