Seeking Secure Retirement Income? An Annuity Could Be a Good Fit
September 20, 2017 by CARL ZEIDLER, CFP, MSFS
Locking down a solid retirement income plan in today’s volatile investment market can be challenging.
Thanks to low interest rates, conservative investments such as certificates of deposit and money market accounts aren’t paying enough to even keep up with inflation. It’s tempting to take the risk and move money into this bull market, but if rising interest rates cause an unpleasant ripple effect, retirees’ nest eggs could suffer. (The Fed has raised rates three times since December, and in July it announced that it looks like economic conditions will “warrant gradual increases” going forward.)
So, what can you do to get a reliable retirement income if you don’t have a pension through your employer?
Using an immediate or deferred annuity as part of an overall income plan can offer some reassurance to retirees who are worried about outliving their money.
The basics of annuities
An annuity is a contract between you and an insurance company: You make a lump sum or series of payments, and in return, you receive regular disbursements beginning right away or at some point in the future. You can receive those payments for a fixed amount of time, for your lifetime or, if you choose, for your lifetime and that of your spouse. Where available, you also can purchase an optional income rider that increases your payment annually at a rate you think will keep up with inflation, so your purchasing power won’t erode over time.
Payments are based on current interest rates as well as your life expectancy. An annuity works a lot like a life insurance policy: The carrier takes the risk that you could live longer than expected. If you do live longer, the annuity could pay far more than your original investment. If you don’t live a long life, it pays less. However, you can mitigate this risk by electing to purchase an optional cash-refund feature or a period-certain feature (10 to 20 years of guaranteed payments even if you are not alive). So if you and your spouse die prematurely, your principal isn’t lost. Someone you designate will get that money back. Or you can select an option for more income than you need and use the difference to purchase life insurance that will go to your beneficiaries income tax-free.
Some tax implications
How you’re taxed on your annuity will depend on what kind you own, your age, the payout and the duration, among other factors. In a traditional IRA annuity, all of the distributions are taxed as ordinary income, and the rules for required minimum distributions apply. But if the money you’re putting into the annuity isn’t from a traditional IRA or 401(k), 403(b) or any type of qualified retirement plan, it is called a non-qualified annuity.
Because you’ve already paid taxes on the money used to fund your non-qualified account, the IRS won’t make you pay taxes on all the income from the annuity you purchased with those funds. It will exclude a portion, calling it a return of your premium, and you’ll pay taxes only on what the IRS considers to be interest. When seeking a quote from an insurance carrier, be sure they include the exclusion ratio, which tells you how much of each payment is excluded from income taxes. That can make it very attractive for non-qualified money.
What to check for before you buy
The guarantees and protections provided by annuities are backed by the financial strength of the insurance company that sold it, so it’s important to start by looking for a highly rated insurer when you decide to purchase one. You want one that has an A rating or higher with such services as A.M. Best, S&P and Moody’s. However, the rating isn’t the only measure of security to be considered: Find out what the insurance carrier’s surplus ratio is — the higher, the better. The surplus ratio measures how much on a percentage basis of excess capital the insurance carrier has exceeding the risks it is insuring.
For some, an immediate annuity makes sense
You also may wish to consider an immediate annuity to use as a bridge until a future source of income turns on. For example, if you wish to retire at 60 but don’t want to take your Social Security benefits until your full retirement age of 66, you could buy an immediate annuity that would generate the income you need for those six years.
Some caveats to consider
When thinking about purchasing an annuity, you must take a few things into consideration. For one thing, you must realize that annuities are not FDIC insured. In addition, the quality, costs, coverage and terms of annuities vary by insurance company. So here are a few areas to focus on:
- The ratings of the insurance carriers
- Annual fees
- Length and ammount of surrender charges
- Death benefit
- Choices of payout options
Final thoughts
When you’re thinking about using annuities for income, keep in mind how to best integrate them with your other resources. A great strategy is to determine how much money you’ll need in retirement, purchase one of these products to be sure you have enough, and leave the rest of your money invested to grow.
If the market cooperates, your net worth will continue to increase while you’re retired. And if it doesn’t, you’ll know your annuity, combined with Social Security, will continue to provide steady and reliable income.
Talk to a financial professional about whether this is a good time to buy the type of annuity you’re interested in, but don’t put it off for too long. I recommend buying within at least five years of your planned retirement age.
The guaranteed lifetime income for all parties to an annuity contract should give you the financial confidence that you will have adequate income to ensure a successful retirement.
Kim Franke-Folstad contributed to this article.
Investment advisory services offered through Wall Street Financial Group, Inc., a state-registered investment adviser with Illinois, Missouri and Tennessee.
