What are Fixed Annuities
Fixed annuities are a contractual way for an investor to receive guaranteed income for life. While other investment options such as dividends may also provide income, none provides guaranteed income. Fixed annuities ensure that an investor will have a steady amount of income for as long as he or she lives.
What Are the Differences Between Deferred Annuities and Immediate Fixed Annuities
Deferred Fixed Annuities:
Deferred fixed annuities have two phases. The first phase is the accumulation phase. During accumulation, which can last for as few as a couple of years to as long as several decades, the annuity owner makes regular deposits into the annuity. These deposits are known as the premium. If the annuity is part of a defined contribution plan offered by an employer, they can be deducted from an investor’s paycheck. Or, they can be made to the life insurance company if the investor is purchasing the annuity directly.
Contributions to deferred annuities grow tax-deferred and can be made with either pre-tax or post-tax dollars. Pre-tax dollars would be those that are made as part of an employer-sponsored plan such as a 401(k). Post-tax dollars are those earnings that have already been taxed. A Roth IRA, for example, is funded with post-tax dollars. Whether the fixed annuity is funded with pre or post-tax dollars, it can grow much more quickly than an account that has its earnings taxed like a regular savings account.
The second phase of deferred annuities is the distribution phase. Once the owner of the annuity, also known as the annuitant, requests the annuity to be annuitzed, distributions begin. Distributions can be sent monthly, quarterly or annually, depending on the needs of the annuitant. Annuitants are always advised to think their distribution election through very carefully.
Once selected, the timing of the distributions cannot be changed. Some insurance companies also let the annuitant choose the length of the distribution. Guaranteed payments can be taken for life or for a certain number of years. This choice will affect the amount of each distribution payment.
Under current tax law, the owner of a deferred fixed annuity cannot begin to take distributions before the age of 59 ½ without incurring a 10% penalty. And, by age 70 ½, he or she must begin taking distributions.
Immediate Fixed Annuities:
Immediate fixed annuities do not have an accumulation phase. They are funded with a single premium. This lump-sum amount is usually made with cash from a savings account, a life insurance policy or the after-tax amount from the sale of property or real estate. As more people are living longer, a larger number of immediate fixed annuities are also being funded with the proceeds of mandatory retirement distributions.
The distributions that are paid by the life insurance company begin immediately. If the contract is set up for monthly payments, payments will begin within one month. If the annuitant chooses annual payments, they will begin within 12 months.
What Are the Risks Associated with Fixed Annuities
Fixed annuities are the easiest to understand of all annuity types because the earnings paid on the principal is always fixed. It does not change based on market or currency fluctuations. While this might be helpful for budgeting purposes, it might not make sense for a younger annuitant who chooses lifetime payments and expects to live for 20 or more years at the time of annuitization.
While the rate of fixed annuities varies, most life insurance companies pay anywhere between 2% and 5% of the total principal, it may not be enough to cover an increase in the cost of living. Inflation, which is considered to be the biggest threat to a retiree’s savings, can easily reduce the overall purchasing power of any account.
For those investors interested in making sure that inflation does not eat into their future purchasing power, a COLA (cost of living adjustment) rider may provide the solution. A COLA rider will increase the cost of the annuity, but it will also increase the amount of money that is distributed each year in order to allow for inflation.
One other risk of fixed annuities is the death of the annuitant before he or she has received back in distributions the amount he or she paid in during the accumulation phase. Most insurance companies, however, now offer a guarantee of the premium. For example, if an annuitant purchased an annuity in the amount of $200,000 and dies after having only received $50,000, his or her beneficiary can receive the balance of $150,000. Another option for the return of premium is called “period certain”. If the annuitant chooses a period of 20 years but dies during year 15, his or her beneficiary will be paid for the remaining five years.
What Type of Investor is Best Suited for Fixed Annuities
Investors who need guaranteed lifetime income for life or for a certain period of time are typically advised to consider fixed annuities. Investors who also expect that the majority of their retirement income will come from dividends or other investment sources that are not guaranteed may also want to look into annuities.
For investors who fear that they will outlive their savings, fixed annuities can provide tremendous peace of mind. No matter how long an annuitant lives, he or she is guaranteed the monthly distribution. Even if the amount of his or her total distributions exceeds the amount of the premium, the insurance company must continue to make the payouts. For those in excellent health with little savings, fixed annuity distributions can mean the difference between a comfortable retirement and one that is not so pleasant.
While the income from fixed annuities is guaranteed, investors must make sure they have adequate cash to cover emergencies. Because an annuity is a contract, it cannot be cancelled. Once the premium is deposited and the contract signed, the only way for an investor to get his or her money back is via the distributions. Keeping enough cash on hand to cover home repairs, doctor visits and other unexpected expenses is always a good idea.
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