Dividing annuities into a few basic categories makes the tax-advantage options easier to understand.
All annuities offer tax advantages, but the different types are quite distinct. Dividing them into a few basic categories makes annuities easier to understand.
Accumulation annuities offer a tax-advantaged way to save for retirement. You make a deposit and your earnings are completely tax-deferred until you withdraw them. Deferring taxes lets your savings compound faster.
Fixed-rate annuities pay a set interest rate for a set term. For example, you can earn 3.60% annually for five years or 2.75% for a three-year fixed-rate annuity, as of late February 2020.
They’re similar to bank CDs with a couple of key differences. A fixed-rate annuity offers tax deferral. Your principal is guaranteed by the issuing insurance company and backstopped by a state guaranty fund. A CD is guaranteed by a bank and insured by the FDIC.
Fixed indexed annuities offer more upside potential but less predictability. They pay a fluctuating interest rate pegged to the annual return of an index such as the S&P 500. But the lowest you can earn in any year is 0%. You get a portion of the market’s upside in return for protection against loss.
Variable annuities, in contrast, let you participate in the market’s gains while deferring taxes. But they don’t offer downside protection. You can lose money in the short or long term.
Eventually, in retirement, when you want to take money out, you can make systematic withdrawals or annuitize your contract and get a guaranteed stream of income. This leads to the next point.
Income annuities are for people who need cash flow now or in the future. They let you convert some of your savings into a guaranteed stream of income. They come in deferred and immediate varieties. The later provide income starting immediately or within a year at most (your choice). Deferred income annuities pay a stream of income at a future date that you choose.
Income annuities can pay out for a set term, such as 10 years, or for a lifetime. Lifetime annuities are more popular. They act as longevity insurance, protecting owners and their spouses from the financial risks that come with living to a very ripe old age.
Annuities can be swapped tax-free for another annuity. A “1035 exchange” lets you switch companies while continuing to defer taxes, ensuring that your annuity stays up-to-date with the latest advantages and benefits and the best rates.
An unneeded life insurance policy can be exchanged for an annuity. Many older people have paid-up cash-value life insurance policies that they no longer need. Section 1035 lets you exchange such a policy for an annuity tax-free. The owner or owners of the life insurance policy and the new annuity must be identical.
Most types of annuities can work well within an IRA. It may sound counterintuitive to use a tax-deferred product inside a tax-deferred account, but annuities can work well. For instance, if you’re looking for a guaranteed yield, fixed-rate annuities usually pay higher rates than bank CDs with the same term. Insurers that offer IRA annuities usually let you take out your required minimum distribution without penalty. Fixed indexed annuities also work well in an IRA.
I normally do not recommend using variable annuities for IRAs. Here you’re typically better off investing in mutual funds directly without the annuity wrapper.
A deferred income annuity (DIA) can work well with IRAs, but you’ll need to make sure your income payments begin no later than age 72 to comply with Required Minimum Distribution (RMD) rules under the new Secure Act. (The age 72 start date applies only to people born after June 30, 1949. Older people had to start their RMDs at 70½.)
A special annuity called a QLAC lets you defer IRA distributions. If you want to defer required minimum distribution (RMD) payments past that age, then you should consider a qualified longevity annuity contract (QLAC). It’s a special income annuity designed to meet specific IRS requirements so that you don’t need to take RMDs on the assets in the QLAC. It’s the only way you can legally delay RMDs for a portion of your IRA funds and thus keep more tax-deferred money in your IRA longer.
You can invest up to 25% of your total IRA money, up to a limit of $135,000, in a QLAC. You can delay taking income payments from the QLAC as late as age 85.
On the other hand, an immediate annuity if you’re 72 or older helps fulfill your required minimum distributions (RMDs). It’s a great way to get a guaranteed lifetime income.
An immediate annuity converts an asset to income efficiently, but in return, you no longer have cash value and you have little or no ability to change the income stream once it starts.
Naming your spouse as your sole primary beneficiary is advantageous. If you do this, upon your death your spouse will usually have the option of filing a claim to take the distribution as a spousal beneficiary or assume ownership of the annuity, continuing it without a taxable event.
Withdrawals of annuity earnings before age 59½ are normally subject to a 10 percent IRS tax penalty plus ordinary income tax. But there are exceptions. For instance, if you purchase an immediate income annuity with a lifetime income payout, you can avoid the 10% penalty on qualified (IRA) or non-qualified funds, even if payments begin prior to age 59½.
Annuity expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, deferred income and immediate income annuities. It provides a free quote comparison service. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities. More information, including updated interest rates from dozens of insurers, is available at https://www.annuityadvantage.com or (800) 239-0356.