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Annuities

Annuities are insurance products that typically are associated with retirement. People often use them as alternatives to certificates of deposit. Life insurance is designed to take care of the situation of dying too soon. Annuities on the other hand are designed to take care of the situation of living too long.

A typical annuity is a lump sum deposit, or a series of deposits, that grows at a compounding rate of interest to be systematically withdrawn at a future date. These are called deferred annuities. A special type of annuity, called an immediate annuity, begins payouts right away.

Under a deferred annuity, the compounding interest is not taxable until withdrawn. This is one of the main attractions of annuities, and the actual taxation is determined by the age at which it is distributed and other factors. As an example, there are penalties for withdrawing the money prior to age 59 1/2.

Usually these interest rates credited to the policy are guaranteed for a period of time, such as one year or five years. After this guarantee period, the interest that is credited is typically at the discretion of the insurance company.

At some point in the future, the “annuitant”, usually the policyowner, can decide that they want the money returned to them. Following are some examples of how money is distributed:

• Lump-sum withdrawal: Taking all the proceeds in a single lump-sum is considered a surrender or termination of the contract. Depending on how long the contract has been in force, there may be “surrender charges” which are typically expressed as a percentage of the balance in the account.
• Partial withdrawal: Many annuity policies allow an owner to withdraw 10% per year without incurring any surrender charges. There may still be tax consequences, however.
• Life only Annuity: Regular payments are made for as long as the annuitant lives, but stop as soon as the annuitant dies, even though the amount returned could be substantially less than what was put in the contract. This usually results in the highest monthly payout, but certainly the most risk.
• Life with term certain: Similar to life only, except the insurance company is promising to continue payments to a beneficiary for a certain period of time, such as ten or twenty years.
• Joint and survivor: Regular payments are made over the lives of two individuals, typically husband and wife. When one dies, annuity payments (or a specified portion) continue to the survivor
• Refund options: Regular payments are made, but if the annuitant dies early, the beneficiary is promised at least what was invested over time into the policy.
• Specified period: Regular payments are made for a pre-selected time period, such as ten or twenty years. State lotteries are good examples of these. Other examples are so-called “structured settlements” for accident victims.
• Specified amount: Payments of a set amount are paid out regularly as long as there is money in the account.

Why do people buy annuities?

The two primary motives are tax deferral and a guaranteed lifetime income. Annuities may also be sheltered from the attacks of creditors in bankruptcy. If one has significant assets, it is a relatively safe vehicle for funds. Over time, the insurance company is promising to return at least the principal amount ($ put in) with at least a minimum % of interest. These earnings are not taxed until they are withdrawn, and the compounding of these earnings on a tax-deferred basis can be significant.

If the payments are taken in the form of a lifetime income, they can be stretched out for as long as one lives, even if it is beyond age 100. There is a peace of mind and security knowing that a promised payment is coming in the future no matter what happens. That's why many corporate pension plans provide retirement benefits in the form of an annuity.

Although not for everyone, billions of dollars every year are put into these specialized insurance policies. Call or write david@dornagency.com for more details.

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