Financial Planning for April 2007

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Purchasing an Annuity?
Get the Facts First
One of life's greatest challenges is saving enough for retirement. If you are lucky, your employer offers some form of retirement plan. Additionally, you may be able to establish a type of IRA and/or Health Savings Account. All together, these investments can assist you in reaching your goal of financial independence in the golden years, but will they be enough?

The fact is that taking advantage of all the tax-qualified retirement savings options may not be enough to provide you a comfortable retirement. So what do you do to augment your retirement funds? You could invest in stocks and bonds, or, if your risk tolerance is low, build a portfolio of accounts that are protected against loss of capital like certificates of deposit, but it's safe to assume that, sometime before you reach retirement, you will pay tax on part of the income generated by these investments.

If you are interested in deferring any taxation on retirement savings until you retire, you might consider using annuities in your investment strategy. Annuities are Insurance company products and may be bought as such in either a lump sum or through periodic payments. The fund's value then grows during the accumulation phase. At retirement, you withdraw the accumulated value of the annuity either as a series of periodic payments or in a lump sum (payout phase).

The chief advantage of an annuity is that income earned during the accumulation phase escapes taxation, thus maximizing the money available for your retirement income. Most annuities include a death benefit that guarantees you the greater of the market value of your annuity or a return of your investment upon death. Annuities' major drawbacks include high fees, treatment of all earnings upon distribution as ordinary income, and lack of liquidity.

Mutual fund companies charge investors fees to cover the cost of fund operations and pay sales costs. In addition to these expenses, insurers charge mortality and administration fees under annuity contracts. Combined, total fees under an annuity arrangement can be nearly double what you would pay if you invested in products other than an annuity contract.

If you purchase a mutual fund and it does well, upon sale the growth is taxed at capital gains rates. Capital gains taxes can be less than half the taxes on ordinary income. In an annuity arrangement, all income, including capital growth, is taxed at ordinary rates.

You may have heard that investors need to have a time horizon of five years or more to maximize their returns. Nowhere does this hit home more than with annuities. Typically, an annuity contract carries with it a surrender charge if you bail out early, which can mean anywhere from zero to ten plus years. If you purchase an annuity in 2007 and need access to your funds the next year, you will pay a heavy price to get that money. Depending on the timing of your withdrawal, you could actually lose money.
There are two basic types of annuities - fixed and variable. The fixed annuity is very much like a bank certificate of deposit without deposit insurance. In fixed annuities, your investment earns a guaranteed rate of return and the principal is protected. Variable annuities, on the other hand, give you the opportunity to earn higher returns by allowing you to invest in mutual fund-type investments. With higher returns, though, come higher risks. Typically, variable annuities do not offer the capital preservation feature that fixed annuities provide.

When the stock market is doing well, variable annuities offer attractive returns, but, as 2000 and 2001 taught us, the stock market does experience periods of decline. These declines can wipe out most, if not all, of the previous years' gains in your portfolio. The designers of variable annuities recognized this and now offer products that offer a combination of near market returns with protection against market declines. While there is nothing inherently wrong with protecting against market downturns, when the investment market recovers, you probably won't enjoy the full value of that upswing.

The bottom line to annuities is that they, like other investments, have their pros and cons. Evaluating the merits of one annuity over another can be daunting for even the most sophisticated investor. Just determining if an annuity is appropriate for you can be confusing. Before you lock yourself into a contract that can literally last a lifetime, give us a call and let's discuss your options.

Happy April!


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