Strings Insurance Group

Most people are have heard of annuities. The general theme is that you make your contribution to an insurance company, and begin to receive monthly payments when you retire. How and when you make the contributions, and when you begin to receive your monthly payments determine if you have an immediate annuity or a deferred annuity.

Similarities between Immediate and Deferred Annuities

In an immediate annuity contract, you start to receive payments out as soon as you buy or fund the contract. In a deferred annuity you buy or fund the contract, and begin to receive payments at some point in the future, which could be one year or many years.

The intent of all annuity contracts is for you to deposit money with the insurance contract, have the money accumulate on a tax deferred basis, and receive periodic payments at some point. While your money is on deposit with the insurance company, you will not be taxed on the earnings each year as you would if your money was in a bank savings account. The earnings will be taxed when you receive each periodic payment or make an early withdrawal.

In addition, the insurance company guarantees your principal and interest (unless you have a variable annuity contract), as well as the payment of the periodic payments. These are the great advantage of annuities. Your interest earnings are tax deferred, and you receive an insurance company guarantee of principal, interest, and eventual payments.

Both immediate and deferred annuities can be designed as variable annuity contracts. In a variable contract, your balance accumulation and payments you receive are tied to the performance of stocks and bonds, or a combination of the two. This gives you more potential for larger, or smaller, increase in your investment and annuity payments than just the interest rate credited by the insurance company. The downside is that the insurance company does not guarantee principal and interest.

Deferred Annuities

A deferred annuity can be a good way to save if you have over 10 years before you will retire and begin to receive payments. You can start the contract without having to make a large contribution immediately. These contracts are designed for you to make a monthly or periodic contribution to the insurance company, and then receive payments when you retire. These tax deferred contracts are especially good if you are already making the maximum contributions under a 401k or IRA plan. Your contributions to a deferred annuity do not come under the maximum contribution rules found in a 401k or IRA, unless you are actually using the contract to fund your IRA or 401k.

A deferred annuity contract can also be purchased with a lump sum contribution. If you suddenly come into a large amount of money, such as inheritance or work bonus, putting this money in a deferred annuity can be advantageous if you do not need the money for a number of years.

The tax effects of a deferred annuity are spread out. When you retire and begin to receive monthly payments, each payment will consist of partly taxable earnings and partly tax free return of your contributions. Therefore the income tax on your earnings is spread over your entire retired life.

Deferred annuities may not be the right choice if you know that you will need to withdraw money within 10 to 15 years. There are a number of penalties that could apply if you take money out before retirement. Withdrawals prior to age 59 ½ will taxable as ordinary earnings, and you may receive a 10% penalty by the IRS. In addition, these early withdrawals will be considered as first coming out as all taxable earnings, and then your tax free contributions, unless you receive periodic payments for a long period of time. Essentially, if you take money out before age 59 ½, the entire payment might be considered taxable, and you may have to pay an additional 10% penalty. It gets worse. If you take money out within the first 7 years of the contract, the insurance company may impose a withdrawal or surrender penalty. This penalty goes down with each year the contract is in effect.

As you can see, deferred annuities should not to be used as a short term savings program or emergency cash fund.

Immediate Annuities

An immediate annuity will start to make payments to you within a month or two after you purchase the contract. You put in the entire purchase price of the annuity in a lump sum and begin to receive payments immediately. These payments can be made under one of the many payout options offered by the insurance company.

These annuity contracts are designed for investors who have accumulated their assets under another investment program, such as a mutual fund or brokerage account. At retirement, you would then transfer your mutual fund or brokerage balances in cash to the insurance company to buy the immediate annuity and commence receiving annuity payments.

The monthly payments you receive under an immediate annuity receive the same tax treatment as a deferred annuity at retirement. Each payment will be received partly as tax free earnings and partly as return of your tax free contributions.

There are several advantages to buying an immediate annuity. You receive guaranteed payments from the insurance company. Interest earned on your contributions is tax deferred during retirement with only a portion of each payment being taxed. You have complete freedom to accumulate your assets prior to retirement in whatever investment program you want, and not be subject to insurance company penalties on early withdrawals.

Be Sure of Your Purpose Before You Leap

Annuities are appropriate for long term savings and guaranteed retirement payments. Either a deferred annuity or immediate annuity fulfills this goal. If you are looking for a short term savings program or plan on withdrawing funds before retirement, you need to really understand the various penalties involved. In many cases, these penalties outweigh the benefits of using a tax deferred annuity.

You also need to analyze the annual expenses charged in annuity contracts.  These expenses can be higher than in other forms of investments. Your insurance agent will also receive a commission on the sale of the annuity contract. Contract expenses are the primary reason financial advisers may not recommend  an annuity to a particular client.

Again, annuities are not for everyone, especially if you have a short term investment plan. However, for many people with a long term outlook, an annuity may be a good choice in saving for retirement.

You do not have to put all your savings in any one investment or annuity contract. You can use an annuity as only one part of your overall financial plan. Many people keep a portion of their savings in a bank account for emergencies or unforeseen expenses, an investment program in mutual funds for continued growth, such as a 401k, and put a portion of their assets in an annuity contract to receive lifetime monthly payments.

An annuity should be considered by all people looking forward to a safe and enjoyable retirement. You need to understand and compare all of the contract provisions so that you know exactly what you are buying. Once you buy an annuity contract, you will then have the peace of mind that your money will be there when you need it in retirement.