Tax-Deferred Annuity Explained

Tax-Deferred Annuity Explained

Within a healthy investment portfolio, many different financial products – including stocks, bonds, CDs, annuities and more – can have a place. You just have to look closely at each financial product as well as your collection of additional investment vehicles to see how a tax-deferred annuity would fit.

Think of your financial portfolio like a tool belt worn by a contractor. He or she has a mighty collection of tools that work well in a variety of situations. The contractor knows that by having them, knowing how they work best and keeping them in fine working condition, things get done well. Having different types of financial tools in your portfolio can help you do a better job saving for retirement.

What is an annuity?

An annuity is a financial product used to save tax-deferred for retirement or to generate regular income payments once in retirement. It is a contract between an insurance company and an individual where the individual pays the insurance company money, either as a lump sum or as payments over time. This money is invested and the individual receives regular payments from the insurance company when they retire. Usually people purchase an annuity to cover specific needs, such as principal protection, lifetime income, legacy planning or long-term care costs.

And since they very much are tools of an important job in-progress, annuities take some exploration and understanding. We see a lot of confusion about what annuities are and how they work. This is understandable since there are several different kinds of annuities.

Types of annuities

There are many types of annuities, including among others fixed, variable, deferred and indexed. Fixed and variable annuities are the most common. Let’s look at these two types of annuities.

Fixed annuities

Fixed annuities pay a fixed, minimum guaranteed rate of interest for a period of time such as 3, 5, 7 and 10 year. They are similar to CDs in that they’re guaranteed to pay interest and you will get your money back in a certain year set in the future assuming the insurance company has the financial wherewithal to pay. These types annuities are best suited for those with a low tolerance for risk or for use in a diversification tool in a fixed income portfolio

Variable annuities

Deferred variable annuities work more like mutual funds with their greater ties to the market and your greater control over how to invest. The investment vehicles contained in an annuity are called separate accounts but they look and taste like equity-based mutual funds, bond funds and money-market funds.

All income that a deferred annuity earns during the accumulation phase is tax deferred: The funds grow tax-free until they are withdrawn. The benefit is long term tax deferral and the hope you will be in a lower tax bracket by the time you are being taxed on these earnings. Variable annuities are generally best suited for individuals:

  • With a higher tolerance for risk
  • Seeking growth in their portfolio
  • Who expect to be in a lower tax bracket in retirement.

But here are the big issues: high fees, surrender penalties and sales agents that high these

Surrender penalties are the penalties you would owe if you were to pull your money out prior to the annuities maturity date. It can be a hefty punishment, too. It is not uncommon to see a 10% surrender penalty and sometimes higher on fixed annuities. This isn’t necessarily a problem as long as you are aware this penalty exists and you can lock the money up with confidence for the time period of the contract.

You have to understand the details in the fine print for any annuities at any time.

Look at the paperwork for any annuities (and of course for any financial product) before you sign. Make ‘when can I take money out of an annuity’ one of your most vital questions before finalizing your arrangements. If you’ve already completed your transaction, now’s the time to look through that paperwork to be sure you fully understand what would be involved in cashing in your annuity.

Confusion about surrender penalties is a very common situation that we see. What we commonly find is that most people either never knew about surrender penalties or did not realize how much the penalties were.

Then we have to talk about the fees.

Fees are not an issue with fixed annuities as the company simply gives you a fixed rate of return similar to a CD.

Variable annuities however can have an abundance of fees. They typically have what is referred to an M & E fee, which is typically somewhere between .95 and 1.4 percent. Beyond this you have expense ratios within each investment option. Add to these additional fees if you want a few bells and whistles with the contract such as a return of premium or guaranteed income rider, among others. These additional features typically run above 1%.

Added together it is conceivable to see 3% annual expenses (if not higher) inside these contracts. If that sounds like a lot, it is. However, annuities do offer tax deferred growth and if the stock market collapses or you die you may have added protections.

Isn’t it someone’s job to make sure I know THIS part of the annuity agreement?!

Well, yes and no.

Importance of fiduciary

In many cases, those who sell annuities are insurance sales people. Within the insurance company, there are many laws and regulations about the selling of financial products. You may have heard the term ‘fiduciary,’ which means that a salesperson who is a fiduciary must, by law, present financial information to you in a manner that puts your financial interests ahead of their own. But today, not every insurance salesperson is a fiduciary.

In fact, very few if any insurance sales people, are a fiduciary.

This is NOT to say that insurance salespeople are out to get you, or that they can’t be trusted. That is not the case but you need to be aware so you can protect yourself.

Don’t let that overwhelm get to you. Take brochures home with you, spend time researching funds, policies and fine print online and call your financial planner with questions.

And by all means, buyer beware.

If you are in the market for an annuity, be sure to explore them from every angle with an objective, financial planner’s help before you pull the trigger. Don’t be the person that says “I wish I knew this before I invested “.

We enjoy helping with these kinds of complicated topics. For more information, check out our podcast and contact us with any questions you may have about annuities and other financial products.