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Annuities -- Part VII
Annuities are yet another vehicle for retirement savings. Like some of the other retirement options, annuities let your money grow tax-deferred.
Annuities differ from other retirement vehicles since they are "non qualified retirement plans," and the funds you put into an annuity are after-tax dollars. This means that you have less money to put into the account since taxes have already been deducted.
Specifically, an annuity is a contract that you enter into with a participating insurance company whereby you pay money to the insurance company today and then receive cash payments later.
If you start to receive payments right away, you've entered into what's called an immediate annuity
If your payments don't begin until sometime in the future, you've entered into
what's called a deferred annuity. Deferred annuities are used
for retirement planning because the money you build up today
can grow tax-free and be paid out to you later.
Some annuities set contribution limits that restrict the dollar amount you can invest. Generally, they require you to pay a penalty on withdraws before age 59½.
How it works:
- The investor (you) pays the insurance company a fixed sum of money (after taxes have been taken out.)
- The earnings on the investment grow tax-free until distribution payments (to you) begin
- You receive distribution payments from the sum that you invested. You choose whether the payments start immediately or at sometime in the future (deferred.)
- The insurance company invests the sum that you originally paid and uses part of its investment returns to make payments to you immediately or at a later date.
Deferred annuities are an important part of any diversified retirement plan, but it's important to make sure that you've set up savings mechanisms on pre-tax dollars first and foremost. Plans that put after-tax dollars to work:
- Annuities
- Cash value life insurance
- Non- Deductible IRAs
- Educational IRAs
- Roth IRAs
Plans that put pretax dollars to work (tax-deferred savings):
- IRAs
- Keoghs and SEPs
- Pension and profit sharing plans
- Employer subsidized retirement plans (401(k), 403(b), etc.)
Annuities can be fixed or variable
Fixed annuity: A fixed annuity guarantees that you'll earn at least a specific rate of interest over the life of the annuity. But, the actual amount you receive in any period will vary with interest rates or another benchmark. Fixed annuities are used as an insurance product sold through insurance agents, financial advisors, and bank representatives.
Variable annuity: Upon opening a variable annuity, you select various mutual fund investment portfolios ("sub-accounts") from a list of options. Your return depends on the performance of the sub-accounts. Variable annuities are also used as insurance products that are sold through licensed financial advisors.
Annuities - The Positives and the Negatives
Positives:
- Investment grows tax-deferred
- No-load variable annuities are available
- There are rarely caps on the amount you can invest each year
- You can choose to be paid in lump-sum or lifetime income
- Many products offer immediate access to earnings
- Easier investment decision since investment choices are limited
- Variable annuities protect you from inflation and have high growth potential
Negatives:
- Gender bias: women tend to live longer so you generally pay a higher premium or receive a lower annual pay-out than men your age
- Often there are higher annual fees on variable annuities than on comparable mutual funds
- Taxes can be higher since long-term capital gains are taxed as ordinary income
- Surrender fees - you usually pay 7% of the amount you invest as a fee if you end the contract during the surrender-charge period.
- The security of your investment depends on the financial strength of the insurance company that sold you the annuity
Continue to: Part VIII: Cash-value Life Insurance (or Permanent Life Insurance)
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