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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
3. I contribute the maximum deductible amount to my IRA, 401(k) or
4. I need an investment that will earn tax-deferred interest for many
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
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
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
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
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
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
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
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
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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