Now that traditional pensions are fading into history, Americans are scrambling for a source of lifetime retirement income. New twists on an old investment — annuities — can sometimes fit the bill.
Here’s this week’s question:
I have a question regarding fixed annuities with an income rider. I’m looking to provide some future security for my wife (11 years younger than me), and I’m being told that these are guaranteed, can’t-lose, programs. I’m always concerned when anyone tells me something is a guaranteed. Are these annuities really can’t-lose investments? What’s the catch?
I wrote about annuities a couple of years ago, but let’s go over them again, including the kind John is interested in, a fixed annuity with an income rider.
Investing with an insurance company
As you’ll soon see, there are various types of annuities. But they all have one thing in common: They’re offered by insurance companies.
Insurance companies offer advantages over bank accounts, mutual funds and other types of investments, because insurance companies are treated differently under the law.
The two chief advantages? Tax deferral and the ability to bypass probate.
- Tax deferral. If you have an IRA or 401(k), you know you don’t pay income taxes on the earnings until you take them out. Annuities offer the same advantage. As long as you leave the earnings alone, you don’t pay taxes on them. As with a retirement account, however, if you take the money before age 59½, you’ll face a tax penalty.
- Bypassing probate. When you set up an IRA or 401(k), you’re allowed to name a beneficiary. If you die, the beneficiary gets the money without the hassle and expense of probate. This, too, is true with an annuity, as well as with another common insurance product, life insurance.
So here are two reasons annuities are popular: They let you postpone a tax bill, and they allow you to leave money directly to your heirs.
Now, let’s explore various types of annuities.
Fixed annuities: Certificates of deposit from an insurance company instead of a bank
Back in my investment adviser days, I’d use the exact words in the heading above to explain single premium deferred annuities, also known as fixed annuities, to clients. Because when you boil it down, that’s what they are — insurance company CDs.
Like a certificate of deposit from a bank, when you take out a single premium deferred annuity, you agree to deposit a lump sum for a fixed amount of time, and the insurance company agrees to pay you a fixed amount of interest. Unlike a certificate of deposit from a bank, however, the annuity is guaranteed only by the insurance company. There’s no FDIC insurance. And, as I mentioned above, as long as you let the interest accumulate, you won’t pay taxes on it.
Immediate annuities: Deposit a lump sum, get monthly income
This is what many people think of when they hear the word “annuity.”
With an immediate annuity, you give the insurance company a lump sum of cash, and it pays you a monthly income. The income can be doled out in any number of ways. For example, it could last for a fixed number of years, or the rest of your life. Or it could last for the rest of your life, then your surviving spouse’s. It could last for life, but for a minimum of 10 years. There are any number of possibilities.