A Myriad of Options

Tax deferral is not the only reason why annuities have mushroomed in popularity. While they typically have maturity dates of five to seven years, annuities require no medical exams and can usually be opened by filling out a basic annuity contract.

Today, there are hundreds of annuities to choose from, designed for different retirement goals. When it comes to fixed annuities, insurance companies sometimes offer higher initial rates to attract would-be buyers, while other companies promise consistent interest rates throughout the life of the annuity contract. Rates, maturity periods and death benefits are just some of the options to look for in a fixed annuity.

With today's annuities, you can tailor your retirement account to meet your own individual needs.

Choices to Consider

When shopping for an annuity, there are several considerations that must be weighed, including:

Immediate vs. Deferred Income

When it comes time to withdraw your money out of an annuity, you have a variety of payment options to choose from. The insurance company either can pay you in a lump sum, make periodic payments or guarantee you a lifetime of income on a tax-advantaged basis. Depending on the annuity contract you purchase, the choice is yours.

Qualified vs. Non-Qualified

Annuities can accommodate qualified or non-qualified money. For instance, suppose you are switching jobs and need to move over a 401(k). However, you already have an IRA and are looking to diversify your portfolio. You can reduce your portfolio exposure by rolling into an annuity and not be forced to lose your money's tax advantages.

In another scenario, suppose you receive an inheritance of $20,000. If you don't need the money right away and want to build a long-term nest egg, consider putting the inheritance into an annuity. You'll gain the advantage of tax deferral. Plus, when it comes time to withdraw from your non-qualified annuity, you'll only be taxed on the accumulated interest, not the principal itself.

Insurance Company

The quality of the insurance company is important, especially when purchasing a fixed annuity. Working with a respected, highly rated insurer can help eliminate default risk and ensure a retirement income when you need it most. Having a solid insurer is also vital if your annuity has any additional death benefits or rate guarantees. 

Common Benefits

All annuities share several common benefits. Here's a summary of what annuities can bring to your retirement portfolio:

• Ideal for Estate Planning: Proceeds from annuities pass directly to your beneficiaries without the delay, expense and publicity of probate in most states. If you've ever had a loved one's estate go through this time-consuming legal process, you know just what kind of advantage this is.

• The Power of Tax Deferral: Because you do not pay taxes on earnings every year, your annuity is able to work harder thanks to tax deferral. You will have to pay taxes on earnings when you withdraw your annuity's gains, but at least you can decide when that happens.

• No Contribution Limits: Contributions to other retirement savings vehicles, like 401(k)s and individual retirement accounts, are strictly limited. Annuities, however, offer tremendous flexibility. You can contribute as much as you want -- up to the limits imposed by the insurer -- to take advantage of tax deferral or variable accounts inside the annuity. Plus, you can add to your annuity contract at any time.

• Flexible Payment Options: Unlike 401(k)s and IRAs, which require that you begin making withdrawals at age 72, you may be able to wait much longer with annuities. When you do decide to begin receiving payments, you can usually select one of the following methods:

  • Lump-sum distribution (a one-time payment)

  • Periodic distributions (you can take money only when you need it)

  • Systematic distributions (a fixed or variable amount is sent to you at regular intervals)

  • Annuitization (fixed or variable payments, guaranteed for the rest of your life)

Different distribution methods behave differently when it comes to taxes; for instance, lump-sum, periodic and systematic distributions exhaust all earnings (which are taxable) before tapping principal. Under annuitization, each payment consists of both principal and interest, spreading your tax liability evenly among payments.

Through these distribution options, you have complete control over when you will pay taxes on your earnings.

• Tax Control: The money inside your annuity is made up of two components — principal and earnings. Assuming your annuity was opened with after-tax dollars, you're only taxed on your earnings.

Annuities are not perfect when it comes to tax control. If you pass away while your annuity is accumulating, all deferred taxes on your growth will become due, reducing your annuity's value.

• Easy to Start and Maintain: Usually, a simple application, a check and your signature begins your annuity. And, at the end of each year, you will not receive a 1099 for income earned within your annuity contract. That's one less thing to worry about when April 15th rolls around.

• Other Features: Annuities also do not offset Social Security benefits like bonds, CDs and other investment income sources do.

Annuities are easy to establish and often come with a "free-look period." Your state of residence or the annuity contract will define a length of time (usually 30 days) when you can cancel your contract if you decide it's not right for you.

You can even exchange older, non-performing annuities into a newer fixed annuity with no tax consequences, thanks to Section 1035 of the Internal Revenue Code.

If you are a conservative investor looking for a consistent way to build your retirement savings, then fixed annuities may be the answer for you. However, if you are financially savvy and believe you can do better choosing your annuity's direction, we would be glad to describe the benefits that variable annuities may be able to provide for you. Please contact us for an individual discussion.

Reducing Taxes

The Internal Revenue Code provides tax advantages for MECs, regardless of whether you choose a fixed MEC or a variable MEC. Insurance products have always received very favorable treatment by Congress, and MECs are no exception.

Unlike stocks and mutual funds, which are taxed every year, any earnings within your MEC remain untaxed as long as they stay within the MEC account. You choose when to pay taxes, since income taxes on the growth of your MEC are due only upon withdrawal. Over the long haul, this tax-free accumulation can produce dramatic advantages.

Tax deferral provides this added value, because of the time value of money. Compare the accumulation of a jumbo CD and an MEC, and let's assume both are earning 7 percent. The CD is taxed on the earnings, reducing your net interest rate. If you're in the 27 percent tax bracket, you're actually earning 5.11 percent.

However, for the MEC, it's a different story. Since income taxes are deferred, the MEC is credited with the full 7 percent.

Of course, CDs have much shorter maturities than MECs, and they're offered by banks (not insurance companies). CDs are also FDIC-insured, while MECs are not. Plus, remember that when funds are finally withdrawn from the MEC, income taxes will be due. However, your MEC money will have worked harder for you, thanks to the time value of money on your side.

Roth IRA

Roth IRAs, unlike traditional IRAs, have a simple premise: You pay income tax going in, rather than when you pull out. The Roth IRA represents an enhanced level of flexibility for people saving for their retirement.

The Roth IRA is a type of account that you establish through a qualified broker. Any contributions that you make to your Roth IRA are considered "after-tax" and cannot be deducted from your tax return. However, when it is time for you to draw money from your account, you will not pay income taxes on the growth of your account. If you're in a high tax bracket, that can amount to tremendous savings.

Just like a traditional IRA, Roth IRA accounts can hold stocks, mutual funds and other types of investments. Retirement-minded investors, looking to build their nest eggs, can open a Roth IRA brokerage account and invest it like they would any other account. However, unlike other types of brokerage accounts, your broker will usually ask you to pick a designated beneficiary for your Roth IRA funds, should you pass away with the account open.

People who are still working and are eligible to contribute more have to think about what kind of IRA they should contribute to. This is especially true if you have already accumulated a large IRA, perhaps from the rollover of a retirement plan, and if you want to know whether you should convert that pot of money into a Roth IRA.

If you have accumulated a large traditional IRA, you can elect to convert the entire account to a Roth IRA. Upon conversion, you must declare the entire IRA taxable balance as taxable income and pay taxes on it in the year of conversion. From that point on, the IRA is federal income tax-free during compounding, and federal income tax-free when you pull money from it (if you have held the Roth IRA for at least five years, you are age 59 1/2 or meet other requirements).

If you are a mature American with a large IRA, you have a big decision. Should you convert your nest egg to a Roth IRA? In many cases, it makes sense. If you qualify for a conversion, you may save thousands of dollars for both yourself and your heirs.

A Look at the Numbers

Suppose you own $20,000 of growth stocks in a qualified IRA, and you believe it will be worth $60,000 by the time you spend it.

For simplicity, you are in a 36 percent tax bracket now, and you expect to be in the same bracket in the future.

If your assumptions are correct and you leave your IRA alone, the IRA will grow to $60,000. After paying $21,600 in taxes, you will have $38,400 of spendable cash.

But suppose, in the beginning, you made the conversion to a Roth IRA. You convert, using $7,200 from the account itself to pay the immediate tax bill. The remaining $13,600 triples to $38,400.

The two outcomes are identical. In this scenario, there's no difference between the two, unless you were under age 59 1/2, in which case money taken from the Roth IRA account to pay tax would also be subject to a 10 percent early withdrawal penalty.

However, there is another option. Suppose you convert to a Roth IRA in the beginning and come up with the $7,200 in initial taxes from some other source of cash that would not have qualified for tax-deferred compounding.

Assuming the same growth rate, your Roth IRA would have tripled in value to $60,000 (a full $21,600 more). Best of all, the entire amount would be income tax-free when you needed to make withdrawals, plus, there would not have been a 10 percent tax penalty on money taken from the account if you were under age 59 1/2.

Sure, you're missing that $7,200 from your outside account, and that money could have grown. However, its growth would have been stunted by the fact you were paying taxes on the income all along.

Remember: In this case, the "time value of money" is definitely on your side. The Roth trade is a bad one for Uncle Sam and a good one for you.