If retirement is on your mind or already a part of your life, shifting your accumulated wealth into income is, no doubt, a companion thought. Of the many investment and insurance products, annuities are considered to be complex and often misunderstood.

Our aging population

A recent study done by Pew Research Center revealed that in the third quarter of 2020, during the height of the pandemic, approximately 28.6 million Baby Boomers (people born between 1946 – 1964) retired from the labor force¹. This was approximately 12.6% more people than who retired the same quarter of 2019. Yet, through 2019, Boomers expected to stay in the labor force far beyond age 65 (Pew Research, 7/24/19)²; the pandemic provided ample rationale for that trend to change dramatically.

I have seen this acceleration myself among my Boomer clients; I’ve had many conversations with clients, friends, and family who made the decision to retire this past year. Frequently their most expressed concern has been how to create their retirement income; how to transform their years of accumulated wealth into a predictable stream that supports them. Pension incomes have been disappearing over the last 30 years as businesses have converted their defined benefit plans to 401k plans. As I help clients to design a retirement income plan, the conversation often turns to annuity products. At this point, I need to point out that everyone’s financial situation is unique and there is never a ‘one size fits all’ option.

Types of annuities & the protections they provide

Annuities are insurance products that can offer a variety of protections or guarantees which are not typically available with other investment products. All guarantees are subject to the claims-paying ability of the issuing company. These guarantees do not apply to the investments in variable annuities, which will vary with market conditions. Investments in variable products will fluctuate and values upon redemption may be less than the original amount invested. Early withdrawals may impact annuity cash values and death benefits. 

Not all annuities are alike and, although they may share some similarities, annuity products vary by the issuing insurance carriers as well as the laws of the state where they are purchased. The basic definition of an annuity is that it’s a contract with an insurance company which can provide a fixed income stream for a person’s lifetime or a specified period of time. This person is called the ‘annuitant’ and is not necessarily the owner of the contract.

An annuity can be purchased with a lump sum or through a series of payments and the account can begin paying out almost immediately or at some time in the future. During the time that the contract is accumulating, it is considered to be a ‘deferred annuity’. The question I most often hear is: “Will I have access to the account value of my annuity?” and in most instances the answer is yes. The account values are available for withdrawal in most deferred annuity contracts, however, there may be costs associated with an early withdrawal, which I will discuss further.

• Fixed Annuities generally offer guaranteed rates of return. You haven’t invested your principal in the markets, so your returns will not fluctuate with the markets. They also offer the option to annuitize — or convert your account to a series of guaranteed income payments — for either a specific period of time or for as long as you live. 
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• Variable Annuities offer diversified separate accounts which invest in portfolios of securities that carry market risk. These contracts typically offer a guaranteed death benefit to the beneficiary of the contract upon the death of the owner or the annuitant. Some variable contracts offer optional ‘living benefits’ which can provide guaranteed lifetime withdrawals that won’t be subject to market risk. These benefits come at an additional cost.

Tax implications of Annuities

Most annuities provide tax deferred growth until you withdraw from it.  Taxes are determined by the specific type of annuity you purchase -- either qualified or non-qualified. With a qualified annuity, generally you fund your annuity with pre-tax dollars. Qualified annuities are subject to Required Minimum Distribution (RMD) guidelines, and you will generally pay income taxes on the entire distribution amount.  In addition, annuity withdrawals made before you reach age 59½ are typically subject to a 10% early withdrawal penalty tax. There are some circumstances when the penalty could be waived and I recommend that you consult a tax advisor.  If you invest in an annuity to fund a retirement plan or an IRA, the annuity will not provide additional tax deferral benefits for that retirement plan or IRA plan.

Non-qualified annuities are funded with post-tax dollars which also affects the tax treatment of your withdrawals. Once you start taking distributions from a non-qualified annuity, any interest or earnings within the annuity will generally be distributed before the premium or principal amount and will be taxed as ordinary income. If you withdraw money prior to 59½ from a non-qualified annuity, typically the earnings and interest will be subject to the same IRS 10% penalty as with a qualified annuity.

Withdrawals may also be subject to surrender charges by the annuity issuer. This may happen if the amount withdrawn exceeds any penalty-free amount during the surrender charge period. Surrender charges vary by the annuity product you purchase

Annuity contracts can be moved or transferred to a new contract without taxation. This process is called a 1035 exchange and may be a tax free exchange to the owner if certain tax rules are followed. Significant fees and charges may be incurred when transferring out of an annuity, including the possibility of paying front-end fees when purchasing a new annuity.

Why an annuity

Through annuities, insurance companies have been providing products that enable an investor to participate in the financial markets for growth. With the increasing advancements in medical technology and health care, people are expected to live longer in the future which is a threat to their retirement savings. The lack of pension incomes along with increasing expectations of longer lives has propelled more retirees to consider annuities for retirement income

The costs and the risks

As with all insurance products, the guarantee is only as good as the insurance company’s ability to pay, which means the financial strength of the insurance company is important when choosing an annuity product. Due diligence is essential when choosing both the specific product and insurance company. Although there are guarantees built in for death benefits or living benefits, variable annuities carry market risk because the contract value is not guaranteed and will fluctuate with the market. The underlying fees charged to your variable annuity by the insurance company are generally for administration and mortality expenses as well as an additional cost if you opt for the living benefit rider or an enhanced death benefit rider. In addition, there are underlying fund management expenses for the separate accounts. All of these fees can add up and range anywhere between 1.4 – 3.5 percent per year depending on the terms and the riders chosen.

Most fixed annuities do not charge additional fees, because the costs for the contract are built into the guaranteed rate of return. It is common, however, for insurance contracts (fixed or variable) to have a surrender charge if you withdraw more than a specified percentage of your contract each year or during a specified period of time. This time period can range from 3 to 15 years, so it is important to know your time commitment before you purchase the contract. Some annuity contracts provide waivers to surrender charges for medical, disability or long term care needs of the owner or annuitant.

Create your plan first

Understanding your full financial picture is imperative because an annuity is not appropriate for everyone. I always recommend that you evaluate all of your current and potential sources of income, assets, and spending needs with a qualified professional, and create a plan before committing to an annuity contract.

Through my process, I evaluate a client’s spending needs and resources to create a retirement paycheck through a diversified portfolio. Annuities can be incorporated as one source of income and be an alternative to traditional fixed income investments.

Please reach out to me for further discussion and questions regarding annuities or other financial decisions. My goal is to help you to make the choice that’s right for you.