Interest rates affect annuities in sometimes strikingly different ways. The interest rate that most annuity companies follow is the 10-year Treasury rate. When it rises, most types of annuities are better off (but not all of them). When it falls, it often hurts many annuities.
Again, interest rates don’t affect all annuities the same way. So, let’s start by looking at annuity types and then how interest rates impact them. That will help you decide what annuity might be best for your needs.
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Taxes are a top retirement concern, and as annuities are the only financial vehicle that can pay a guaranteed lifetime income, you might wonder about annuities and taxes. To understand how annuities are taxed, you should first understand the different types of annuities and how they can be used.
Basic Annuity Types
There are a few basic types of annuities in the market today. It’s good to note that all annuities are capable of paying a guaranteed lifetime income. But some annuity kinds are better equipped to pay you lifetime income while others are stronger for growth.
That being said, these basic types of annuities are:
Fixed Annuity – A fixed annuity typically provides a guaranteed rate of growth for a specified period. The longer the term is for your fixed annuity, the higher that interest rate tends to be. So, it’s vital to select the company from which you buy an annuity carefully.
Fixed Indexed Annuity – A fixed indexed annuity offers growth potential that is tied to an underlying financial benchmark index. The annuity allows the contract holder to have their money earn interest, based on what the index does, without downside exposure.
Variable Annuity – A variable annuity allows someone to place money in various mutual fund-like accounts for investment purposes. Legally, it’s both an insurance policy and a security. However, a variable annuity does expose the annuity assets to the full risk of loss in the market.
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If you are one of the lucky few with a defined-benefit pension, then you might have wondered about what your options are with a pension versus an annuity. But while pensions were a common thing of the past, they aren’t around as much anymore.
In the days before smartphones and social media, many people had only one employer. Throughout their career, folks worked for one company and received a pension when they retired. From there, they would receive payments for the rest of their lives.
Today, unless you have a government job of some sort, pension benefits are rare. An annuity may be a good option for you if you don’t have a pension but like the idea of receiving income for the rest of your life.
As you consider the pros and cons of annuities vs. pensions for retirement, here are some key factors to consider.
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A non-qualified annuity is a contract designed to provide you with regular, guaranteed income during your retirement years. Non-qualified annuity policies are started with money which has already been taxed.
Non-qualified annuities can be a nice addition to a well-rounded portfolio. They can ensure that you have regular, predictable income on top of your Social Security benefits during retirement.
While they are funded with after-tax money, non-qualified annuities give the benefit of letting your money grow tax-deferred. In certain situations, they may also help reduce your overall taxable income in retirement, which can lower how much of your Social Security benefits might be taxed.
Another use for a non-qualified annuity is if you wished to retire early (say in your early 60s). It can fill in any income gaps between your monthly expenses in retirement and what your other assets may generate for cash-flow.
Here’s a closer look at how non-qualified annuities work and how they can be adapted for different situations in a retirement financial plan.
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An equity indexed annuity is simply a dated name for a fixed indexed annuity. Fixed index annuities came about in the mid-1990s.
They were intended as an option for retirement savers looking for alternatives to low-interest CDs and low-paying fixed-interest instruments, such as Treasury securities.
How the “Equity Indexed Annuity” Came About
Life insurance companies used different names in marketing fixed indexed annuities to the public. Since they are fixed insurance contracts and therefore under the authority of state insurance commissioners, the term “equity indexed annuity” eventually went out of vogue.
It made people think that a fixed index annuity was a securities product. However, it still remains a fixed insurance product regulated by the states to this day. There is no “equity” component at all to a fixed index annuity.
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How can a fixed index annuity help you with health costs, specifically certain long-term care expenses? Nowadays, many fixed index annuity contracts come with a provision called a wellness benefit.
In some situations where you need certain kinds of long-term care, the income from your annuity can be “enhanced” for a certain time period. Your annuity income can increase, often double, in order to help you pay for long-term care and its high costs.
This enhanced income generally lasts for a certain period, such as up to 60 months (or five years). The benefit can vary from indexed annuity contract to contract, so your financial professional can go over the details, pros, and cons of any contracts you may be considering.
How Likely Is It that Someone Needs Long-Term Care?
Statistics show that over 50% of those aged 65 or over will need some form of long-term care at some point in retirement. Couples in this age group have over a 50% chance of one of them needing this type of care at some point.
The costs of long-term care can be staggering in many cases. A year of home healthcare can easily cost anywhere from $50,000 to $55,000 per year.
Yearly residence in an assisted living facility costs around the same. Then a semi-private room in a nursing care facility can cost as much as $90,000 to $100,000 per year, depending on where you are in the country.
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Annuity laddering is a strategy in which someone buys or staggers several annuity contracts over some years. The goal is to maximize the benefits that you receive from the annuities, like guaranteed income streams, while managing risks such as interest rate risk.
Strategies for laddering annuities can give you more flexibility in your retirement plan. You can crack down on potential downsides, such as locking yourself into a reduced annuity payout while interest rates are low. That can be a helpful guard against inflation.
When you buy multiple annuities and then wait for some years to turn some of those contracts on, that gives them time for their contractual benefits to grow. You can have more higher lifetime income, or higher interest earnings for your money, as a result of this drawn-out strategy.
Depending on your situation, you may want to tap more than one annuity as part of a laddering strategy in order to maximize your benefits over time. Here are a few different laddering strategies that you can use with annuities to achieve this goal.
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Note: With the passage of SECURE Act 2.0 in 2022, provisions of the SECURE Act from 2019 have been updated. For the most part, inherited IRAs and their RMD rules remain the same except for inherited special needs trusts. Talk to your financial professional for guidance on your personal situation and for any other changes coming from SECURE Act 2.0 that may affect you financially.
You may have heard of annuities and how they are the only thing besides Social Security that can pay you guaranteed lifetime income. But what happens to an annuity when someone passes away? The tax rules surrounding survivor or inherited annuities are already complex, but the SECURE Act and now SECURE Act 2.0, federal laws passed in 2019 and 2022, have made them even more complicated.
The proceeds in a survivor annuity are generally taxable when the heirs receive them. If the recipient isn’t a spouse of the original annuity owner who passed, that recipient will pay taxes on the money they receive from the annuity.
If the surviving recipient is a spouse, then there are some steps that they can take to defer the taxes on the annuity proceeds. How much of the proceeds are taxable will depend on what type of account the annuity was housed in.
Most annuities are bought with pre-tax qualified money, meaning the premiums often come from a traditional IRA, a 401(k) plan, or another qualified plan. Since most annuities are bought with this pre-tax money, we will talk about how the SECURE Act can affect an heir’s tax burden now.
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Despite the negative headlines and money columns painting them as otherwise, annuities are neither good nor bad. They are simply an instrument that works well in some situations and not quite as well in others.
For instance, an annuity is the only thing besides Social Security that can pay you a truly guaranteed income stream for life. That is a feature that you won’t find anywhere else. Period. You can also get other benefits such as tax-advantaged growth and financial protection from market risk, among other things, from different annuities.
Yet, you wouldn’t be able to tell that from the way that many folks, including financial professionals, react when annuities are brought up in retirement planning. And what do these critics say?
Such options “only” serve as a way for financial advisors or agents to make a commission, nothing more. They don’t quite stack up to other investments, according to the naysayers.
The issue with that sort of talk is it focuses on just the negatives. For starters, annuities aren’t an investment but a risk-managing tool.
They provide a strong defense against the risk of running out of money in retirement, which tops the list of financial concerns for many retirees and those nearing retirement.
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In past decades, more people have been buying annuities. A big part of this is due to the unique features that annuities offer, such as tax-advantaged growth and contractual guarantees such as lifetime income.
Of course, many kinds of annuities are available now. Knowing what annuity is right for your situation (if indeed a good fit) can be a challenge in some cases.
If you are looking for growth, then you might look at fixed index annuities or variable annuities, as they both offer more growth potential than traditional fixed-type annuities.
But to make a confident and well-informed decision here, it helps to know how these types of annuities are alike and how they differ.
At their core, both are contracts with a life insurance company for a certain period. Where their differences lie is how their money grows, their exposure to market risk, and the fees that they carry, among other things.
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