Consider the following before buying any type of annuity:
The money you put in the principal, for a non-qualified annuity, may be post-tax money. If you want to put after-tax money into your annuity, you can put as much money as you want, without any issues. Of course, before putting this money into an annuity, you should consider putting the maximum pre-tax money into a qualified retirement plan, such as an IRA, 401(k), 403(b) or SEP. Keep in mind that your annuity can fund these qualified retirement plans, as long as they are in the accumulation phase. If you want to do this, there are several contribution limits that will apply. Also, federal tax codes require that you take minimum distributions after April 1st of the calendar year after you reach the age of 70 ½. If you fail to do this, you will be penalized with 50 percent of the shortfall amount. Keep in mind that, once you have funds in your 401(k) or 403(b), you cannot withdraw any money before you reach the age of 59 ½, except for certain special cases, such as disability, severance from employment or death. If you do take withdrawals based on these exceptions, you may be subject to the 10 percent federal tax penalty for pre-59 ½ withdrawals.
The annuity’s expenses can vary a lot. Pay attention to the fees, charges and other costs that your annuity may incur. Make sure you find the best offer on the market, before buying your annuity. There are several independent rating services, like Lipper Analytical Services or Morningstar, which publish full reports on Variable annuities available on the market. Don’t necessarily go for the cheaper annuity; similarly, don’t go for the most expensive, as higher fees and expenses can offset your gains.
Pay attention to your tax situation as it pertains to all of your investment income. Annuity income is subject to normal income tax. For instance, if your ordinary income tax during retirement is higher than the long-term capital gains tax rate, you will essentially pay higher taxes overall. Obviously, you still get the tax deferral on your annuity earnings during the accumulation phase. Other investments are not tax deferred and you will pay taxes each year albeit at a lower tax rate. Your tax advisor will help you with your tax planning.
If you are determined to buy an annuity, here are some questions you should ask yourself before signing the contract:
- Have you done your market research? Have you checked the options?
Annuities are long-term investment products, so you’ll have to make sure you choose the best provider. Pick a company that has experience in the industry a good track record and will be in business for your lifetime. A good insurance company can offer multiple features, a wide range of choices, prices and flexibility.
- Is the rate on the fixed annuity too good to be true?
Obviously, clients prefer the best, most competitive interest rates that they can find. However, some interest rates simply look too good to be true. What’s more, if the company offers bonus rates, special offers and other high interest products, make sure you check the underlying interest rate, additional fees or charges. Also, pay attention to the surrender charges. Keep in mind that bonus interest rates or special offers are only guaranteed for a limited amount of time – you have no guarantee that the normal rates will still be competitive.
- What are the annuity’s surrender fees? How long are they in place?
Always check out the annuity’s surrender fees and the surrender charge schedule. Typically, they hover around 10 percent and decline after several years, reaching 0 after by the end of the contract period. If the surrender fees are high, and they don’t decrease over time, you may find yourself locked in a contract that you have no way of exiting without a high surrender fee.
- What is the track record of the funding options offered in a variable annuity?
Make sure to check the track record for the funding options, but don’t fall for the last month’s top performer. Look for good returns over a longer period, typically 3 to 5 years. There are several newspapers who publish these charts, such as Wall Street Journal or Barron’s. Also, you can check the history of various funding options in Lipper Analytical Services publications and in the Morningstar. Keep in mind that past success is not always an indication or guarantee of future performance.
- Does a variable annuity offer multiple fund options? What happens if you change your investment strategy?
In this case you should constantly be on the look-out for new funds to invest in. You should always try to diversify your retirement savings, particularly as your needs change.
- Will your ordinary income tax be larger than the applicable capital gains rate when you begin to take distributions?
In case this happens, you will pay more in taxes if you choose annuities over different investment options that are taxed at the capital gains rate. However, your money accumulates in the annuity without having to pay taxes. If you choose an annuity, you can still enjoy the tax-deferred aspect, while your money grows.
- What is your insurance company’s rating?
Whenever you find an insurance company that sells annuities, make sure to check its ratings. Of course, annuities can be sold by agents, brokers or banks, but the annuity is always issued by an insurance company. Always check the ratings of the insurance company. Is it financially strong? Does it have good practices? What are their clients saying about it? All these questions are important before signing any type of annuity. You can check up on your insurance company on the internet, as well as at your state’s Department of Insurance.
- How secure do you want the annuity to be?
If you want a guaranteed, predetermined income at a fixed interest rate, then a fixed annuity is your best bet. On the other hand, if you want a higher return for a higher risk, then a variable annuity is best for you. Increasingly popular are fixed indexed annuities that offer a potential higher return from the growth of a stock market index but with no risk to the principal. Income riders can be added to either type of annuity.
- How do you want to pay for your annuity?
There are several ways you can pay for your annuity. You can either pay a lump sum for your annuity, in which case a single premium annuity is better suited. On the other hand, if you want to make regular payments, then a flexible annuity is your ideal choice.
- When do you want to receive payments from your annuity?
An immediate annuity plan is your best bet if you want to receive payments right away. If you want to receive payments at a later date, similar to a retirement plan, you should buy a deferred annuity.
- How do you want your paychecks to be paid out?
If you want the highest payments for the rest of your life, and have no beneficiaries you should go for a straight life only option. If you have beneficiaries you should add a period certain to the life option.
If you want payments for you and, after you die, for your spouse, then you should choose a joint-and-survivor option.
If you want steady payments for the rest of your life, but in case you die, you want the remaining lump sum to go to your beneficiaries or heirs, you should choose a life annuity with a refund feature option.