How Do We Get There? Annuities

The scenario

Amy and Ben aren’t sure their income will last through retirement, and they want financial products that can pay them a secure, consistent income.

To help Amy and Ben, the first thing we might do is collect some basic information about their goals.

1. Not to outlive their money
2. To provide for their children and grandchildren
3. To take advantage of any available tax efficiencies

To reach these goals, we may suggest a guaranteed income annuity as one option for lifetime income. Annuities are provided by insurance companies, which take on the risk. It can help to think of an annuity as a financial tool that uses contractual guarantees from an insurance company to give you access to income for life.

The main types of annuities

Annuities also differ by timing. An immediate annuity starts paying income soon after you buy it. A deferred annuity grows first and pays later. Annuity contracts are full of confusing jargon, so it’s always wise to have an objective financial advisor walk you through one.

Reading the numbers on an income rider

A good way to understand the numbers on a fixed annuity with an income rider is to tell its two values apart:

• Regular account value: the true market value.
• Income account value: the value of the guaranteed lifetime income.

From the income rider, you can calculate how much lifetime income you can receive. The income account value usually isn’t money you can withdraw as a lump sum; it’s the number your income is calculated from. Income riders also usually carry an annual fee, so we look closely at what you’re paying for the guarantee.

Because Amy and Ben also want to pass income on to their children, we might recommend a guaranteed income annuity with a protected income benefit rider and a free death benefit.

Why does age matter?

The income an annuity pays is based on your age, using mortality tables. Someone expected to live ten more years will get a different amount than someone expected to live 30. Add in the different types of annuities, and choosing the right one can feel stressful. Amy and Ben will also want an advisor who helps structure their plan in the most tax-efficient way.

Five things to know before you buy

1. Surrender charges

Most annuities charge you for taking out more than a set amount in the first several years. The charge usually shrinks each year until it disappears.

2. Taxes

Growth inside an annuity is tax-deferred, and it’s taxed as ordinary income when you take it out. Taking earnings out before age 59½ can also trigger an extra 10% federal tax.

3. Fees

Riders and other features can add yearly costs.

4. Guarantees

Every guarantee depends on the claims-paying ability of the insurance company that issues it.

5. The free-look period

Most contracts give you a short window after you receive them to cancel without a surrender charge.

Taking care of the kids, and the taxes

If you have children, as Amy and Ben do, you’ll want to keep taxes from eating into what you leave them. In general, most beneficiaries inherit money in their peak earning years, when they’re in their highest tax brackets. When an annuity passes to your children, they generally owe income tax on its growth as they take it out.

With some forethought and the objective guidance of a fiduciary advisor, you may be able to make the most of your annuity’s tax-deferred growth by controlling when those taxes are paid. If it’s overlooked, it can take a significant bite out of the income you pass on and shrink your legacy.

How an annuity fits your plan

An annuity is one tool, not a whole plan. It belongs alongside Social Security, any pension, your investments, and your tax picture. In our 8 Elements, it’s part of Income Optimization: making sure you have enough guaranteed income sources to bring certainty to your financial life.