7 August 2012 0 Comments

Annuity Tutorial (Part 3)

Having covered Immediate Annuities in my last two entries, now let’s take a look at Deferred Annuities.

Deferred Annuities (DA) are contracts issued by insurance companies for the purpose of accumulating funds, as opposed to Immediate Annuities which distribute funds.  The unique feature of Deferred Annuities is that income tax is deferred during the accumulation phase.  So, unlike funds placed in a bank CD or a Money Market account, where earnings are subject to taxation when they are earned, interest credited to a Fixed Deferred Annuity are only taxed when they are withdrawn from the annuity.  Thus, if the interest credited to the annuity is no less than what is credited to one of these other instruments, the DA is a  much better deal.

But, it’s not quite that simple.  First, if you withdraw any money from a DA before you are age 59 ½ there is a 10% penalty tax.  And, unlike a life insurance policy, withdrawals from an annuity are taxed “last-in-first-out”, so all earnings are taxed first.  Second, there will be surrender charges for early withdrawals from DA.s that can be draconian.  So, they should not be considered for short term purposes or by those who are apt to need funds prior to age 59 ½.   However, for other savers primarily interested in safety, deferred annuities can be a viable alternative especially since DA interest usually competes favorably with bank CD’s.

Deferred Annuities that are Variable or Indexed are not as simple as Fixed DA contracts.  The Variable DA is similar to investing in a series of mutual funds that allow you to trade from one fund to the other without creating current tax and also defer all tax in the same fashion as described above for the fixed DA.  However, mutual fund gains are normally subject to capital gains tax and the withdrawal of funds from a Variable DA will always be subject to ordinary income tax.  So, as long as we have a reduced tax for capital gains, this must be weighed against tax deferral.  Also, the loads in a Variable Annuity will be slightly higher than a Mutual Fund with comparable investment criteria.

Indexed DA’s have some of the features of both the fixed and variable contracts.  They provide a fixed account guarantee plus an indexed account tied to an index (S & P 500, for example) with a cap that also protects the annuity holder from negative index performance.  They can be attractive to individuals who want to participate from the upside of the market, but are risk adverse and want to defer taxes.

As with the Fixed DA, the Variable and Indexed versions also carry the 10% tax penalty for withdrawals before age 59 ½ and contain surrender charges that must be taken into consideration.

In my next and final Annuity Tutorial, I’ll recap my concerns, the opportunities and discuss some questionable sales practices.

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