Annuities are attractive retirement savings instruments, in large part because annuity earnings grow on a tax-deferred basis until withdrawn. There are three primary types of annuities: fixed, equity-indexed, and variable, each having similarities. There are pros and cons to all types of annuities. It is up to you to determine if an annuity suits your retirement savings portfolio.
There are three main types of annuities. Fixed annuities pay a fixed interest rate on the amount invested and the principle is not at risk. Equity-indexed (or "indexed") annuities are a type of fixed annuity. Instead of a guaranteed interest rate, the investor chooses a crediting strategy tied to a major index like the S&P 500. Indexed annuities have specific indices from which to choose the crediting strategy; you can split the principle among multiple index crediting methods as well as a fixed interest rate. Variable annuities invest the principle in sub-accounts similar to mutual funds. Principle is at risk when invested in a variable annuity.
Annuities offer tax-deferred growth. The investor does not pay income taxes on the gain in an annuity until she takes a withdrawal. Tax on the withdrawal is at the investor's current income tax rate. Annuities can offer a guaranteed income stream, which can give a retiree a steady income, unlike stock dividends. Interest rates on fixed annuities are usually higher than a bank can offer on a certificate of deposit. The annuity company counts on holding the investment on a long-term basis. It anticipates investing over time in such a way that the gains pay the interest rate, the company overhead, and create a profit. Unlike stocks or mutual funds, fixed or equity-indexed annuities provide safety for principle. Annuity contracts are available with long-term care riders, allowing an owner to withdraw a significant percentage of the contract without penalty if this need arises.
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Fixed and Equity-Indexed Annuity Considerations
To create a guaranteed income stream, annuity owners sacrifice liquidity. Most annuity contracts only permit a 10 percent annual withdrawal unless it must be a higher percentage to meet the IRS required minimum distribution once an owner is 70 ½ years old. With a required distribution in excess of this amount, the owner may have to pay a surrender charge. This can be quite high if the owner takes the additional withdrawal within the first few years of purchasing the annuity contract.
Variable Annuity Considerations
Variable annuities can have significant fees associated with the contract, making it difficult for the annuity owner to see a significant growth unless he annuitizes his account. If the value of the sub-accounts decreases significantly, this may force the annuity owner to annuitize the account to create an income stream. After annuitizing, certain payout provisions can restrict the payments received. For example, a "life only" payout may generate the highest payment, but the payments cease once the owner dies, even if the owner has only received one payment. Because of the contract's structure, the heirs may not receive any death benefit if this occurs.
Because of the significant penalties for terminating an annuity contract early, investors should carefully review material before investing in an annuity. Investors should have a liquid emergency fund equal to at least six months' living expenses at their disposal before considering an annuity in most cases. Annuities can be a strong component of a diversified investment portfolio.
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