When it comes to deferring taxes, people normally think of retirement accounts like 401(k)s, Keoghs, SEPs, and IRAs. But there's another way to defer taxes on your investment earnings until you reach retirement age: by purchasing an annuity.
What is an Annuity?
An annuity is a contract between a purchaser and an insurance company. All tax-deferred annuities have two phases: an accumulation phase and a distribution or payout phase. During the accumulation phase, your money potentially grows on a tax-deferred basis. In the distribution or 'annuitization' phase, funds are paid out in installments over a period of time. Earnings that are generated in your annuity account are then taxed as ordinary income as they are paid out. Withdrawals taken prior to age 591/2
may be subject to an additional 10% IRS penalty tax.
Immediate annuities differ from other annuities in that the distribution phase begins "immediately," meaning payments start right away. In most cases, the payout option that best suits the buyer's financial needs is selected upon purchase.
Depending on your investment objectives and risk tolerance, you can purchase either a fixed annuity or a variable annuity. A fixed annuity is somewhat comparable to a certificate of deposit in that it offers a guaranteed rate of return for a specified period of time. Also, a fixed annuity may include an early withdrawal penalty and surrender charges if not held until the contract matures. However, the tax-deferred status of the earnings generated in a fixed annuity account clearly distinguishes it from a CD. CD interest is taxed yearly. Penalties for cashing a CD before maturity vary by institution. In addition, bank CDs are FDIC insured and offer a fixed rate of return. The fixed annuity guarantees are provided by the claims paying ability of the issuing insurance company.
The other type of annuity product is a variable annuity. A variable annuity is an investment vehicle specially designed for your long-term investment needs and offers multiple investment options. It is considered a hybrid product, regulated by both the state securities and insurance divisions. As such, a variable annuity is a contract between a purchaser and an insurance company and broker-dealer.1
Typically, the investor can choose among several investment options (stock, bond and/or money market sub-accounts). Money may be transferred into and out of the various investment options without incurring taxes. This makes it possible to respond to changes in your investment objectives and risk tolerance. Although a variable annuity offers the potential for higher rates of return than a fixed annuity, it is subject to market fluctuations and carries the greater risk inherent in fund investments so that when redeemed, the value may be less than the original amount invested. Like fixed annuities, variable annuities are also subject to early withdrawal penalties and taxes upon distribution and surrender charges if not held until the contracted maturity date. Variable annuities can offer tax deferral, lifetime income and death benefits. Variable annuities have riders that may be available at an additional cost.
Purchasing a single-premium annuity is done in a lump sum -- an attractive option for the well-heeled individual who wants to begin experiencing the benefits of tax-deferred accumulation as quickly as possible. Alternatively, a flexible-premium annuity can be chosen if you prefer making payments in a series of installments, or in a less systematic way.
Distribution or Payout Phase
Distributions from a deferred annuity can take place in two ways. You can either annuitize (enter the payout phase), or you can take withdrawals from the contract during the accumulation phase of your tax-deferred annuity contract.
Keep in mind, some important restrictions apply to withdrawals from annuities. During the accumulation phase of your contract, many products will permit you to withdraw up to a certain percentage of your account balance -- usually 10% for a fixed annuity and 15% for a variable annuity -- without incurring surrender charges or penalties. However, keep in mind that taxes will be applied to the earnings amount withdrawn.
There are also IRS penalties for early withdrawal that parallel those of other tax-advantaged retirement vehicles. Except in cases of extreme hardship, such as death or disability (as defined by the IRS), withdrawals from an annuity taken before the age of 59-1/2 (and in the absence of a contract that has already entered the distribution phase under a lifetime payment arrangement) may trigger an additional 10% Federal penalty tax on the earnings that are withdrawn. The moral: plan carefully when setting up your annuity and fund it with money that you're fairly certain you're not going to need until your contract calls for you to begin receiving payments after you reach age 59-1/2.
During the "payout" phase, you can withdraw your money in a variety of ways. A lifetime annuity guarantees you a certain level of income for the rest of your life -- however long or short that might be. This guarantee is backed by the claims-paying ability of the issuing insurance company. This option appeals to people who are worried about outliving their assets. Like anyone else on a fixed income, though, purchasers of lifetime annuities will find that inflation may reduce their purchasing power. You may want to consider delaying the start of lifetime annuity payments for as long as possible.
Annuity payments also can be set up over a certain period, where the payments will continue for that specified period regardless of whether you live or die. In the event of your death, they will be paid to your beneficiary for the remainder of the period.
Annuities offer many advantages, including flexibility in payments, payout options and, above all, the benefits of potentially accumulating tax-deferred earnings. A qualified financial advisor can help you determine whether an annuity is consistent with your financial objectives.
Variable annuities are offered by prospectus. An investor should carefully consider the investment objectives, risks, charges and expenses of the variable annuity and the underlying fund options before investing. To obtain a prospectus that contains this and other information call your financial services representative for a free prospectus. Read the prospectus and underlying fund prospectus carefully before you invest or send money.
Advisor is a registered representative and investment advisor representative of Lincoln Financial Advisors Corp. This information should not be construed as legal or tax advice. You may want to consult a tax advisor regarding this information as it relates to your personal circumstances.