Annuities can vary greatly. Some are straightforward, while others are highly complex. They can be used in pre-tax accounts (i.e., an IRA, 403(b), 401(k)) or purchased with after-tax funds. There is a lot to consider with an annuity contract. This article will highlight important factors to keep in mind throughout the decision-making process and provide several valuable planning tips.
Exploring the Annuity Contract
1. Taxation Basics
Money placed in annuities grows tax deferred until distributions begin or the contract is surrendered. The taxes are deferred but still due at some point. Unlike mutual funds, gains and income generated by annuities are taxable as ordinary income when due. That is, you don’t enjoy gains being taxed as capital gains as you would with an individual stock or a mutual fund owning stocks. Generally, capital gain tax rates are lower than ordinary income rates. Annuities purchased in an IRA are pre-tax contributions, so any money coming back is 100% ordinary income.
2. Keeping vs. Eliminating an Existing Annuity Contract
Annuities have changed significantly over the years. Depending on the type you have, it may be obvious what you should do. Your decision could be greatly swayed by any existing benefits that would be forfeited upon surrender. Some examples include:
♦ Variable Annuity – Variable annuities were widely popular because consumers could aggressively allocate money inside the contract and still put the insurance company on the hook for a guaranteed income for life beginning at age 65 (and, in some instances, the joint life of the annuitant and spouse). Investors often had the courage to invest more aggressively because even if the contract value was zero, the income guarantees continued. Insurance companies have recognized this and are currently offering contract owners lump-sum payouts to exit these arrangements. Having reviewed some of these offers, I have yet to see one that benefits the contract owner.
You may be advised to surrender this annuity contract to avoid the higher costs, but keeping it might be a better option if you can’t find an alternative investment that can provide the same level of guaranteed income for life. Given that the alternative investment would have no guaranteed income offered, the actual investment allocation would likely need to be more conservative. As such, performance return may be lower and the fund would not outlast the investor’s life expectancy.
If you decide to exit the annuity, you’ll need to manage the tax liability. If it’s held in an IRA, the annuity surrender will not cause current taxation (as the proceeds are still held inside the IRA and continue to enjoy tax-deferred treatment). However, if the annuity was purchased with after-tax funds, there might be a taxable gain. You may want to exchange it for a lower-cost annuity (some companies offer lower-cost, no-load annuities) and avoid the current taxation. Recently, after meeting with a new client who owned a high-cost variable annuity, we did a non-taxable exchange to a lower-cost annuity, and then agreed to liquidate over the next 36 months. In doing so, we spread the tax liability over three tax years. Note that the first liquidation payment must start after 180 days post-exchange to qualify.
♦ Indexed Annuity – Indexed annuities credit interest annually depending on the performance of an equity index selected by the contract owner. The annual interest credited is subject to a cap and a floor. That is, they credit up to a certain annual percentage (i.e., 6%) but also guarantee that the amount credited will never be less than zero. Deciding to keep this kind of annuity contract depends on a number of factors including the credit worthiness of the insurance company. Your values are backed by the general account assets of the insurance company and are not “separate account” assets exempt from the claims of the insurance company creditors (unlike variable annuities that are separate account assets and exempt from the claims of the insurance company creditors). Surrender charges can be assessed for as long as 20 years or even for life, and taxes also matter.
Indexed annuities should be thought of as a fixed income alternative, not an accumulation equity strategy. An analysis performed by Cannex, a market research firm, found S&P 500-linked annuities have an estimated average seven-year return of 3%, which is similar to the rate offered on multi-year guaranteed annuities.
3. Purchasing a New Annuity
Annuities have significantly changed over the last decade. For example, insurance companies once offered variable annuities that provided lifetime income guarantees while allowing aggressive allocations inside the contract. In effect, the insurance companies were accepting the risk of market meltdowns while still providing lifetime income guarantees. Today, insurance companies limit how much can be allocated to equity investments and also reserve the right to unilaterally move cash when deemed necessary. The contract owner has lost asset allocation control inside the contract. In 2017, sales of such annuities purchased in IRAs plummeted by 16% according to LIMRA Secure Retirement Institute. Indexed annuities purchased in IRAs also fell by 9%.Insurance companies are scrambling to come up with new kinds of plans. Most recently we’ve seen companies offering so-called “buffer” and “longevity” annuities.
♦ Buffer Annuities – These contracts are a cross between indexed and variable annuities. The insurance company credits interest annually based on an index selected by the contract owner and includes a “buffer” on downside returns. For example, if the market goes down 25% and the contract has a 10% buffer, the contract owner would see the contract value go down by 15%. In effect, the insurance company eats the first 10% of loss. This is technically classified as a variable annuity and has more of an accumulation focus rather than an income focus.
Buffer annuities should be attractive to individuals whose primary objective is accumulation (not income), but who also want some downside protection. Given that the accumulations (gains) will be taxed as ordinary taxable income (as opposed to the lower capital gains tax rate), the contract should be held in an IRA and not purchased with after-tax funds. IRA accumulations are taxed at ordinary taxable gain rates anyway, so the fact that an annuity is used doesn’t change the character of the taxable gain when distributions are taken.
♦ Longevity Annuities – We’re beginning to see traction and demand for longevity annuities. Once purchased, they provide guaranteed income for the annuitant’s life (and spouse’s life, if desired) beginning and ending at selected dates. At the annuitant’s death (and spouse’s death, if applicable), there’s no lump sum available to be paid to beneficiaries. Options include:
- Fixed income beginning 13 months after purchase for a finite number of years thereafter (i.e., 30 years). If the annuitant dies before the end of the 30th year, beneficiaries receive the remaining payments.
- Fixed income beginning at age 75 and continuing until death. Beneficiaries receive nothing.
- Joint life income beginning immediately or in 13 months. Beneficiaries receive nothing.
- A Qualified Longevity Annuity Contract that permits the investor to defer taking income from the qualified plan assets (i.e., an IRA or 401(k)) past the age of 70 ½ when applicable law ordinarily requires such distributions. It provides a specific amount of income beginning at age 85. These contracts enable individuals to take a portion of their accumulated funds and lock in income that they can’t outlive beginning at a certain age or date. Knowing that they have this income as a backstop might give them the confidence to potentially use other accounts for living expenses and / or invest more aggressively for higher returns. As markets continue to experience high volatility, allocating a percentage of your investment portfolio to an income backstop may make sense.
Do Your Homework
Prior to surrendering or purchasing an annuity contract, it is prudent to explore some of the analysis identified in this article. Carefully consider costs, guaranteed income / death benefits and taxes. Make sure you understand your financial planning decisions and don’t allow yourself to be swayed by an aggressive pitch. Not all annuities are bad, but some aren’t always a good fit. Your planning objectives are of utmost importance, whether it is a need for income or accumulation. The wealth management experts at SilverStone Group can help you evaluate existing contracts or determine if the purchase of a new annuity contract makes sense. No two situations are the same, so individualized guidance is strongly encouraged.
This information is provided for educational purposes only and should not be construed as advice. Any reference to a recommendation is general in nature and not specific to you or any investor. You should discuss your situation with a Financial Professional prior to making any decisions.
Variable annuities are long-term investments designed for retirement. The value of the investment options will fluctuate and, when redeemed, may be worth more or less than the original cost. Withdrawals and other distributions of taxable amounts, including death benefit payments, will be subject to ordinary income tax. If withdrawals and other distributions are taken prior to age 59 ½ a 10% federal penalty may apply. A withdrawal charge may also apply. Withdrawals will reduce the value of the death benefit and any optional benefits. #0417-2018
This article originally appeared in the 2018 | ISSUE ONE of the SilverLink magazine, under the title “The Annuity Contract: Good Investment or Bad Decision?” To receive a complimentary subscription to the SilverLink magazine, sign up here.