Annuity Basics or How To Have a Guarenteed income

Annuities are term deposits with insurance companies. They are similar to certificates of deposit at the bank and to a 401(k) product. There are a very dramatic taxation differences between an annuity, 401(k) and certificate of deposit. The annuity accumulates funds tax deferred and is tax advantaged at payout, whereas the 401(k) product gains are tax deferred and they are not tax advantaged at payout. With a certificate of deposit, gains are not tax deferred (they are taxable annually) and they are not tax advantaged at payout.

There are basically three types of fixed annuities. They are the indexed annuity, fixed annuity and single premium immediate annuity. All of these annuities have the same features:

• Principal is guaranteed, it will never decline.
• The insurance company adds interest to you deposit each year, which compounds.
• The annuity is for a specific term that you select.
• All interest is tax deferred until you withdraw funds.
• You may withdraw 10% of you balance annually.

Most fixed annuities offer an initial interest rate the first year that may change in subsequent years. A few companies offer a locked in rate for the entire period.

The indexed annuity returns are usually tied to increases in the S&P 500 Index, Dow Jones Index or Russell 2000 Index. So your interest is tied to the performance of the stock market but you can never lose your original principal. You get the guarantee of a fixed annuity with the potential upside and profit of the stock market.

The single premium immediate annuity is an immediate one time payment of the premium to the insurance company. In exchange, the company provides you with a monthly income for life. And you cannot outlive the income if this option is chosen!

Here’s a hypothetical example. A 65 year old paid $50,000 in premium to an insurance company (the source could come from a CD, savings or 401(k). He now receives $486 per month, every month for the rest of his life. That is $5832 each year of checks in the mail. For his $50,000 investment where else can you get a guaranteed $5832 for the rest of your life?

If this person dies early (before his funds are depleted), his beneficiaries will receive the $486 monthly until the $50,000 is used up. This is called “installment refund” provision of an annuity. Does a CD, IRA or 401(k) have this provision? Unfortunately they do not.

As you can see annuities are great sources for accumulating funds tax deferred and advantaged at payout. We have just skimmed the surface on this great financial product.

If you would like additional information on specific annuity products we would be happy to discuss the numerous options available.