Retirement Income Blog

Deferred annuities are designed for building a tax-deferred retirement nest egg by people age 20 to 60.  During volatile times, this may be one of the better retirement options for conservative investors.  You can have your funds guaranteed by the insurance company and receive their modest annual declared interest rate or you can opt for a variable annuity where you, the investor, select from a menu of investment accounts in hope of gaining a return better than the fixed annuity rates provided by the insurance company.  In both cases, your money accumulates tax deferred.  IRS wants these vehicles to be used for retirement savings so there is a 10% penalty for withdrawals prior to age 59 1/2.

Accumulation Phase

During the accumulation phase is when the money goes in.  You can make a single payment, additions over time or systematic monthly payments from your checking account. During this time period, the funds grow tax deferred.  In a deferred variable annuity, you have the flexibility to switch your funds between the various investment options offered.  During the accumulation phase surrender charges apply.  Think of these as early withdrawal fees.  If the annuity has a 7 year term (which you can renew at the end of each term if you choose), any withdrawals during the term may trigger a surrender charge.  Most every insurance company allows you to withdraw 10% of your account value each year before the surrender charge is assessed.  Additionally, many allow larger withdrawals, exempt for surrender charges, for emergencies so as confinement in a nursing home.

Distribution Phase

After age 59 1/2, you may want to take distributions for your retirement years.  You can choose several ways to distribute your money

1. in a lump sum.  This is not a good idea as you would need to pay the deferred income tax all at once.
2. in payment over a term of years (e.g. 10 years) or lifetime payments.  In the case of lifetime payments, the insurance company guarantees a regular payment for as long as you live.  if you live to 105, you win.  If you die tomorrow, they keep your money and they win.  The lifer arrangement can also be arranged over two live, e.g. you and your spouse.
3. interest withdrawals

In the case of the life annuity, it is best to start that flow later in life.  The monthly guaranteed payments to you are higher the later you start. In the case of a variable annuity, your payments will normally vary based on the performance of your investment choices by most insurance companies will offer conversion to a fixed payment stream for retirement.  It’s possible that between a social security check and a lifetime fixed payment from your annuity, you may have all the income you need.  Consult the retirement calculators.  (Note that if you like the idea of a fixed payment for life and have not saved through a deferred annuity, you can still purchase a retirement annuity or immediate annuity now).

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One of the advantages of immediate fixed annuities is the feature that provides you with income for the rest of your life, for both you and your spouse, or simply to pay you for a fixed number of years. But what’s the best choice for you? Let’s consider some payouts based on annuity type and other factors to get a feel for what to potentially expect.

We’ll hypothetically assume a man has $50,000 to invest in an annuity. He’s 70 years old with a remaining average life expectancy of 16 years. What kind of payouts can he expect to get?

If he wants an immediate fixed life annuity on himself, a hypothetical insurance company  determines a monthly payout for him based on his sex, age, investment amount, and the current interest rate. The current interest rate is particularly important since their profit will be based on how much they’ll get for investing his $50,000. They’re predicting the man will die 16 years later (at least that’s their bet based on the average life expectancy of males age 70) so they know how many monthly payments they must make. They’re obliged to keep paying if the man lives longer, but also get to keep the investment if the he dies earlier than expected.

Life Expectancy
In our hypothetical case, the monthly payout is $385.  Incidentally, if the man were 80 years old his remaining life expectancy would be 11 years. So the insurance company would pay out $554 per month since they’ll be statistically paying for fewer months.

Gender
Women statistically live longer than men. A 70 year old woman has a remaining life expectancy of 20 years. This implies more monthly payouts by the insurance company so her payout is only $352 for that $50,000 investment. And if she were 80 years old, her monthly payout would be $498 – somewhat less that then 80 year old man’s, because of her still longer life expectancy.

Joint Life
A married couple may opt for a joint life annuity where payments will continue until the second spouse dies. In the case that both are 70 years old, the insurance company would pay $318 since statistically it turns out that between the two, the survivor would statistically live longer. The payout remains the same even if only one remains alive 

Finally, if the single 70 year old man chose an annuity for a certain period – 10 years – under the prevailing rates, he’d receive $515. But in this case, the insurance company would pay his beneficiary the remaining payments if he died. The payout is the same for the women since there’s no age or age-related sex difference issue here.

For the most current rates, use the immediate annuity calculator.

Immediate fixed annuities are the payment of a single premium to an insurance company in return for periodic payments over a specific period or life.  Once payments begin, the annuity cannot be surrendered for value (there are a few companies that do allow commutation–the surrender of the annuity for a discounted refund).  Income from annuitization is taxed part as ordinary income and part as return of capital and a 10% penalty could apply if the recipient is under age 59 1/2. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. For other ways to generate income in retirement, visit the retirement planning center.

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While tax-free bonds can be a popular source of tax-free income, some retirees are not aware that they can receive a potentially higher source of cash flow from insurance companies using an immediate fixed annuity.

In exchange for the premium payment, the insurance company pays the annuity owner a cash payment for life or for a term of years. Each of these payments is comprised of interest and principal as determined by an actuarial calculation set forth in Section 72 of the federal tax code. The principal portion is not subject to income taxation. Once the owner has recovered his or her investment, the remaining payments will be taxed as ordinary income.|

Let’s take a look at the hypothetical case of Mr. Jones, age 70 with a $500,000 portfolio of municipal bonds, earning 4.17% tax free. He receives $20,850 of annual tax free income (4.17% x $500,000).

He decides to cash in his tax-free bonds and pay a premium to an insurance company of $500,000 for an immediate fixed annuity. With the immediate annuity, his yearly cash payment from the annuity would be $48,000 per year of which 65% is tax free (the tax free portion of an immediate annuity is the part the IRS considers return of your principal and is based on your life expectancy and the expected return). After taxes, he will have $43,800 to spend. His spendable cash increases by $22,950 annually ($43,800-20,850) over the tax free bonds.

You can see how much you could obtain form an immediate fixed annuity using the immediate annuity calculator.

So in this particular example, the yearly cash flow has increased by using the fixed immediate annuity. Of course, your results will vary based (among other things) upon your age, health, and premium payment. The payments in the example shown above are calculated on the life expectancy of the annuitant and the spot interest rates effective for the month of purchase under the contract. The spot interest rates can vary from month to month. The payments shown above are not subject to mortality fees, administrative charges, or other expenses. However, actuarial calculations, life expectancy assumptions, and interests rates can vary from insurer to insurer. Therefore, your results will likely vary from the examples shown above.

An immediate fixed annuity will usually not leave anything for your heirs unless you purchase from a company that offers a refund feature. This refund feature will typically reduce the size of the monthly annuity payments. The amount of the refund could also be reduced by surrender charges in some cases. Therefore, the fixed immediate annuity is generally better suited for people who place more importance upon increasing lifetime cash flow rather than leaving an estate to heirs.

Of course, an immediate fixed annuity or tax free bonds would only be a portion of a retirement portfolio and resources in the retiremenmt planning center can help you plan your entire portfolio.

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Although there are several flavors of annuities, the term “retirement annuity” typically refers to an annuity taken from an employer pension plan (e.g. monthly payments for life) or a non-qualified annuity purchased by an investor with after tax funds in return for monthly payments from an insurance company.  Retirement annuity rates or monthly payments will depend on the amount you invest, your age and the term you select for payments (you can generally select payments over 5 years or lifetime).  If you select lifetime payments, both you and the insurance company share risk on your life expectancy.  If you get hit by a bus and killed tomorrow, payments stop, they keep all your money and they win.  If you live to age 110, you get a great retirement annuity rate and they will be sorry to have you as a client they must pay for life.

A retirement annuity provides dependable security–think of it like another social security check but likely better.  While the Social Security system is upside down (has more payments due than it will have assets), commercial insurance companies invest and preserve your money to pay your claim.

To purchase a retirement annuity from an insurance company, you make a one-time payment and distributions typically begin within a month. A retirement annuity can be fixed or variable–your payment can be the same every month, you can opt for smaller payments in the beginning that grow over time (i.e. inflation adjusted) or you can have your payments based on a menu of investment options and you take the risk of how well the investments perform.  In  the case of the variable annuity, retirement annuity rates cannot be forecasted although some annuity companies will provide a minimum guaranteed rate of return.

In the case of he income payments you receive from a “fixed” retirement annuity, these will never change and are based on the amount you deposit, the age when you start and the interest rate environment at the time of purchase.

You can check retirement annuity rates with the immediate annuity calculator.  For an even more current quotation, ask your retirement consultant to get quotes from a number of insurance companies.

Note that the quotes you receive will show the monthly payment you get.  You will likely not see any interest rate on these quotes because the total payments to you may be unknown in the case of a life annuity, i.e. no one knows how much you will receive.  But if you died at your life expectancy, you could calculate the retirement annuity rate and get an internal rate of return about 2%.  You may be surprised why anyone would buy a retirement annuity at such a low rate.  It’s because of the security involved–no matter how long you live, you cannot outlive the funds on a lifetime retirement annuity.  The insurance company takes a substantial risk and provides a relatively low rate when priced to life expectancy.

If you are age 70 or above, you will likely not find a source of cash flow larger or safer than what you can obtain from the retirement annuity, with the comfort of knowing your payments are quite secure from a AAA rated insurance company. Even though the retirement annuity rate may be low (because your principal is never recovered), the monthly payments cannot be matched by an alternative with the same degree of safety.

Additionally, under current tax law, a portion of each payment received from a retirement annuity is tax-free until your total premium is recovered. The remainder of each payment is taxed as ordinary income in the year received.

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Your Immediate Annuity May Give You a Double Tax Break

If you’re concerned about having enough income to last and you want to maximize it while reducing taxes – perhaps an immediate annuity is for you. You’d ensure an income for life but it’d depend on your age and sex. When you die, that’s it – your investment is gone. But this may be fine in your case if you desire to maximize your cash flow.

How does the immediate annuity help reduce tax?
Each payment from an immediate has both a taxed and untaxed portion.  This is due to an IRS rule that may make no logical sense but it helps seniors interested in reducing taxes. The untaxed part is your basis –i.e. your purchase price. Its fraction of each payout - called the exclusion ratio - remains fixed at the ratio of your purchase price to the expected total payout based on your remaining life expectancy.  This part of the annuity payment is not taxed over term of the annuity.

To illustrate the power of reducing taxes, we’ll estimate the total payout for 15 years for a 65 year old male living in California who invests $100,000 - based on a leading supplier of immediate annuity quotations. Fifteen years is the IRS’s expected life at of a 65 year old man. Their estimate gives $675/month – with no beneficiary (lower payouts would include guaranteed term payouts to beneficiaries). The total payout over 15 years at $675/month is $121,500. So the exclusion ratio is 82.3% (= $100,000/$121,500)!  Therefore, of each payment received 82% is not subject to tax for the next 15 years and this makes immediate annuities a powerful choice for reducing taxes.

So, your annual income from your $100,000 immediate annuity investment is $8,100 of which only $1,434 is taxable. At a 25% marginal tax rate , you net about $7,700 per year.

If you had invested your $100,000 in 10 to 30 year corporate bonds at the prevailing 5% rate , you’d generate a $5,000 yearly income but all of it taxable. Again at a 25% marginal tax rate, your net income is $3,750 – about half as much as you net from your annuity.  So a large part of your increased cash flow comes from reducing taxes using the exclusion ratio that IRS provides for an immediate annuity.

Purchasing tax free bonds – at a lower prevailing interest rate- may give you more net income, but still significantly less than from an immediate annuity.  Additionally, taxfree bonds will not provide the tax reducton feature described below.

Further possible tax reductions on taxable social security
Social security becomes subject to tax for provisional incomes beyond $25,000 for single individuals, and $32,000 for married filing jointly. It can be taxed up to 85% beyond the $34,000 and $44,000 thresholds respectively. This provisional income includes all taxable income, 50% of your social security income, and tax free bond income. Reducing taxes on social secuity income is an obvious desire of most seniors.

Your immediate annuity income adds only $1,434 to your provisional income compared to $5,000 from 5% tax free bonds or corporate bonds. If you’re near or within the above threshold levels, you’ll reap additional tax savings from social security income that remains untaxed due to your annuity’s lower contribution to provisional income. Reducing taxes in this manner could be an additional $1,000 annually to spend.

Note that if select lifetime payments for your immediate annuity and live beyond your life expectancy, reducing taxes with your immediate annuity no longer works as all payments become taxable.  However, most immediate annuity owners are happy to live beyond their life expectancy to give up tax reduction.

You can learn  more about retirement annuities and tax planning for retirees at our main web site.

Get your copy “Six Ways that Retirees Can Reduce Taxes”

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Annuities are term deposits with insurance companies.  They are similar to certificates of deposits at the bank (note: bank deposits are FDIC insured while annuities are guaranteed by the issuing insurance company).  There are two types of annuities: fixed annuities and variable annuities. Fixed annuities have these features:

  Your principal is guaranteed, it will never decline
  The insurance company adds interest to your deposit each year
 The annuity is for a specific term that you select—generally, the longer the term, the higher the interest
  All interest is tax deferred (you do not report it on your tax return) until withdrawn
  You may withdraw 10% of your balance annually
 If you withdraw more than 10% during the term, you will pay withdrawal penalties (called surrender charges)

Most fixed annuities offer an initial one-year rate with the rate changing each year.  A few companies offer a locked-in rate for the entire period.  We recommend that investors always get a locked-in rate.  Fixed annuities are the safest, most conservative choice.  In this short description of how fixed annuities work, we have not covered the many permutations–each annuity company’s contract is different so read it thoroughly. The annuity calculator will give you an idea of the amount you can accumulate.

Next, let’s consider how variable annuities work. With variable annuities, rather than receiving interest from the annuity company, your money is invested into stock or bond accounts (these are investment accounts like mutual funds).  You may earn more or you could lose principal, depending on the accounts you select and if the stock and bond markets rise or fall.  Variable annuities are the riskiest choice.

Maybe the best choice is an index annuity as it is a “hybrid” of a fixed annuity and variable annuity. With an index annuity, your principal is guaranteed like the fixed annuity, but your interest each year is based on increases in the S&P 500 index (this is an index based on 500 large stocks, such as IBM, General Motors, Intel, etc).  So, your interest you earn is tied to performance in the stock market but you can never lose principal (unless you withdraw your principal prior to the end of the term and pay surrender charges).  You get the guarantee of a fixed annuity with the potential profit of a variable annuity.

Everything discussed about how annuities work up until this point describes the growth phase (called the accumulation phase) of the annuity.  When and how do you get your money out? Here’s how annuities work regarding the accumulation phase and you generally have three options:

  You can leave the annuity alone and continue to let it grow
 You can exchange the annuity to another company that may pay you a higher rate
  You can start to make withdrawals

 The withdrawal phase is called the distribution phase.  You have three options:

  You may withdraw all of your money at once
  You can withdraw some money each year based on your desires
  You can annuitize the policy

Annuitizing means that you accept fixed monthly payments from the annuity company.  The payments can span your lifetime or be limited to a specified period (e.g. 10 years).  At the end of the period you select, the annuity is completely paid out.  If you select a lifetime payout, the payments will continue for as long as you live.

As you might imagine, the monthly payments are usually more for a fixed 10-year payout than if you select a lifetime payout (the option which pays the most depends on your age).

Annuitizing may or may not be a good deal and depends on your circumstances.  

If you are single and need to maximize your monthly income, the lifetime payments may be a very good deal.  On the other hand, if you want to leave money to your heirs, annuitizing would not be good because there will be nothing left at the end of the annuitization period.  

What is an immediate annuity?

An immediate annuity has no accumulation phase.  You make a deposit with the insurance company and immediately begin receiving payments.  These annuities are generally suited for senior investors (age 70 plus) who desire to increase their monthly income.  You can see how much you get using the immediate annuity calculator.

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Index annuities are fixed annuities that have the interest you receive tied to a stock market index. An index annuity is ideal for investors who want to participate in market-related returns yet are uncomfortable
with market risk. But with about 40 known interest crediting methods, you may find that even if
two index annuities are linked to the same index, their returns might not be the same.  That’s because these index annuities have several moving parts as described below.

The Participation Rate in an index annuity is the amount of the increase (not including dividends)
in the underlying index that will be credited to your index annuity. For example,
suppose the index (the S&P 500) increased 9% and the participation rate is 70%. The index annuity will be
credited with 6.3% interest (9% x 70% = 6.3%).

Annuity companies can set different participation rates for newly issued index annuities as often as each
day. Therefore, the initial participation rate will depend on when the company issues your index annuity. Annuity companies usually guarantee the participation rate for a specific period (from one
year to the entire annuity term). Then when that period is over, a new participation rate is set for
the next period. Some annuity companies promise that the participation rate will never be
set lower than a specified minimum or higher than a specified maximum.

However, you should insist on a fixed participation rate for the entire annuity term.
Some annuity companies may provide 100% participation today, but if they change that
to 50% next year, you won;t be happy. Therefore, look for an index annuity with a fixed participation rate for the entire term.

Try to get an index annuity with an Annual Reset. This feature compares the index value at the end
of the contract year with the index value at the start of the contract year. And it is
especially important for retirees as the gains are better protected from subsequent declines in the index. Without the annual
reset feature, you cannot protect one year’s gain from the next year’s loss. There’s
nothing worse than when you make 30% one year then lose it the next. If you want to take that risk, you
may just as well be in a variable annuity or in a mutual fund.
However, in every case of an index annuity that offered an annual reset, we have seen it
combined with an averaging feature, which is not beneficial.

Averaging of the S&P 500 at the beginning of a term is supposed to protect you from
buying at a high point in the index cycle, which would reduce the amount of interest you might earn over the term.
Averaging at the end of the term protects against severe declines in the index and losing
index-linked interest as a result.
And while most annuity companies claim that this is a good feature, it’s not beneficiaial for the index asnnuity owner. It dilutes the return. However, it’s nearly impossible to find a product that
doesn’t use averaging.

Based on an analysis of periods over the past 30 years, an index annuity with a 55%
participation and no averaging will do about as well as a 100% participation, with
averaging. However, from the annuity owner’s view, the 100% sounds better.

The best index annuity performance will come from the riskiest arrangement: A point-to-point design
with no averaging. The point-to-point method calculates the interest return every
contract year and then, ultimately, combines these returns to arrive at the total return for
the contract term. This permits index annuity owners to take advantage of a market recovery after a
year of losses. The change in the index is a “price change only” measure and does not
reflect dividends.

The high-water point, or high-water mark, is a variation of the point-to-point term
method. Rather than using the ending point, the calculation is based on the highest
obtained value during the term of the contract based on annual contract anniversary index
values. For example, if the index doubled its original value on the first anniversary date
and then proceeded to decline for the remaining contract period, the high-water point
method would calculate an index return of 100%. The high-water mark is locked in no
matter how much the market may go down. This is a beneficial index annuity feature for the investor.

Any type of Annual Cap has a significant effect on returns. Most people don’t realize
that two or three years out of 10 produce the big gains in the stock market. If you remove
those big gain years by capping them, the performance dives. Averaging of the S&P 500
reduces those big gains. And since index annuities already protect the original principal,
there can be no argument that averaging provides any value in down markets. Try and avoid index annuities with any type of cap.

Index annuities are not designed to outperform the index long term. So you will
not earn anything near what the stock market delivers. Index annuities will deliver about 40%-65%
of stock market returns. So if the stock market has delivered a 12% return over time,
figure an index annuity (with the averaging feature) will deliver 6%.

Start with the retirement planning calculatorto see how index annuities may fit into your retirement income strategy and then use the fixed annuity calculator to determine what part a fixed annuity can play in your retirement portfolio.

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