With the future of Social Security uncertain and traditional pensions becoming a luxury of the past, the burden of financing retirement is increasingly falling on the shoulders of your clients. To address these growing concerns we reviewed how we can help our senior clients with risk management strategies that include annuities. We have looked at the “features” of an annuity. We pointed out that features are what the product “has” or “does”; benefits are “why” your client would want those features. In other words, features are about the product, while benefits are about the client.
In this article we will look at the benefits of the annuity product for our clients. In other words we will learn “why” our clients would want to have an annuity. The reason we want to review both the features and the benefits of the product is because “features” are the language of logic. Even people who insist they buy logically or based on features do so because that’s what makes them “feel” better. Benefits are the language of emotion. Focus on emotions, not intellect. People buy on emotion but are moved to action by logic. We have to provide an emotional justification to make a logical purchase.
1. Tax Deferral
Perhaps the most attractive advantage of an annuity, other than income for life, is tax deferment. Earnings credited to an annuity are not taxable as income until withdrawn.
Tax deferment and the miracle of compounding allow annuities to out-perform most other taxable investments. Because of tax-deferment, annuities (through “triple compounding”) produce more growth more quickly.
Triple compounding allows annuities to accumulate interest on principal, earn interest on interest, and earn interest on money not taken out for taxes, thus a higher effective yield.
The following chart compares how money may grow taxable versus tax-deferred.
2. Taxes on Social Security
It may be generally unknown that annuities can reduce or eliminate taxes on Social Security. Income over a certain amount may cause a portion (up to 85 percent) of Social Security income to be taxed. Enough money may be placed into an annuity to reduce income below the threshold amount so that Social Security benefits will not be taxed. This, of course, only works for those who do not need the investment income to augment their current income.
3. Avoid Probate
Probate is the process used by individual states to determine the tax liability and the proper transfer of an estate. If the deceased has no will, he or she dies intestate, and the probate courts will determine how the estate is to be apportioned. There are many problems with probate. Among them:
- Lack of Privacy. The process of probate is a matter of public record. Notice is required to be given to all interested parties so that claims may be brought against the estate.
- Delay. It is not unusual for the probate process to require several years depending on the size, complexity and number of claims against the estate.
- Cost. Probate can be expensive. There are associated fees for court, attorney, filing, appraisal and executors and/or conservators. It is usual for fees to amount to as much as 10 percent of the estate and in many cases much more. Sometimes it is necessary to sell estate assets to cover probate cost.
Insurance companies are required by regulation to maintain reserves to the extent of expected withdrawals. The insurance rating companies investigate insurance companies regularly to assure they have maintained the financial stability necessary to protect their ratings.
Deferred annuities usually have a withdrawal provision after the first year that allows the owner to make penalty-free withdrawals of up to 10 percent of the principal or, in many cases, the account value.
6. Guaranteed Income for Life
Annuities can provide a guaranteed income stream for a lifetime, depending on the settlement option chosen. The owner has the ability to choose from one of several settlement options, including payments for a specified period, or income for lifeno matter how long. With non-qualified fixed annuities, a portion of each income payment is considered return of premium and is not taxed, thus reducing the tax liability. An annuity maximizes the use of retirement funds and guarantees them to last a lifetime.
7. No Management Fees
Investments, such as variable annuities, stocks, bond and mutual funds, assess management fees, sales fees and miscellaneous expenses. The cost of administering a fixed annuity is built into the product. The only additional cost to the consumer is if the policyholder chooses a rider, such as an income, death or family endowment rider.
Of the money invested, 100 percent earns interest immediately. The investment and management of the account is the responsibility of the insurance company.
In variable contracts and mutual funds, the investment risk is borne by the investor. With annuities, the investment risk is borne by the insurance company.
With annuities, the amount of premium payment, the type of premium, the persons involved, and the payout methods are all the decision of the owner. A great amount of flexibility is available to an annuity owner.
9. Tax Timing
In addition to deferring taxes and earning interest on money that would otherwise be paid in taxes, the investor may also exercise control over the timing of the payment of taxes.
In early retirement years, there may be sufficient income from other sources without withdrawing annuity funds. If additional income is not needed from the annuity, or if the goal is to delay taxation until later retirement years when taxable income may be less, distributions can be postponed.
NOTE: Annuities funding qualified accounts may have minimum distribution requirements.
10. Tax Favored Income
In the payout phase of an annuity, the payments are split between the return of premium and gain. This is accomplished by using the exclusion ratio.
- A. Assume that $100,000 paid in grew to $150,000.
- B. Assume monthly payments of $1,500 based on the settlement option chosen.
In this example, $1,000 would be return of premium (not taxable) and $500 would be gain (taxable). Therefore, only 33 percent ($500) of the income realized from the annuity income would be subject to income taxes.
An annuity guarantees the return of principal plus the guaranteed interest as long as there are no early withdrawals and surrender charges are not incurred. Typically, fixed annuities have minimum guaranteed rates. These are guaranteed in the contract and reflect the minimum rate that can be credited to the annuity account.
12. Medicaid Qualification
Certain annuities can be made irrevocable and cannot be converted to cash. This type of immediate annuity may provide an income stream to the non-institutionalized spouse, a portion of which may not be counted for Medicaid qualification. Properly structured, this annuity can provide income that is outside the spend-down requirements. It may be considered an unavailable asset if it is placed under an irrevocable settlement option paying principal and interest in equal installments. To qualify, an annuity must be in the payout period prior to applying for Medicaid.
CAUTION: States have different requirements and agents should use caution when advising on Medicaid qualification. It is always good practice to consult an elder care attorney when dealing with Medicaid.
13. Develop Income With 100 percent Tax Dollars
Tax-deferred annuities allow interest on tax dollars to accumulate, providing future income on the money that would have been paid in taxes. The annuitant can have a lifetime interest income, and may never have to pay taxes on the funds that provided the income.
Annuities may provide the necessary diversification for portfolios that include riskier investments. They provide the safe and stable income account to balance the portfolio.
Keep in mind there is no typical senior; however, there are commonalities. It is helpful to understand the similarities and to respect the differences when working with seniors. Seniors tend to focus on how a situation makes them feel. Their responses are based on their total life experiences. So keep in mind that their number one fear may be loss of independence.
“Independent living is not doing things by yourself–it’s being in control of how things are done”
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