Retirement and Holes in the Social Security Net: A 3-Part Series
Part 3: Annuities
With 401(k)s and IRAs down, it’s now time to move on to annuities. Annuities are an animal all of their own, quite different from the investment vehicles described in Part 1 and 2. Where 401(k)s and IRAs both pay out in one lump sum, typically, annuities pay out at set intervals beginning on a specific date. Also, insurance companies issue annuities, instead of employers or banks.
When an individual takes out an annuity, he or she is making an agreement with an insurance company to make payments to the individual, or the individual’s heirs, beginning on a specific date. In order for this to happen, the individual must either make a lump sum payment or periodic payments (monthly, for instance) to the insurance company. At the time of the set payout date, the insurance company will begin to make payments to the designated individual(s) until the funds are gone. In some cases, annuities can have death benefits, allowing the annuity funds to be paid out to the insured’s designate; generally, the death benefit is equal to the amount of funds the insured paid into the fund.
Annuities offer tax-deferred income growth in that individuals do not pay taxes on them until the funds are distributed; this is very similar to the setup with traditional IRAs, discussed in part 2 of this series. Also as with IRAs, there are two types of annuities: fixed and variable. These two terms refer to the amount of interest the deposit amount will earn during its deposit period. We’ll talk about fixed annuities first.
FIXED ANNUITIES
In a fixed annuity situation, the insurance company agrees to pay the depositor a minimum interest rate on their funds during the deposit time, and that they will pay the depositor a guaranteed amount for each dollar in the account. The life of the agreement lasts the length of the annuity agreement–10, 20, 30 years, or even for the depositor’s lifetime.
Fixed annuities provide a stable, predictable growth pattern for investors who are more conservative and who aren’t interested in the potential for the type of more volatile risk that can be associated with variable annuities.
VARIABLE ANNUITIES
Variable annuities are still purchased through an insurance company, and the insurance company still agrees to pay the depositor, but from there on out variables are far different than fixed annuities. In this situation, the depositor has the choice to decide what investment vehicles the insurance company invests his or her money in, and the performance of that vehicle decides what interest rate the depositor is paid. Investors can choose mutual funds in the stock market, in bonds, or in money market vehicles, or a combination of all three.
There are three unique ways in which variable annuities differ from other investment instruments; period payments, death benefits, and tax-deferrance. We’ll look at each of these briefly below.
First, variable annuities allow investors–or their beneficiaries–to receive periodic payments from the annuity, in case the investor outlives his or her other static assets. For instance, if an investor lives longer than her 401(k) funds last her, she could still rely on the payments from her variable annuity for the rest of her life.
Second, these investments allow investors to provide financial security for their loved ones via a death benefit provision. If an investor dies before the insurance company has begun making payments, their named beneficiary/beneficiaries will receive a set amount, usually the amount of the deceased’s purchase payments, which can be especially valuable if the account value is less than the annuity’s guaranteed amount.
Third, variable annuities are tax-deferred (just like the Roth IRAs we talked about in Part 2), meaning account holders don’t pay taxes on the income and investment gains until they take the money out. Also, investors can transfer their money from one investment option to another inside the annuity (from stocks to bonds, for instance) and not pay taxes at the time of the transfer. The government always gets its, though, because at withdrawal time the government will tax the earnings section of the funds at ordinary income tax rates instead of capital gains rates. However, in most circumstances, the tax benefits of deferral outweigh the costs only when investors use variable annuities as a way to obtain long-term financial goals.
Wow! What a whirlwind guide to 401(k)s, IRAs, and annuities! Again, remember that this series was meant just as a brief overview to these three vehicles, and if you want more in-depth analysis of these and other investment products, check back here, or contact your financial professional. Best of investing luck!
About the Author
I am a consultant working in the Boise, ID area. I work with businesses to make sure their accounting system and software is as effective as it can be. I write about finance and the financial industry because it is important that others be aware of how the financial system works so that they can make the best financial decisions possible.