Defined benefit plans, better known as pensions, have been slowly disappearing from the private sector ever since the creation of 401(k) plans in the early 1980s. According to CNN Money, only four percent of private sector workers rely on a company pension as their only retirement plan. 14 percent of private sector companies offer their employees a pension plan or a 401(k), and many of the companies that still offer pension plans are looking to cut these plans. If you don’t have a pension, but like the idea of having a secure retirement with an income you can never outlive, then you should consider purchasing an annuity.

Do you need an annuity?

The answer to this question depends on your current income, your overall financial condition, and your financial goals. If you are wealthy, then an annuity may not be appropriate for you. If you are not wealthy but have plenty of money coming in from Social Security, have plenty of money saved in a retirement account, and have other income-producing investments like real estate, then an annuity may not be appropriate for you. Also, if you have health issues that may shorten your lifespan, then an annuity will not be appropriate for you. If you do not fall into any of these categories and would like to purchase an annuity, then you need to know what types of annuities are available.

Types of annuities

There are several types of annuities. Knowing which one is best for your situation can go a long way in helping you accomplish your financial goals. The types of annuities include:

1) Fixed

Every person will need a source of income when they retire. An annuity can provide a retiree a dependable and reliable form of dollars for the rest of their life. There are some drawbacks with annuities. However, some of those drawbacks can be avoided if you make some smart choices.

Here are a few things you should take into consideration regarding the upside and downside of fixed annuities:

Annuity Safety

  • Pros – The premium that your insurance company invests as part of your portfolio is never lost. The company is often backed up with substantial funds to protect your money.
  • Cons – The cost of this type of safety means limited growth potential. For some people, this isn’t good enough.

Guaranteed Earnings

  • Pros – The interest of your annuity is protected against loss. This is a great benefit when the market is volatile.
  • Cons – Since crediting only takes place once a year, your earning potential is dependent solely on how the market works on one day. This means you could have significant gains. On the other hand, you could get wiped out.

Caps and Rate Spreads

  • Pros – You have the option to track your performance. The cost of the option dictates how much of a gain received. The yields are greater than any safe asset.
  • Cons – Expectations may not be great. But if you can find better options, do so.

Surrender periods

  • Pros – Relative to safe money, CDs and Bonds have long commitments. Annuities have protection from interest rates.
  • Cons – Experts often say you don’t need to lock money up for an extended periods. It all depends on what you are doing with the money. If the withdrawal annuity isn’t enough to meed your needs, it’s not for you.

The bottom line is annuities can generate a lifetime of income. Many annuities are increased to keep up with inflation. An example of an annuity is a 65-year-old man receiving a $100,000 annuity. The man would receive about $546 monthly income. This money is a permanent stream of income that will last a lifetime.

Another consideration about lifetime annuities is that you could actually die without having benefited significantly. If this happens, it means the annuity could go back to the annuity company.

People should also know that not all annuities are created equal. The range is quite expansive:

  1. Immediate vs deferred – Some annuities can begin paying immediately, and others can be deferred to start at a later date.
  2. Fixed vs variable – Fixed have fixed interest rates and predictable income. Variable have to do with the overall market.
  3. Lifetime vs fixed period – Some lifetime annuities pay for the rest of your life. Others can pay for a standard number of years like 10, 15, or 20.
  4. Single premium vs multi-premium – You can deposit one check or many over a period of time.
  5. Single owned vs joint owned – You can buy a single annuity for one person. Or you can purchase an annuity for both partners.
2) Variable

There are several types of annuities that are available on the market. One of the main types of annuities is the variable annuity. Part of the variable annuity is a self-directed investment product, and the other part is an insurance product. The self-directed investment part of a variable annuity, known as the sub-account, allows you to decide how your contributions are invested. The amount of money you can earn in this sub-account depends on the performance of the investments you choose. You can choose from a pre-selected list of mutual funds, bond funds, and money market accounts. You can also choose to be an aggressive investor, a conservative investor, or an investor that uses a combination of the two strategies.

The insurance aspect of a variable annuity means that the principal balance of your annuity will be paid to your beneficiary no matter how poorly your sub-account performs. For example, if you put $50,000 into a variable annuity and you pass away at a time when your sub-account is losing money, your beneficiary will still get a $50,000 death benefit. Since a variable annuity is considered an insurance product, all the interest, dividends, and capital gains are tax-deferred. You are only taxed when you begin to receive payments from the annuity at retirement or when you withdraw money before you turn 59 ½ years of age.

Is a variable annuity right for you?

There are many benefits to owning a variable annuity, such as:

  • Having flexible investment options
  • Having tax-deferred investment growth
  • Having a lifetime stream of income
  • Allowing beneficiaries to avoid probate when they receive your assets

Unfortunately, a variable annuity is not for everyone. A variable annuity may not be right for you if:

  • You are less than 10 years away from retirement or 59 ½ years of age
  • You are wealthy and have other income-producing investments
  • You have serious health issues

Do your due diligence

A variable annuity is a long-term investment that requires a thorough understanding of how it works. They have ongoing fees, and if you make an early withdrawal, there is a 10 percent tax penalty. Be sure to work with a trusted financial advisor and have them explain in detail how a variable annuity works and if it is the right option for you. Insurance companies typically offer a 10-day free look period option where you contribute to a variable annuity to see how it works. Take advantage of this free look period to study how the variable annuity works first hand to see if it’s compatible with your situation.

3) Equity-indexed

A popular long-term retirement product is an indexed annuity. It provides a combination of different features of variable and fixed annuities. This annuity is like a fixed annuity because it provides a guarantee of a minimum return. It resembles a variable annuity because its rate of return is based on stock market performance. It is possible to purchase an indexed annuity from an insurance company. The terms and conditions of the payout will be based on the annuity contract.

  1. Stock Performance: Indexed annuities provide those who own them with the chance to earn higher returns based on stock market performance. It also provides protection against any type of market decline. Those who have an indexed annuity often receive returns that are lower than anticipated. This is because deductions are taken from returns that are fee-related. There is also a cap on the maximum amount of interest an indexed annuity can earn.
  2. Minimizes Risk: Someone who wants to avoid risk may want to consider adding an indexed annuity to their portfolio. It is often very attractive to individuals who are working on their retirement or getting close to retirement age. One of the goals with buying an indexed annuity is to have a better return than other investment vehicles like bonds, CDs or money markets and still protect the investment principal. In a typical year, the purchases of indexed annuities could represent over 29 percent of all annuity sales.
  3. Surrender Charge: The mechanics of indexed annuities are often very complicated. The returns an indexed annuity holder may receive could vary by a considerable amount based on the year and month they purchased it. There is often a surrender charge for any type of early withdrawal. Charge-free surrender periods could be as short as 3 years and as long as 16 years. The average surrender period is ten years.
  4. Rate Cap: If the index increases by 15 percent, the holder of an indexed annuity won’t experience a 15 percent return. The indexed annuity interest rate will have a cap. It’s possible for a 15 percent increase to result in a 5 percent return. It’s also important to realize interest rates for indexed annuities are calculated using a participation rate. This means the interest rate is a predetermined percentage of the increase of an index. If an index increases by 10 percent and the annuity provides the holder with an 80 percent participation rate, the indexed annuity would provide an 8 percent return. This will happen as long as it is not more than the rate cap.
  5. Taxation: Any type of gains experienced from an indexed annuity is taxed the same way as a fixed annuity. Taxes are deferred until the holder of the annuity receives the money. Interest in a fixed annuity is taxed first and at the same rate as regular income.

Indexed annuities are regulated by a state’s insurance department. When an investor purchases an indexed annuity, they must choose a deferred option or an immediate option. With an immediate option, an investor will begin receiving payments right after purchase. A deferred annuity provides an investor with the opportunity to let their annuity grow for a predetermined length of time.

If you are looking to purchase an annuity, be sure to work with a reputable financial advisor. Also, make sure you purchase an annuity from a solid and financially stable insurance company. Finally, always be sure to ask a lot of questions before your purchase.

How Are Annuities Taxed?

There are different types of annuities and they can each be held to different taxation rules. When someone obtains or purchases an annuity, they are often confused about what to expect from the IRS. With such complexities involving taxation, many annuitants make the wise decision to consult with a tax professional, so they can be sure they are paying appropriately.

Although annuities are meant to offer protection against income taxes, it is essential individuals understand holding an annuity does not necessarily mean they will be able to receive payments or withdraw money without any tax implications.

It is important individuals realize, while annuities are meant to offer tax deferment, this does not mean the annuity is entirely tax-free. The main benefit of an annuity is the ability of the account to gain interest while remaining tax-free until funds are withdrawn.

Taxes will not be due on an annuity until payments are received or a lump sum is withdrawn. Withdrawals and any lump sum distributions are considered income by the Internal Revenue Service and they will be taxed as such. These withdrawals are not taxed at the lower capital gains tax rate.

Qualified or Non-Qualified?

When it comes to income taxes being owed on annuity payments or withdrawals, one of the most important things to consider is the type of annuity. A qualified annuity means the money used to open the account has never been taxed, such as with a 401(k). Those receiving payments or withdrawals from a qualified account are going to be taxed as if they received income.

Non-qualified annuities are annuities that were purchased after taxes were already taken out. The amount of taxes that are owed on this type of annuity will depend on the exclusion ratio. To figure the exclusion ratio, one must know the principal amount that was used to purchase the annuity, the amount of time the annuity has been held by the annuitant, and the interest earnings that have accrued since opening the annuity.

Get Help From a Tax Professional

When in doubt, it is wise for annuitants to meet with a tax professional, so they can discover what type of taxation they can expect from their payments or withdrawals. As long as the money stays in the account, the IRS will not tax the amount.

If an individual begins receiving payments or withdrawals, it is essential they understand their tax implications, so they can plan accordingly. Without proper knowledge, individuals could end up neglecting to properly report their annuity earnings and be in trouble with the IRS. A failure to report these earnings could result in hefty penalties.

Annuity holders need to make sure they are aware of any tax laws that may affect their ability to withdraw from their annuity account. It is wise for a person to make sure they understand the tax implications before they begin making any withdraws, so they will not get any unwanted surprises when it comes time to file their income tax return for that year.

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Present vs Future Cash Value of An Annuity

Understanding the present cash value versus the future cash value is important for individuals who are considering purchasing an annuity. Knowing this information allows people to wisely invest in their future, for greater financial stability.

Knowing the present versus the future cash value of the annuity will help you to make wise decisions as you begin investing in your future. Annuities can be used to fund your retirement or simply offer you peace of mind in the event of a job loss or unexpected expenses.

Understanding the Present Cash Value

The present value of an annuity is the amount of cash it will take to be able to generate consistent payments that will provide you income for years to come. With careful calculation, you can determine your necessary contributions. You will need to know the following to be able to calculate your annuity’s present cash value.

Interest rate

Number of payments

Payment amount

The present value calculation will allow you to know the contributions you will need to make to ensure you are able to receive your desired number of payments.

Understanding the Future Cash Value

The future cash value of an annuity is the calculation of how much money will be accrued from the payments you make and the interest that is earned. This type of calculation helps you to understand the projected growth of your fixed rate annuity, so you will know what the value of your annuity will be within a certain period of time, say ten years.

Calculating both your present and future annuity cash value is important for ensuring you are making the right contributions for meeting your financial goals. There are online calculators that can help you easily determine these values, so you can use this information to make wise investments.

Benefits of Owning an Annuity

There are many benefits to owning an annuity and more and more people are using them as an investment tool. The following are some of the benefits annuitants can expect when they begin to invest in an annuity.

Guaranteed future income

A sound alternative to the stock market

Predictable interest earnings

Can be passed on to heirs

Before investing in an annuity, it is important you understand the ins and outs of this investment tool, so you will be able to make the right decisions for your financial security needs.

If you do not feel confident purchasing an annuity on your own, you can gain assistance from a personal finance advisor who can help you understand what to expect and how to ensure you are getting the most for your money. With an annuity, your financial future can be made much more secure.

Annuity and Divorce

The unfortunate and often complicated side of divorce is the division of assets. The division of community property can be dictated by certain laws that govern your state. It is best to enlist the help of a divorce lawyer to help you understand the consequences of how divorce with affect your annuity.

With about 50% of American marriages ending in divorce, a number of couples are forced to deal with the division of property, annuities, and retirement funds. While some divisions are easy, others are a bit more complicated. Annuities often fall into that category.

When a couple divorces, there are some ways that annuities can be addressed:

  • Withdrawal – The annuity owner may opt to a portion or some of the annuity and distribute it between both parties. However, there are consequences to this option. Withdrawal can mean the reduction in death benefits from the contract.
  • Transferal – Couples going through a divorce can agree to have the amounts transferred directly into an IRA account.
  • Start a New Contract – Withdrawing the existing contract and creating a new one with new benefits is one of the most common ways to divide the annuity.
  • Transfer Ownership – While ownership is not considered an annuity split, it does grant all rights to one party in order for a new contract to come into play.

Not all divorces are the same. In fact, there are many ways to get a divorce. Depending on the state, the division of annuities may ride on what type of divorce you are getting. Here are some options:

  • Fault Divorce
  • Fault & No Fault Divorce
  • Mediated Divorce
  • Uncontested Divorce
  • Contested Divorce
  • Arbitration

There are other things to consider regarding annuities when getting a divorce late in life:

  • Carefully analyze your retirement accounts. You should understand the consequences before the divorce. In many situations, the annuity will be divided regardless of which person is at fault.
  • Always contact an attorney about your rights. Find out about health insurance and other factors that could change your status.
  • Discuss your taxes with an accountant. Understand how this could possibly affect annuities.

Divorce Settlement Laws

If you are getting a divorce, you will need to understand that annuities are considered part of community property. However, it must meet the test of state laws regarding division.

First of all, certain annuities if purchased before the marriage cannot be factored in as part of community property. So, if the original owner had it before the marriage, there is no need for a split.

Couples should also know that there will be tax implications if couples own joint annuities. The IRS does offer certain exemptions in some cases. But if you rely on a good lawyer who helps with the transfer, some fees may be avoided.

It is imperative that you speak with a divorce lawyer who is steeped in annuity and tax laws to handle your case.

What Happens to An Annuity After Death?

When someone is awarded an annuity through a structured settlement, they may receive payments for a specific time period or the rest of their life, depending on the terms of the settlement. Many of the terms of an annuity agreement can be negotiated and it is essential individuals learn about their negotiation options before they sign their agreement.

What Is a Death Benefit Provision?

Provisions can be made with any annuity or structured settlement. Typically, the provisions need to be made before the agreement is signed, though some changes could be made after the agreement becomes legally binding, depending on the circumstances.

One of the provisions individuals need to consider for their annuity agreement is a death benefit provision. With this provision in place, individuals will be able to pass their annuity payments on to their heir, upon their death.

How to Start the Process

The owner of the annuity will be able to work with the insurance company to create their custom contract. Working with the insurance company will help to ensure the annuity contract is specific and will spell out what is done with any leftover payments or money after the annuitant dies.

In some cases, the arrangement can be set up so the beneficiary continues to receive payments just as the annuitant did before they died. Instead of annuity payments, the beneficiary could receive a lump sum payment that pays out the remainder of funds in the annuity account.

What Options Does the Beneficiary Have for Payment?

The beneficiary of an annuity typically has three options for receiving payment. Knowing these options will help to ensure the beneficiary is prepared for seeking their annuity payout. The following are the main options that are available.

  • The beneficiary may receive the remainder of the annuity funds in one lump sum payment.
  • A non-qualified stretch agreement means the beneficiary will receive reduced payments that are stretched out over the rest of their life.
  • With the five-year rule, beneficiaries can make withdrawals during a five-year period and can choose to withdraw the entire amount at the end of the fifth year.

How Is the Beneficiary Chosen?

The owner of the annuity is the only one that can choose the beneficiary. The beneficiary will in no way receive any benefits of the annuity unless the owner passes away.

It is important to note, the owner of the annuity has the right to change beneficiaries at any time and they can also choose more than one beneficiary, at their discretion.

Those who own an annuity need to speak with the guarantor to ensure their annuity agreement includes a beneficiary, so their funds will not be lost upon their death. It is essential annuitants understand the ramifications for each decision they make regarding their annuity, so they can make sound decisions that will benefit themselves and their beneficiaries. When in doubt, individuals should receive guidance and research their options, so they do not find themselves making changes that are not beneficial.