Another thing that annuities offer is tax-deferred growth. Annuities offer an insurance wrapper that shields the account value from tax until you take distributions.
- The good news is that by growing and compounding without paying tax each year the investments inside the annuity grow faster without the tax "drag" of annual taxes in a taxable account.
- The bad news is that all distributions from an annuity must pay tax on all of the growth as ordinary income. The same growth in a taxable account would be able to pay capital gains tax, at a lower rate, on all capital growth.
- A great alternative to an insurance wrapper to defer tax is the Roth IRA or the Roth 401k. Both require you to pay tax on your deposits, just like you would for the money you would use to buy a non-tax-qualified annuity. But, all distributions are TAX FREE. It’s a great deal. And current savings limits are higher than they used to be.
- Roth IRA contribution limits for 2022 are:
- Every taxpayer can save $6,000 each year into a Roth IRA.
- If you are better than 50 years old, you can add an additional $1,000 each year to bring the total to $7,000.
- 401(k) contributions limits for 2022 are:
- $20,500 of your earnings can be saved each year.
- If you are better than 50 years old, you can add an additional $6,500 each year to bring the total to $27,000.
- Roth IRA contribution limits for 2022 are:
So, What Is a Guaranteed Outcome?
The term annuity refers to an insurance contract issued and distributed by financial institutions with the intention of paying out invested funds in a fixed income stream in the future. In its purest form, and the investor makes a single investment and the insurance company guarantees a series of payments back -- usually monthly payments. The payments may be for a fixed number of years, or they might be for as long as the investor lives. Once the contract is started, the payments are guaranteed. You KNOW EXACTLY what you will get back.
What is a fixed versus variable annuity?
Annuities are a contract issued by an insurance company that accepts deposits, then makes payments later. The deposits can be invested in fixed-interest instruments, like bonds, or the deposits can own stocks.
- Fixed annuities are much like a CD at your bank.
- When you open up the contract you get a known rate of return. Usually for the life of the annuity contract.
- Your return is guaranteed by the issuer and will not vary.
- No downside risk.
- No chance you will do better than the published rate.
- Variable annuities are much like an investment account.
- You own various investment funds that own stocks.
- You will get the market returns of the investments you own.
- You get the possibility of loss and the chance of better returns.
What’s a fixed-indexed annuity?
An indexed annuity is a type of annuity contract that pays an interest rate based on the performance of a specified market index, such as the S&P 500. It differs from fixed annuities, which pay a fixed rate of interest, and variable annuities, which base their interest rate on a portfolio of securities chosen by the annuity owner. Indexed annuities are sometimes referred to as equity-indexed or fixed-indexed annuities.
- An indexed annuity pays a rate of interest based on a particular market index, such as the S&P 500.
- Indexed annuities give buyers an opportunity to benefit when the financial markets perform well, unlike fixed annuities, which pay a set interest rate regardless.
- However, certain provisions in these contracts can limit the potential upside to only a portion of the market's rise.
- Indexed annuities offer more possibility of upside gains and protection from downside loss.
- Good -- One place an annuity can be great is to provide predictability. When you buy a fixed annuity, you know what the return will be. You know how much you will receive each month. There are no surprises.
- Bad -- The problem is that fixed annuities base their rates on US Treasury rates which are at historic lows. As I write this a 30-year Treasury bill pays about 3.5% interest for 30 years. Inflation has been bad this year. Up over 8%. And inflation has averaged 3% over the last 50 years and is likely to be higher than that for the next few years, so money invested in an annuity that pays 3.5% will not keep pace with inflation.
- Bad – If your situation changes, you do NOT always have the option to take out larger distributions.
- Good – You own stocks in a tax-deferred wrapper. You pay no tax on dividends or interest. And any capital gains on profitable sales of stocks inside the contract are also deferred.
- Good – Stocks have historically grown faster than the rate of inflation. The average rate of return on the S&P 500 (the 500 largest U.S. companies) over the last 100 years has been 84% per year with dividends reinvested.
- Good – Annuities offer contractual guarantees of income that can provide for more income over your life. If you live longer than expected, contractual guarantees can deliver substantially more income to you over your life than a plain investment account.
- Bad – Many of the guaranteed options are really complex. They are often designed by marketing experts, so they sound fabulous. Sometimes, they can be quite expensive -- as much as 2% to 3% of the account value per year. The is expense reduces your net return on the contract.
- Bad – Growth in your stocks will be taxed when you remove it from the contract. That tax rate will be your personal income tax rate at that time. Based on the current tax rates, personal income tax rates are higher than the rate for Capital Gains on the same stocks in a taxable account.
So, clearly, you will want some advice about how an annuity might help you reach your goals. That advice will be better if it comes from somebody with great training, lots of experience, and a commitment to acting as your advocate as a financial planning fiduciary.
It would ALSO be great if that advice did NOT come from an “advisor” who works for an insurance company and is rewarded more for selling more annuities.
If you would like to talk with me about annuities and your financial goals. I would be honored to have a chat. Follow this LINK to find a time that works for you.
As a financial planner who is ALWAYS an advocate for my client – a fiduciary advisor – I LOVE talking with new families and helping them move toward their financial goals. I would be honored to help you and your family.
I have more than 20 years of experience along with extensive training through the
CERTIFIED FINANCIAL PLANNER™ professional certification program.
Yes, I am a CFP® professional. I’m always a fiduciary and I work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.
If this article has you thinking about your own circumstances, contact my office at email@example.com. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.