https://www.webprez.com/7540/4

Annuities are the only financial product on the market specifically designed to convert a lump sum to a guaranteed income. As such, they are powerful tools for hedging against uncertainty and risk. But they also come with powerful tax advantages as well.

The Power of Tax Deferral           

Tax deferral is a powerful tool that an investor can use to magnify potential returns – over and above what you might gain using similar investments in a taxable account. Any tax you can put off paying to Uncle Sam is equivalent to taking an interest free loan from the government – and investing it.

For example, if you make a series of investments that generate $1,000 per year in the first year in interest income and you held those in a taxable account, you would likely have to pay $250-$280 to the IRS in income taxes. You would only be able to reinvest $720-$750 of that money and let it compound over time. By holding those same investments in a tax-deferred vehicle, however, you get the benefit of compounding the entire amount – year after year after year.

As investment mogul Warren Buffett has noted, this is the same as the government handing you that extra amount to invest – with no payments and no strings attached, as long as the money stays in the annuity. Yes, you pay income tax on gains – eventually – but you get to decide when, subject to RMD rules.

Annuity Taxation Basics

As long as the annuity owner is still living, they are taxed very similarly to traditional IRAs with nondeductible contributions, and have many of the same tax advantages.

• There is generally no up-front tax deduction on premium (unless you hold the annuity in an IRA).
• There is no capital gains tax. You can exchange from annuity to annuity as much as you like, using Section 1035 of the U.S. Tax Code, without worrying about capital gains or losses). If you just used mutual funds outside of a retirement account, you’d have to pay capital gains taxes on any net gains each year.
• There are no taxes on dividend income.
• There is no tax on interest income.
• Distributions are taxed as ordinary income.
• You don’t pay taxes on the entire distribution – only the part attributable to growth from non-deductible contributions.
• You must begin taking distributions by April 1 of the year after the year in which you turn age 70½.

Annuity Taxation At Death

The tax treatment of annuities depends on whether the annuity was still in the growth phase, or began paying out income benefits. If the owner dies before the annuity started paying an income, the beneficiary has several choices:

• Keep the annuity contract intact and treat it as his or her own (an option for surviving spouses only).
• Surrender the contract, take the cash immediately and pay income taxes.
• Spread out withdrawals over five years (similar to inheriting a non-spousal IRA)
• Let the contract continue to grow tax-deferred, and then take the entire annuity income at that time.
• Annuitize the inherited annuity and take payments over his or her life expectancy. This allows much of the annuity to grow tax-deferred over a lifetime! You must make this election within 60 days of inheriting an annuity, however.

In addition, surviving spouses who inherit an annuity have these options:

• Keep the annuity contract intact and treat it as his or her own.
• Annuitize the inherited annuity and take payments over his or her life expectancy. This allows much of the annuity to grow tax-deferred over a lifetime! You must make this election within 60 days of inheriting an annuity, however.

If the annuity has already started paying out income, the beneficiary must continue to take the income at least as fast as the annuitant was taking income.

Wall Street is notorious for creating financial products that are difficult to understand. One such product is the annuity, and even experienced investors often have trouble coming up with an annuity definition that’s easy for a beginner to understand. Nevertheless, with many financial planners recommending certain types of annuities to their clients, it’s important for you to learn what an annuity is, and whether it’s suitable for your situation.

Defining annuities
The meaning of the word “annuity” comes from the Latin root for year, emphasizing the essential nature of the product as providing annual income to its owner. Historically, the term referred to annual allowances that people received from various sources, including family members or legacy bequests.

The modern definition of an annuity is broader. As the SEC describes it, an annuity is a contract with an insurance company that requires it to make payments to you, either immediately, or at a specified time in the future. You can buy the annuity either with a single payment or with a series of payments. The insurance company can satisfy its obligations either with a lump-sum payment, or through a number of options that involve a longer payout period.

Annuities come in several different types. Fixed annuities are designed to offer predictable streams of income, providing minimum rates of interest, but little opportunity for growth. Variable annuities, on the other hand, are contracts that are tied to different types of investments, including stock mutual funds and similar investment vehicles. By its nature, you can’t be certain what a variable annuity will pay you, as its returns are tied to the investments linked to the particular annuity you choose.

The pros and cons of annuities
Annuities have good points and bad points. On the favorable side, annuities are among the only financial products that can address what has become known as longevity risk, better known as outliving your money. Annuities can be structured to make set payments for your lifetime, with the insurance company taking on the risk of your living longer than your life expectancy in exchange for a potential profit if you die earlier than your life expectancy would predict.

In addition, annuities get favorable treatment under the tax code. In particular, annuities give investors tax deferral, with any rise in the value of the annuity contract not being taxed until the owner starts taking money out of the annuity.

On the other hand, annuities have some unattractive features. Costs can be higher than on other types of investments, with fees going to the insurance company to cover mortality and insurance-expense risks. You might have to pay surrender charges to cash in an annuity before a certain number of years passes, with tax penalties also potentially applying to annuity withdrawals before age 59-1/2. In addition, administrative costs can also boost overall costs.

Moreover, many annuities are structured so that after you die, your heirs receive nothing. That allows you to receive larger payments than you would otherwise be able to generate from an investment portfolio; but many are uncomfortable with the thought of potentially losing every penny of their investment if an unforeseen accident or illness led to their death shortly after buying the annuity.

Finally, annuities offer a number of guarantees and other features that can be well-suited to certain investors’ needs. For instance, guarantees of minimum income benefits or minimum withdrawal eligibility can give investors additional protection against market swings, especially for those who choose variable annuities. However, these guarantees also come with an extra cost; so when you add up all the fees associated with an annuity, the amount of money taken out of your annuity account can be sizable, and weigh on your long-term returns substantially.

Should you use annuities?
Annuities bring out strong emotional responses from their proponents and their detractors. It’s true that features tied to life expectancy are almost impossible to duplicate with any other type of financial product, making annuities especially useful for those who want to eliminate that aspect of risk in their financial planning. Yet critics point to high commissions paid to insurance salespeople as a sign that customers overpay for annuity coverage, and you’ll find many stories in which inexperienced investors were sold annuities without fully understanding their features.

If you have a need for the insurance element that annuities can provide in ensuring a lifelong stream of income, then including annuities in your overall investment portfolio can be a smart move. Yet if you don’t understand exactly how a particular annuity product works, it’s a fair bet that the annuity is more complicated than what you actually need to meet your financial-planning wishes. If you do buy an annuity, it’s critical for you to understand the exact terms governing how you’ll get paid, and any costs associated with the account.