Tax-Deferred Annuities

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So potent are the words “tax deferral” that, in their presence, otherwise strong minds turn to pudding. Analysis flies out the window and becomes less important it seems. Of all the unexamined premises of financial planning, one of the most dangerous is that tax deferral is always smart. It’s not. Sometimes it’s just downright dumb.

Which brings us to discuss tax-deferred annuities.

Important: This does NOT include the retirement annuities bought by teachers and others for their tax-deferred 403(b) retirement savings plans.

Instead, the focus here is retail tax-deferred annuities, bought by conservative savers with after-tax dollars. In certain limited circumstances, they make financial sense. But the majority of annuities are sold inappropriately, to the wrong people, at too high a price. The annuity hype comes from salespeople earning high commissions for roping you in. Beware, beware, and beware some more.

All retail annuities have three things in common:

  1. You get no tax deduction for the money you put up.
  2. Inside the annuity, your money compounds tax-deferred.
  3. At withdrawal, the earnings—including any capital gains—are taxed as ordinary income.

Beyond that, each annuity has its own cost structure (usually it is high), there are gimmicks (translation: expensive), and rate of return (reduced by costs). You buy annuities from stockbrokers, financial planners, insurance agents, or mutual funds. No matter who sells you the annuity, the annuity is always backed by an insurance company. Always.

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Let’s clear the air with some definitions:

An immediate-pay annuity pays you an income over your lifetime or for a fixed number of years, starting now. A tax-deferred annuity— accumulates money for the future.

Tax-deferred annuities come in three types, depending on how you want to invest. A fixed annuity pays a fixed interest rate for a certain term. An equity-indexed annuity is loosely linked to the stock market’s rise and fall, but with a guarantee that you’ll always earn a fixed minimum rate (which can be pretty close to zero). A variable annuity offers you a menu of mutual funds, known as subaccounts, that are invested in stocks and bonds.

You choose the investments you want.

Variable annuities have been tricked out with various retirement income benefits. A single-premium deferred annuity is bought with a single sum of money. The minimum purchase is generally $10,000, although buyers typically put up much larger sums. A flexible-premium annuity takes smaller or irregular amounts. You might pay $100 a month or dump in $1,000 every now and then. Due to extra fees, this is a particularly expensive way to buy.

When you decide to quit accumulating money and start spending it (known as the payout phase), annuities offer another range of choice. You can take guaranteed monthly payments for the rest of your life (called annuitizing). You can make periodic withdrawals. You can also take the money in a lump sum. Yet another choice is you can roll your savings into another annuity tax-free.

Your insurance company typically imposes a penalty on withdrawals made before 7 to 15 years have passed. One exception: you’re usually allowed to take 10 percent of your money out each year, penalty free. There’s a 10 percent tax penalty on withdrawals made before you reach age 59 1/2. If you die, your heirs, including your spouse, will owe income tax on any annuity money they inherit.

Selling Annuity Payments Is Simple

For faster service, call an annuity professional: