Updated: May 3, 2013 12:14PM
Originally published: August 5, 2004
Tax deferred annuity sales have sprung to life again with some new features that make the salesperson wealthy instead of you, the buyer. Here’s an update on the latest twists in tax-deferred annuities.
Tax deferred annuities. The buyer of a tax-deferred annuity gives the insurance company a check now, and the insurer invests it, with all the growth compounding tax-deferred. Eventually, you can take the money out, either in one withdrawal or in any amount you choose at any time -- or you can annuitize, and take the monthly check for life.
Tax-deferred annuities have two costly restrictions. The first is the surrender charge, which may be charged as long as the first eight years you own the annuity. The second concern is the federal rule that says withdrawals from tax-deferred annuities before age 591/2 face a 10 percent federal tax penalty. So, tax deferred annuities are best for people over age 60, who don’t need their principal for a number of years.
Fixed-rate deferred annuities. These work like bank CDs, but without federal deposit insurance. You get the insurance company’s promise of a fixed rate for a certain number of years, or an initial high rate that may be adjusted in the coming years. It’s easy to compare these annuity products, because all the fees are figured right into the yield you have been promised. But look for an annuity where the surrender charge doesn’t last longer than the fixed rate guarantee.
Variable tax-deferred annuities. These have “sub-accounts” that work like a series of mutual funds inside the annuity contract. Your choice of investments determines the growth of your account. With variable annuities, you’ll want to check costs closely -- in addition to surrender charges. Also important: Withdrawals of gains from variable annuities are always taxed as ordinary income, not at the lower capital gains rates.
Special deals in variable annuities. In recent years, given the experience of the bear market, insurance companies have recognized that investors are looking for security, but don’t want to lock themselves into fixed-rate annuities. So they’ve created some new products that combine certain guarantees against loss of principal with at least some of the upside potential of the stock market. Each of these products has its costs and limitations, but depending on your willingness to pay the price and give up some of the upside, they may appeal to investors over age 591/2 who are looking for tax-deferred growth.
Guaranteed minimum income benefits. With these GMIB annuities, the insurance company offers a guaranteed rate (today around 5 percent) on the principal, typically for 10 years or more from the date of the investment. At some point in the future your original investment, plus this guaranteed rate, can be annuitized into a check a month for life. This annual rate promise is really a variable annuity. If the market falls, the insurance company is promising that you’ll at least get your principal, plus that 5 percent annual interest -- if you annuitize and take a check a month for life. If the market rises, of course, you’ll have gains that you can withdraw at any time after the surrender period expires, paying only ordinary income taxes on the gains.
The cost of this minimum guarantee is a 50 basis point charge (one-half of 1 percent) per year. But there’s another, more subtle, cost to this protection. The company may calculate those annuitized withdrawals based on a lower age than your current age, resulting in a smaller monthly check.
Principal protection. This is another twist on the tax-deferred variable annuity with a guarantee of protection if your investment choices within this variable annuity decline because of a falling stock market. It allows you to get back the cash you invested, subject to certain conditions, even if the value of your investment account goes to zero. The cost is typically less than one-half of 1 percent.
Subject to certain condition in the annuity contract, you can withdraw an amount equal to your original investment, no matter what the current market value is of your investments.
My expert annuity source for this information is Jeffrey Oster at (888) 655-1035. Or you can ask your own insurance agent. But always be sure you check the costs and restrictions, instead of being blinded by promises of tax-deferral. You may be better off in a low-cost mutual fund instead of a high cost tax-deferred variable annuity. That’s the Savage Truth.
Terry Savage is a registered investment adviser, and appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast. Distributed by Creators Syndicate.