25 April 2014 0 Comments

The Truth About Annuities

shutterstock_176233616The mere mention of annuities among investment advisors can conjure up a myriad of opinions from: they’re a lousy investment—to—what a great tax advantage.  Interestingly, both of these statements might be true.  Of late, the debate has grown louder due to a plethora of Indexed Annuities that seem to promise the best of both worlds—growth and guarantees.  Let’s try to dig our way through this potentially confusing arena.  The starting point is to first understand the two basic annuity types:  Immediate Annuities and Deferred Annuities.

Immediate Annuities

With this type of annuity you pay a single premium to an insurance company in exchange for an income that is guaranteed to be paid for a pre-set period of time, or for the lifetime of a single person, or the joint lifetime of a couple.  Typically, the income starts within a year of the premium payment, but there are now some “Immediate” annuities where the starting date for income can be delayed for many years.

What’s good about Immediate Annuities?  The lifetime income option can absolutely guarantee an income for the remainder of your life no matter how long you live; or, in the case of a Joint Annuity, for as long as the second-to-die of a couple lives.  Depending on the age of the annuitants, the payout can be very attractive.  The taxation of the amount received is also advantageous, allowing you to spread the tax free return of basis over the projected payment period, as opposed to being taxed first on all earnings before the tax tree basis comes into play.

The problem with Immediate Annuities is that they typically provide no access to remaining principle, or payment flexibility once payments begin.  So, you better have sufficient additional assets to cover unexpected future need for capital and be content that you cannot change your investment strategy in the future to take advantage of changing investment opportunities.  In the case of lifetime payments, if you die early the total payments you receive might be significantly less than the premium paid.  In the instance where the initial payment has been deferred for years, it is possible that the entire premium will be forfeited if death occurs within that deferral period if you don’t opt for a “premium refund” provision.

Deferred Annuities

The primary purpose of a Deferred Annuity is to accumulate assets.  It is an investment vehicle that normally accepts a single premium, though flexible premium contracts are also available.  Ultimately cash from a Deferred Annuity might be applied to income payments mirroring payments from an Immediate Annuity, but accumulated assets from any investment could be used to obtain Immediate Annuity payments, so that is not a unique advantage of the Deferred Annuity (One exception will be noted later.)

The main advantage of Deferred Annuities over other savings or investment vehicles is that all earnings grow tax deferred, so during the accumulation phase, if all else is equal, the value of your account is greater due to compounding growth on 100% of the fund as opposed to the net amount left after paying taxes each year.

The disadvantages of Deferred Annuities fall into the categories of surrender charges, expense loads, tax penalties for early withdrawal and transference of taxes from capital gains to ordinary income.

That’s where I start in my next entry—Potential Pitfalls of Deferred Annuities

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