Considerations for Fixed Annuities

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Considerations for Fixed Annuities

If a fixed annuity looks like a good deal to you, that’s because it is one of the safest ways to generate a guaranteed future income. But, as with any investment, there are tradeoffs for the guarantees of fixed annuities.

Effects from inflation

While the rate of return on fixed annuities compares favorably to other "safe" investments such as certificates of deposit or government bonds, they are generally lower than could be realized if you invested in higher-risk investments such as stocks or high-yield bonds. Because return rates are relatively low, fixed annuities can lose much of their value to inflation, especially if you live a long time.

Tax issues

When considering taxes, you must be careful in the use of annuities. Though annuities can be used outside of a retirement plan, such as an IRA, 403(b) plan, or 401(k) plan, they should still be treated as one. An annuity outside of a retirement plan is called a non-qualified annuity, and premiums are paid with after-tax dollars. While interest still grows tax-deferred in a non-qualified annuity, early withdrawals (before age 59½) are subject to both ordinary income tax rates and a 10 percent tax penalty, just as they would be from a retirement plan. In addition, there may be early surrender charges from the insurance company as well. (These charges do decline and eventually disappear over a period of time.) Further, non-annuitized withdrawals from non-qualified annuities are taxed as income (earnings) first and tax-free return of principal last. Annuitized distributions are treated as a combination of tax-free return of principal and taxable income (earnings) through the life expectancy of the annuitant, then all taxable income thereafter.

Payout options

Okay, you purchased your annuity with long-term retirement objectives in mind and you have now reached that magic time in your life called retirement. Now, what do you do about all those payout options? Be careful—with every benefit there is usually a tradeoff. One of the unique benefits of annuities is that they can guarantee an income that you cannot outlive—for a price. If you select a life payment option without a period certain or refund provision (whether it be on a single life or joint life), you give up the right to transfer to your beneficiary the remaining value of your annuity upon your death or the death of your survivor (usually your spouse). Why might you select this option? A life payment option without a period certain or refund provision provides a higher payment than otherwise; thus a tradeoff on benefits. What is best for you depends upon your particular goals and objectives.

Estate planning considerations

A final strategic consideration is estate planning. In our discussion of annuities, we have often referred to the beneficiary of an annuity, the person who receives the value of the annuity upon the death of the owner or annuitant. With a beneficiary designation in an annuity, wealth can be distributed outside the probate process, the legal method of transferring the assets of a deceased person. This can be beneficial if you do not wish this transfer of wealth to be a matter of public record and subject to the claims of creditors upon your estate, not to mention disputes among heirs. Once again, there are tradeoffs. The proceeds of an annuity to the beneficiaries are subject to income taxation, while proceeds of life insurance and the transfer of stock are not.

In sum, it is wise to consider rate of return, tax implications, payout options, and estate planning issues carefully before signing your fixed annuity contract.