Financial Planning for November 2000

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A New What?
If you are looking for a new investment and don’t want to pay taxes on your earnings, then annuities may be the answer for you.

What are annuities?

In the simplest terms, an annuity is a contract between you and an insurance company where you give the insurance company money up front and the company gives you money back sometime down the road. What we will be talking about are Tax Deferred Annuities (TDA). These are annuities where the earnings are not taxed until you withdraw them. You can pay for the TDA either in a lump sum or in periodic deposits over a specified period.

The three basic types of annuities:

Fixed Annuities
are arrangements where the amount you will be paid is fixed based on a single rate of return. In other words, you know how much you will receive when the payments start, and the number will not change. This has the advantage of letting you plan with a reasonable amount of certainty, but does not protect against inflation. For an extra amount, you can get an annuity that will increase from year-to-year, to help with inflation.

Variable Annuities
change from year-to-year based on market conditions. This is because you are allowed to invest your funds rather than letting the insurance company do it. Variable annuities have the advantage of allowing you to participate in an up market. They also have the disadvantage of allowing you to participate in a down market, such as we have recently seen. If you look at the money in the annuity as long-term (15-20 years), history suggests you will eventually outperform the results you would have with a fixed annuity.

Equity-index Annuities
are the new kid on the block. This is a kind of fixed annuity tied to some stock index (S&P 500, etc.). In up markets, you participate in the index increase, but not to the full extent of the market (generally, you are limited to an increase of 50%-90% of the market increase). This is the price you pay for the fixed feature of the annuity. This feature will protect your investment in down markets because it has is a minimum guaranteed rate of return - typically 3%. This type annuity will appeal to the risk adverse investor who wants to participate to some extent in rising markets.

You might want to invest in annuities if you:

  • are trying to save for retirement and you have maxed out on your 401(k) plan at work, you can’t invest any more in your IRAs and you don’t want to pay tax on any investment gains in the near term;
  • prefer to invest in mutual funds rather than separate stocks and bonds;
  • plan on keeping your annuity for 15 to 20 years (i.e. you are a long-term investor);
  • are in a 28% or higher tax bracket today, but expect to be in a lower bracket when you retire;
  • won’t need the annuity fund proceeds until you are 59 ½;.
  • don’t care all that much if you heirs have to pay ordinary income taxes on any appreciation; and
  • want a “guaranteed” income for life after retirement.

If the above apply to you, then you are a candidate for a tax-deferred annuity.

However, if all you want to do is invest a few bucks, here are some things to consider before signing on the dotted line(s).

TDAs generally have a higher expense structure and are not liquid investments. TDAs have higher costs because they are, in the end, insurance products and as such have associated mortality and expense charges. These fees go to pay for the insurance portion of the annuity as well as commissions, selling and administrative expenses of the contract.

Generally, there are surrender charges attached to annuities. A surrender charge is what it will cost you for the insurance company to give you back your money. These charges are generally in effect for 1-12 years and can be quite steep. Their purpose is simple – discourage short-term investors from using annuities. This is the reason annuities are meant for long-term investors.

Finally, we get to the management fees. These are basically the same thing as investment manager fees. Depending on whether you look at managed or unmanaged mutual funds, these fees can be pretty steep by comparison.

We’re accountants, so we’ve saved one of the bigger considerations for last – income taxes. If you invest in a mutual fund, when you sell the asset you get long-term capital gains tax treatment, assuming you held the asset longer than a year. The current maximum long-term capital gain for these type investments is 20%. However, if you withdraw funds from an annuity, the portion subject to tax will be taxed at ordinary income rates – currently with a maximum of 39.6%.

Since you are investing for retirement, don’t forget to consider the impact of taxes on you’re decision.

Comparison Shopping

No, you’re not at the grocery store, but we wanted to leave you with a final thought. Just as some mutual funds are better than others, some annuities are better than others – especially depending on your needs. Investigate all possible offerings before purchasing an annuity. Sometimes, annuities aren’t the way to go.

This is where we come in. The bottom line is we are here to help you decide what you want and help you get there. Before committing any long-term funds, give us a call. Let us help you decide your best alternative. You’ll be glad you did.


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