How a Variable Annuity Can Boost Tax-Deferred Retirement Savings
Variable annuities can be a suitable option for individuals looking to enhance their tax-advantaged investments, even after maximizing other qualified savings options like a traditional IRA and 401(k). Variable annuities offer diverse investment options that grow on a tax-deferred basis and allow for continued portfolio growth without maximum annual contribution limits. They also provide additional benefits such as the opportunity to receive ongoing income in the future and a death benefit that can be passed on to loved ones as a legacy.
What is a Variable Annuity?
A variable annuity is a contract between an individual and an insurance carrier, allowing for either a single lump sum or multiple contributions over time. The investment options in variable annuities typically consist of mutual funds, where the funds are invested in "sub-accounts" at the insurance company. The value of the annuity's account can fluctuate based on the chosen investments and market performance, presenting both growth potential and the risk of loss.
Variable annuity benefits include the potential for higher returns compared to fixed and fixed indexed annuities, tax-deferred growth until withdrawal, the ability to generate ongoing income, a death benefit payable to named beneficiaries, and the opportunity to contribute to tax-advantaged savings even after maxing out other qualified savings options.
How Do Variable Annuities Work?
Variable annuities have two phases: the accumulation phase and the payout phase. During the accumulation phase, contributions are made and investment options are chosen, including a fixed account for diversification. Funds can be reallocated without tax implications. Immediate variable annuities skip the accumulation phase and begin income payouts shortly after purchase.
In the payout phase, various income options are available, such as a fixed number of years or lifetime income. Variable annuities may offer death benefits payable to beneficiaries, but these are subject to income tax. Living benefits, such as guaranteed minimum accumulation, withdrawal, and income benefits, may be available for an additional premium.
Understanding variable annuity options and features can be complex, so consulting with an annuity specialist is recommended. A prospectus is required before purchasing a variable annuity, and financial advisors selling variable annuities must hold specific industry licenses. Conducting a fee analysis can help assess the costs associated with a variable annuity.
Types of Variable Annuities
Variable annuities, like fixed and indexed annuities, can vary in their features and options. They can be immediate or deferred, depending on when the income starts. Immediate variable annuities are suitable for individuals nearing retirement who want a steady income stream to replace their paycheck. Deferred variable annuities are ideal for those planning to retire later and seeking tax-deferred growth through market-related investments. However, it's important to note that variable annuities carry risk if the market or underlying investments perform poorly.
Variable annuities can also be qualified or non-qualified. Qualified annuities involve pre-tax contributions and tax-deferred growth, resulting in taxable funds upon withdrawal. Non-qualified annuities, on the other hand, contain contributions that have already been taxed. While the growth inside the account is tax-deferred, a portion of each income payment or withdrawal is subject to tax, while another portion (considered a return of the contribution) is tax-free.
Variable Annuity Pros and Cons
Variable annuities offer guarantees to their holders, ensuring the return of the initial investment through income payments or a death benefit for beneficiaries. They can provide a reliable income stream during retirement, reducing concerns about running out of money. Compared to fixed annuities, variable annuities have the potential for higher returns as they are linked to market investments like mutual funds.
However, variable annuities also come with added risk due to market performance. If the underlying investments have negative returns, the annuity may experience losses. To mitigate risk, some variable annuities offer additional protection at an extra cost.
Variable annuities have associated fees that can impact returns. These fees include mortality and expense charges, administrative fees, contract fees, and distribution charges. Additionally, fees can be incurred from individual investment options chosen within the annuity. Overall, variable annuity fees can reduce annual returns by 2% or more.
Variable Annuity vs Fixed Annuity
When considering your short and long-term financial goals, it's important to compare variable annuities and fixed annuities to determine which option is best suited for you. Variable annuities offer several features, including the potential for market-related growth, tax-deferral, guarantees, a death benefit, ongoing income, and living benefit options. However, it's essential to be aware that variable annuities come with market-related risks, as their performance is linked to the fluctuations of the market. Additionally, variable annuities are known for their fees, which can potentially add to any losses experienced during "down" years.
On the other hand, fixed annuities offer a range of benefits, particularly in terms of safety, predictability, and guarantees. They provide principal protection regardless of market conditions, a set interest rate, tax-deferred growth, and the option of guaranteed income for as long as you need it. However, one potential drawback of fixed annuities is that their returns may be relatively low and may not be sufficient to meet, let alone surpass, inflation rates. This can result in a loss of future purchasing power.
Both fixed and variable annuities typically offer some level of liquidity, allowing you to withdraw up to 10% of the contract value, even in the early years of the annuity. However, it's important to note that most annuities impose surrender charges, which means that if you withdraw more than the allowed percentage during the surrender period, you may be subject to withdrawal fees. These surrender charges usually start at a higher percentage and gradually decrease over time until they reach zero.
It's also crucial to consider the implications of making withdrawals from an annuity before reaching the age of 59 ½. In such cases, you may incur an additional 10% "early withdrawal" penalty from the IRS.
Regardless of the type of annuity you choose, it's crucial to approach them as a long-term financial commitment. Therefore, it's essential to have a good understanding of how these products work and how they align with your specific objectives. Consulting with a specialist who specializes in annuities can be an excellent way to gain education and make informed decisions about your financial future.