The first annuities date to 300 BC and took the form of annual payments to Roman soldiers for their service to the empire. As investment vehicles, they’ve gotten quite a bit more complicated since then.
Helping your clients understand the basics of annuity contracts puts them in the best position to make informed decisions about what is right for their financial needs. Here’s a quick review.
Types of Annuity Contracts
Annuity contracts fall under two types and three primary categories:
- Immediate – The client receives payments soon after making the initial investment.
- Deferred – The client waits to receive payments while the annuity principal grows. Money is invested in either a lump sum or periodic payments.
Within each type, investors planning for retirement have three main options:
- Fixed – Working much like a CD, a fixed annuity guarantees the investor’s principal plus a fixed rate of interest, a defined term and equal monthly payments. Unlike a Certificate of Deposit, however, fixed annuities grow tax-deferred.
- Variable – More complex, a variable annuity also carries the most risk. Clients select from defined mutual fund offerings held in subaccounts and the variable annuity pays out depending on the performance of those investments. In the industry, they are also called “mutual funds with an insurance wrapper.”
- Indexed – A newer option, indexed annuities also provide a principal guarantee and a set term but that rate of return is tied to a major market index such and the S&P 500. The owner does well when the market does well; when the market stays flat or dips, the owner receives only a minimum return.
*All annuities are tax deferred.
Annuity Taxes and Potential Penalties
Outside an IRA or employer-sponsored retirement plan, annuities are the only investment that grows tax-deferred. After age 59.5, withdrawals are taxed as ordinary income, not capital gains unless the annuity is purchased as part of an IRA.
However, make sure clients understand early withdrawals are subject to a 10 percent penalty, as are IRAs, payable to the U.S. Treasury.
Also review any schedule that spells out surrender charges, or penalties separate from taxes the insurance company will assess for early withdrawal. Depending on the contract, a surrender charge may last for up to 15 years.
An annuity may be the perfect fit for a client who wants more tax-deferred investments and an income stream. The industry in 2014 saw sales grow 3.8 percent over 2013, and 8.2 percent over 2012, to $229.4 billion, according to the Insurance Retirement Institute, which used data from Beacon Research and Morningstar, Inc.
Despite the slight drop during the quarter, industry-wide sales were up for the full year. Industry-wide annuity sales reached $229.4 billion in 2014, a 3.8 percent increase from $220.9 billion in 2013 and an 8.2 percent increase from $212 billion in 2012.
Sales of fixed annuities were especially strong, growing 17. 2 percent – from $78.1 billion in 2013 to $91.5 billion in 2014. Variable annuities, however, counted for 60 percent of new contracts.
Hopefully, you can make use of this information to inform your clients and help them make the right investment decisions.