Who should buy an annuity?
Among other reasons, the most common ones to purchase an annuity include:
- Principal protection: No risk of loss to your principal.
- Probate avoidance: Keep financial information out of public access.
- Lifetime income: Income guarantees as long as you’re still living even if the contract has no account value.
- Tax deferral: Control taxes on a year-to-year basis, including Social Security taxation, Medicare Part B premiums, and Net Investment Income Tax (NIIT).
- Bond alternative: Not having to purchase riskier or junk bonds.
- Money mishandling: Beneficiary is either a habitual spender or not as good with saving.
- Asset protection: Certain states protect the annuity contract value.
- Long-term care: Tax-favorable 1035 exchanges under the Pension Protection Act of 2006.
You can’t lose the money you used to purchase the annuity. Besides surrender charges, principal protection means you will always walk away with your contract value no matter what.
While this is true with immediate, fixed, indexed, and long-term care annuities, variable annuities don’t offer this guarantee. This is the reason why it’s important to choose the right one or you might otherwise suffer potential consequences.
When you purchase an annuity, you’ll have to designate a person as the beneficiary. At your death, your beneficiary receives the account value according to the contract. If no beneficiary is designated, the annuity will go through probate.
In order to avoid probate, the beneficiary must be alive at the time of your death. If they die prematurely, another must be named for the annuity to avoid probate.
Immediate, indexed, and variable annuities can provide a lifetime income guarantee for you (and potentially your spouse’s) life. An immediate annuity begins in the payout phase–or annuitization–while an optional rider can be purchased to either an indexed or variable annuity to avoid annuitization.
Fixed, indexed, and variable annuities can be purchased with either a qualified or non-qualified account. Qualified accounts include retirement plans such as an IRA or Roth, and employer plans such as a 401(k) or 403(b). Non-qualified accounts are outside of a retirement plan and not tax-deductible.
Non-qualified annuities are tax-deferred until withdrawn–meaning it doesn’t avoid taxes–but defers them until you receive a withdrawal or lump sum distribution. They are taxed as ordinary income and do not receive the capital gains tax treatment.
With deferral, the annuity earns interest on principal, interest on interest, and interest on what would’ve been paid in income taxes. Subject to your tax bracket, the comparable rate to a bank CD might be significant.
Although taxes will have to paid at some point, it might be favorable to you with the control that annuities offer.
As bonds are the fixed-income portion of an investment portfolio, lower yields might tempt you into riskier junk bonds. This can lead to sequence of returns risk–the longevity of timing a portfolio with withdrawals. Allocating the bond portion of your overall portfolio to an annuity can lead to a higher success rate that sequence of returns risk will not happen.
Although trusts are typically the better option if you don’t want to leave a beneficiary that’s a chronic spender a lump sum of money, annuities can also assist. Specifically, an immediate annuity with a joint option will make sure that your beneficiary doesn’t receive a substantial amount at once and consistently receives a monthly or yearly benefit.
Asset protection can come in different forms. While certain states exempt annuities from creditor claims, including bankruptcy, withdrawals are protected even after being deposited into a bank account as long as it can be traced back to the annuity. Another type–known as Medicaid planning–can assist with avoiding nursing home spenddown.
As laws vary by state, it is crucial to consult with an asset protection or elder law attorney to avoid fraudulent conveyance or “look-back” penalties.
When the Pension Protection Act passed in 2006, it created the long-term care annuity. Any withdrawals from a non-qualified long-term care annuity are withdrawn tax-free if used to pay for qualifying long-term care expenses.
The significant part is that it allows you to do a 1035 exchange from an existing non-qualified annuity into a long-term care annuity. More importantly, it can eliminate the potential tax liability on an existing annuity and solving the need for long-term care.