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Confused about annuities? You're not alone. Many people have difficulty understanding them. The main reason for all the confusion: Annuities may be deferred or immediate. Both are financial contracts you make with an insurance company. However, a typical deferred annuity helps you accumulate money, while a typical immediate annuity provides you with a steady stream of retirement income in return for your purchase.
Although you put money into both types of annuities, the difference is when you start receiving money from them. Just as the names imply, you get money soon from an immediate annuity and you delay getting money from a deferred annuity. This easy quiz will help you determine whether you're at a stage of life where you can consider an immediate or a deferred annuity. Answer the following questions:
1. Saving for future retirement is one of my main goals.
2. I will not touch my principal or interest until I am at least 59 1/2 years old.
3. I contribute the maximum deductible amount to my IRA, 401(k) or 403(b).
4. I need an investment that will earn tax-deferred interest for many years.
5. I am retired or very near retirement now.
6. I have a lump sum of money and I want to begin drawing an income from it.
7. I want immediate return from my investment.
8. I want to receive a steady monthly check for the rest of my life.
If you answered true to questions 1 through 4, a deferred annuity may be appropriate for you. If you answered true to questions 5 through 8, you're more likely to need an immediate annuity. A financial advisor or qualified insurance agent can help you decide if an annuity is the right retirement savings vehicle for you.
Deferred annuities can be a great way to accumulate money for retirement, particularly if you have many years before retirement. Your money grows tax deferred, which means you pay no taxes on earnings until you begin to withdraw your money.
There are two basic types of deferred annuities you can buy -- fixed and variable. Between them they offer a variety of funding options.
Fixed annuities earn a guaranteed rate of interest for a specific time period, such as one, three or five years. Once the guarantee period is over, a new interest rate is set for the next period. This guarantee of both interest and principal makes fixed annuities somewhat similar to Certificates of Deposit (CDs) purchased from a bank. Unlike a typical CD, however, an annuity is not backed by the Federal Deposit Insurance Corporation (FDIC); its security is directly related to the financial health of the company that sells the annuity.
You can purchase a fixed annuity in two ways:
* Make one lump-sum payment to purchase a single premium annuity. If you want to contribute more money at a later date, you will have to purchase another annuity.
* Make ongoing contributions to a flexible payment annuity. Contribute smaller amounts of money at regular or even irregular intervals.
Variable annuities typically offer a range of investment or funding options. These funding options may include stocks, bonds and money market instruments. Variable annuities are uncertain compared to fixed annuities. Your principal and the return you earn are not guaranteed; they depend on the performance of the underlying funding options. If the funding options you choose for your annuity perform well, they may exceed the inflation rate or fixed annuity returns. If they don't, you may lose not only prior earnings, but even some of your principal. Some variable annuities offer a fixed account option that guarantees both principal and interest, much like a fixed annuity. That gives you the option of dividing your money between the low-risk fixed option and higher risk vehicles such as stocks, all under the umbrella of just one annuity. Variable annuities are usually sold on a flexible payment basis, as opposed to a one time lump-sum investment.
Why Buy a Deferred Annuity?
There are a number of good reasons to consider an annuity as part of your financial retirement plan:
* You postpone paying income taxes on any earnings until you withdraw money, typically during retirement, when you may be in a lower tax bracket. Any earnings grow tax-deferred.
* You can take advantage of non-taxable transfers. In other words, if you transfer money to a different funding option within your variable annuity, you won't have to pay taxes on any earnings you have made. Tax-free switching lets you reallocate money to suit changing market conditions, without worrying about the tax hassles.
* You can put in as much money as you want. Unlike Individual Retirement Arrangements (IRAs), there is no IRS restriction on the amount that can be contributed annually to deferred annuities.
* You can provide a death benefit to your heirs. If you die, your annuity can offer a death benefit to your beneficiaries without the costs and delays of probate. A spouse who inherits an annuity before distribution has begun can step in as the new owner of the annuity and the tax deferral continues until amounts are withdrawn. If distribution payments had begun, the benefits would generally have to be distributed to the beneficiary at least as rapidly as through the method in effect at the time of the annuitant's death. Taxation will continue to apply to those proceeds.
Generally, a beneficiary who inherits an annuity before distribution can request a lump sum distribution without penalty but will be subject to full taxation on the accrued interest or gain on the contract.
* You can use it as an additional source of retirement income. If you want retirement income beyond what you will receive from Social Security or your pension plan, an annuity can provide it.
* You choose how to receive your money once you retire. When you're ready to start withdrawing your money, you can take it all out in a lump sum or you can receive it in a steady stream of periodic payments -- so-called "annuitizing." When periodic payments are received for life (or life expectancy), rather than in a lump sum, income is guaranteed for life (or life expectancy) and the tax liability can be spread out over a period of years. Some of the earnings are included in each payment and are taxable. Meanwhile, tax-deferred earnings continue to accumulate on the remaining principal and earnings that have not yet been distributed. So, receiving distributions as periodic payments after retirement may further reduce your income tax liability, if you are in a lower tax bracket.
Before You Buy an Annuity Consider the following:
* You can lose money. Variable annuities are subject to market risks, and you can lose earnings and even principal. If you need a guarantee of principal and/or earnings, fixed annuities or the fixed-interest options of variable annuities may be more suitable.
* The money contributed to an annuity is in post-tax dollars. Before you purchase an annuity, it may be advisable for you to put the maximum pre-tax amount into a retirement plan such as your IRA, 401(k) or 403(b).
* Expenses vary. Make sure that the annuity contracts you consider have competitive fees. Independent rating services such as Morningstar and Lipper Analytical Services both publish reports that compare variable annuity fees. Check your local library for copies. While cheaper doesn't necessarily mean better, if a contract is too expensive it could offset any gains from the tax-deferred status.
* Deferred annuities are long-term accumulation vehicles. After all, they're intended to help you save for retirement, so they're not a good choice if you're looking for liquidity. Do not put money you may need for current expenses into an annuity. If you withdraw income before age 59 1/2, the IRS will usually slap you with a 10% penalty in addition to ordinary income tax, similar to the penalty for early IRA withdrawals. What's more, your insurer may impose its own early withdrawal penalty. You can usually withdraw small amounts (e.g., 10%) annually without any penalty from your insurer, but the IRS penalty still applies. The IRS views all withdrawals as income until all income has been paid out.
* If you switch annuities, you may incur withdrawal charges from your current annuity. Some insurance companies will penalize you for early withdrawal. If a salesperson or broker advises you to change annuities despite the fact that you will be penalized, make sure you know why. Do the benefits of the new annuity -- such as a higher interest rate or more flexibility -- offset the withdrawal charges? Be sure the salesperson isn't benefiting from the switch at your expense. If you decide to switch annuities, be sure to use federal tax form 1035, which avoids both income tax and the IRS penalty for early withdrawals by allowing for tax- free exchanges.
* All earnings from annuities are taxed as ordinary income.* If your ordinary income rate at retirement is higher than 28%, which is the current capital gains rate for other investments, you would actually pay higher taxes. For example, if your income is taxed at 36%, you could pay an 8% higher tax rate on your annuity earnings than you would with long-term capital gains from another type of investment. You do, however, gain a tax deferral on earnings. With some other investments, you could be subject to capital gains taxes annually, even if you have not cashed in the investment, which can reduce the value of your earnings.
[Note: Tax regulations are subject to change. The examples given may not be currently valid. -- Staff]
Immediate annuities can provide dependable security: a stream of income payments that will continue for the rest of your life or for a period you select. If you are about to retire, an immediate annuity may be a good place to put a large lump sum of money accumulated through a deferred annuity, a retirement plan or other savings vehicle.
To purchase an immediate annuity, you make a one-time payment, and distributions typically begin within a month. Immediate annuities can be fixed or variable, just like deferred annuities. The income payments you receive from fixed immediate annuities are based on the amount you contribute and the interest rate environment at the time of purchase and will not change. The payments from variable immediate annuities fluctuate based on the performance of the investment options you chose. Although payments may go up and down, variable annuities are designed to provide income that you hope will rise over time to help you keep pace with inflation.
You can choose from a number of options for receiving income from an immediate annuity. A life option guarantees a specified income for as long as you live. A period certain annuity guarantees an income for a specific period of time, such as 15 years. Perhaps the most popular choice is known as a joint and survivor option, which guarantees that income payments will continue for the life of the primary owner and a second person. The guarantee is made by the insurance company issuing the annuity.
These options can usually be mixed and matched to provide an ideal income plan for your needs. For example, say you and your spouse retire at age 65 with 10 years left on your mortgage. You could choose a joint and survivor option with a 10-year period certain, so that if you both die before the guarantee expires, the mortgage could be paid off for your heirs.
Why Buy an Immediate Annuity?
Among the reasons to consider an immediate annuity are the following:
* An immediate annuity is a financial vehicle that can provide a guaranteed income for life.
* You choose how often to receive your income payments. Whether monthly, quarterly, semi- annually or annually, there's a payout plan to fit your particular needs.
* You may lessen your financial worries. Financial management can be a burden in your retirement years. Because you don't know how long you'll live, it's hard to be sure your resources will last as long as you need them. If you withdraw too much of your nest egg, your future income can suffer or you may run out of money entirely. If you are on the conservative side, your level of living may suffer. Immediate annuities can remove some of these burdens by providing you with a fixed payment for life, so you can concentrate on enjoying your hard-earned retirement.
* You pay income taxes only as you receive your payments. When you receive income payments, you will be taxed for the portion of the payments that is earnings. The portion that is principal is not taxable. You may also shift other income-producing assets to an immediate annuity to decrease your current tax payments.
Some Factors to Ponder
* You may lose liquidity. With an immediate annuity, you lose access to the principal. You can minimize this drawback by keeping some of your retirement funds in a liquid account, such as a savings account or money market fund, for emergency use and unexpected expenses.
* If you choose a variable immediate annuity, your income payments will fluctuate. These annuities can let you participate in stock market growth, historically shown to be one of the best ways to combat inflation over the long-term. However, the downside is that payments can drop if the market drops. Not only is this unnerving, but obviously it will make it harder for you to budget. If you still want the potential for higher payments, you can hedge your bets by allocating some of your nest egg to a guaranteed fixed option.
* If you choose a fixed immediate annuity, your income payments may not keep pace with inflation. Again, you may want to divide your retirement savings between fixed and variable options to provide fixed payments, as well as growth potential.
* You may lose some of your principal. If you choose a life option with no guarantee, and you should die before your principal is all paid out, the balance of your principal and any earnings will go to the insurance company rather than to your heirs. If that bothers you, you can opt for a period certain guarantee, which specifies that your annuity will be paid out for a minimum period of time, even if you die, If you should die within that time period, the income payments will be made to your heirs until the end of the period. Yet another choice is a refund option, where your beneficiary can either receive one lump sum or continue to receive installment payments until all of the principal has been paid out.
Variable annuities usually have larger fees than fixed annuities. With fixed annuities, all contract expenses -- such as maintenance and contract fees -- are taken into consideration when the company declares periodic interest rates or determines the payment amount.
Variable annuity fees are more complicated. They may include an annual contract charge that covers administrative expenses, surrender fees and a mortality and expense risk charge. Variable annuities charge this latter fee to guarantee the death benefit, the availability of payout options and the level of expenses. A typical mortality and expense risk charge is 1.25% as of this printing, according to Lipper Analytical Services.
In addition, there are fees that are deducted daily for the management and operating expenses of the funding options in which your money is invested. These charges pay for everything from the fund manager's salary to the costs of printing the fund prospectus. Typically, the management expenses of the funds are less than you would pay for mutual funds with the same investment objective. You usually pay no front-end sales commissions when you purchase a variable annuity, as you might when purchasing a mutual fund.
You are generally responsible for a surrender fee if you cash in your deferred annuity (surrender it) within a specified period (often seven years after your date of purchase). Often there is a separate fee for each deposit. So, a new deposit may have a 7% fee while a 10 year old deposit may have no fee at all. The fee, which is usually highest in the beginning, will usually decrease and be eliminated over time.
For a variable annuity, all fees and other important information will be spelled out in the prospectus which describes the variable annuity contract and which must be given to you when you are solicited to purchase a contract. Read it carefully before you invest or send money and be sure you understand exactly what your expenses will be.
If you are buying an annuity largely for the tax deferral advantage, make sure the expenses do not outweigh the tax benefits. This can be a tough judgment call, but a good guideline is that if the expense charges are more than 1.5% greater than a comparable financial vehicle and your time horizon is less than 10 years, an annuity may not be the option for you. Consult a tax advisor for assistance in making this determination.
Some Questions to Ask Before Buying
If you've decided that an annuity makes sense for you, here are a few key questions to ask yourself before signing up:
1. Have you learned all you can about annuities before purchasing? The National Insurance Consumer Helpline can answer questions about annuities at 1-800/942-4242. The Helpline also will send you a free booklet called A Consumer's Guide to Annuities, which lists basic terminology and outlines the differences between types of annuities.
2. Have you done some comparison shopping and considered all of your options? Because annuities are long-term accumulation vehicles, you'll want to make sure the company you pick will be around at least as long as you will. And, as you learned in the previous discussion, different annuities offer a wide range of choices, prices, features and flexibility.
3. Does the rate on a fixed annuity look too good to be true? You want a competitive interest rate at renewal time. If the company is offering bonus rates, a higher interest rate for a set period of time, make sure the underlying interest rate and the company selling the annuity are financially viable. Once the bonus rate term expires, there is no guarantee going forward that renewal rates will be competitive. Be especially careful if you are switching annuities.
4. What are the annuity's surrender fees and how long are they in place? If the exit fee is unreasonably high (typical fees are 6% to 7% and decline over a period of five to seven years), you could be locked into a contract from which it will be costly to escape.
5. What is the track record of the funding options offered in a variable annuity? Don't be swayed by last month's top performer. Look for strong returns over a three- to five-year period or more. Newspapers such as Barron's and the Wall Street Journal-available in larger public libraries-publish rankings of various funding options on a regular basis. The history of various funding options also can be found in Morningstar and Lipper Analytical Services publications, available in most local libraries. Remember, though, past performance is not a guarantee of future results.
6. Does a variable annuity offer several funding options in case you change your investment strategy a few years down the road? Look for a range of funds to diversify your retirement savings as your needs change.
7. Is your ordinary income tax rate greater than 28%? If so, it's possible that you will lose a tax break by choosing annuities over another investment that would be taxed at the capital gains rate. Keep in mind, however, that your money in an annuity is accumulating on a tax-deferred basis. By selecting an annuity, you avoid paying yearly ordinary income tax on the earnings while your money compounds and grows.
8. What is the insurance company's rating? While anyone who is properly
licensed to sell insurance products (e.g., banks, brokers, agents)
can sell annuities, the annuity contract is issued by an insurance
company. So, you'll want to consider the company's rating. Is it
financially secure, with a good claims paying record? While this is
most important for fixed annuities it is relevant to any guarantees
(e.g., death benefit) in a variable annuity as well. Checking up on
an insurance company is easy at your local library, or you can
contact your state's Department of Insurance. A.M. Best, Standard &
Poor's and Moody's all rate the financial stability of insurance
company general accounts. Morningstar and VARDS evaluate and report
information for variable contracts only. Variable annuities are
rated by independent sources such as Lipper Analytical Services and
Morningstar. It's a good idea to choose an annuity from a company
that gets high marks from at least two independent rating sources.
Material produced by the MetLife Consumer Education Center and is intended as general information only.
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