Fixed Indexed Annuities.

As you approach retirement, you may be looking for a financial strategy that will grow, while at the same time keeping your money safe in any type of market environment. Fixed indexed annuities can provide that for you – and they also offer guaranteed income for a set period of time, or even for the rest of your lifetime.

But even though these financial vehicles sound like they offer the best of all worlds, fixed indexed annuities (also referred to as fixed index annuities) are not right for everyone. So, it is important that you know more about these products, such as how these annuities work, before you commit to purchase one for your portfolio.

What are Index Annuities and How Do They Work?

Fixed index annuities, or FIAs, are a type of annuity that generate a return based on the performance of an underlying stock market index like the S&P 500 or the Dow Jones Industrial Average (DJIA). So through its interest rate crediting, FIAs offer the opportunity for a higher return on the contract value than regular fixed annuities that provide safety but also a low fixed interest rate.

When the index performs well, a positive return is credited to the annuity’s contract value. Oftentimes, there is a “cap,” or a limit on the upward potential of these annuities. But in return for that, your principal will remain safe in any type of market – even if there is a significant correction or extreme market volatility. This differs from variable annuities where your principal can be a risk.

As with other types of annuities, an income stream can be generated from an FIA by the insurance company. This can last for a pre-determined amount of time, or alternatively, it can continue making payments for the remainder of your lifetime. Given its guaranteed lifetime income option, FIAs can alleviate the worry about running out of money before you “run out of time.”

Depending on the offering insurance company and the specific annuity, there may be other enticing features available – or benefits that can be added – on to an FIA. So, these financial vehicles can essentially be “customized” to fit your particular needs. This type of annuity can also offer some enticing features for both before and after retirement.

Are Index Annuities a Good Investment?

Although these annuities are not an investment per se, they can provide you with many of the same benefits as certain other financial tools. For instance, the value of the account can increase, based on the positive performance of one or more market indexes. And, similar to fixed investments, FIAs will typically provide a fixed account as one of the allocation options.

The funds that are inside of a fixed index annuity grow on a tax-deferred basis. This means that there is no tax due on the gain until the time of withdrawal. Therefore, over time, the account value can grow exponentially.

Market Index Linked Return

Fixed index annuities can offer the opportunity to generate a nice return. But it is important to understand some of the internal FIA components so that you know what to anticipate as far as performance. As an example, a fixed index annuity may have limited upward potential based on caps, participation rates, and/or spreads. (This is not the case with a variable annuity where you have unlimited growth potential, but also market risk that could reduce the contract value).

Cap

The cap rate on a fixed index annuity is an upper limit that is placed on the return each contract year. For instance, if an FIA has a cap of 5%, and the underlying index generates a 6% return in a given annuity contract year, the return for that year will be 5%. (If the underlying index returns 3% for that period, though, 3% will be credited to the contract value).

Participation Rate

An FIA may also have a participation rate. This determines how much of the underlying index’s increase will be used when computing the return. In this case, if there is a participation rate of 80%, and the underlying index generates a 10% return for a given period, then the annuity will earn 8%. This is because 80% of 10% is 8%.

Spread

The life insurance company offering the annuity might also use a spread when determining the amount of return in a given period. Here, a certain percentage will be subtracted from the gain in the underlying index’s performance. So, for example, if the index has a return of 10% and the annuity has a spread of 4%, there will be a return of 6% credited to the account. This is because 10% minus 4% is 6%.

Fixed Indexed Annuities – Safety of Principal

Even though a fixed index annuity may not achieve an unlimited positive return, the “tradeoff” here is that these fixed index annuities won’t lose money – even in a significant stock market drop.

For instance, if the performance of the underlying index is negative during a given annuity contract period, no loss will be credited to the account. Rather, the annuity will attain a guaranteed minimum “floor” amount. Today (in 2020), this is usually between 0% and 2%, depending on the annuity and the offering life insurance company.

As an added bonus, because there are no losses to make up for, once the underlying index (or indexes) that is being tracked performs in the positive again, new gains can be added to the previous growth. This, in turn, could lead to a higher amount of lifetime income in the future.

Tax Deferral

The growth that takes place in an FIA is deferred from taxation. This means that there is no tax due on the gain until the time of withdrawal. If funds are not accessed for a long period of time, the funds could grow quite a bit.

When the gain is accessed from the annuity – whether it is received in the form of an income stream or via one lump sum payment – the gain will be taxed as income at your then-current rate.

Withdrawal and Income Options with Fixed Indexed Annuities

Fixed index annuities typically have several different options for accessing withdrawals and/or income. Based on the particular annuity – as well as the offering insurance company – you can usually choose to receive an income stream that lasts for a specific number of years, such as ten or twenty.

You may also choose a guaranteed lifetime income stream that will continue for the remainder of your life, no matter how long you need it. In addition, you could choose a joint life income option where income continues for the rest of a second recipient’s life, such as a spouse or partner. Income options may differ, based on the issuing insurance company.

In lieu of a regular income stream, you could opt to take out the entire lump sum of the account value. If this is the case, you will be taxed on the entire amount of the gain for the year it is received.

How are FIA Annuity Payments Taxed?

The taxation of fixed index annuity income and/or withdrawals will be dependent on whether it is a qualified or a non-qualified annuity. See more on taxation of annuities here.

Qualified FIAs

A qualified fixed indexed annuity is funded with money that has not yet been subject to taxation. For instance, if you have a traditional IRA (Individual Retirement Account) and/or employer-sponsored retirement plan (such as a 401k), you could roll over this money to an FIA. It is likely that you contributed funds into these types of accounts on a pre-tax basis (which in turn reduced the amount of taxable income you had in the year of contribution).

Further, because the growth that takes place in an annuity is tax-deferred, it is common that none of the money in a qualified annuity has been taxed. With that in mind, 100% of your income or withdrawals from a qualified annuity are taxed as ordinary income.

Non-Qualified FIAs

Non-qualified annuities are funded with after-tax dollars. These funds may come from your personal savings or investments. However, the growth that takes place in a non-qualified annuity is still tax-deferred.

This means that when you take a withdrawal or access an income stream from a non-qualified fixed indexed annuity, a portion of each payment will be considered taxable gain, and another portion will be considered as a tax-free return of principal. The percentage of the non-taxable income from an FIA is called the exclusion ratio.

It is important to note that once the full amount of your contribution has been repaid, the remaining income that you generate from an annuity will be considered gain. Therefore, 100% of these future payments will be taxed at your then-current income tax rate.

Additional Features on FIAs

In addition to tax-deferred growth and a guaranteed income stream, there are some other benefits that could also be included with a fixed indexed annuity. In some cases, there is no extra charge for these, and in others, you will be required to pay an additional amount of premium.

Death benefit

Many of these annuities will include a death benefit. If the amount of contribution has not been returned to the annuitant (i.e., the income recipient) before he or she dies, the remainder will be paid to a named beneficiary.

Note that whereas the death benefit proceeds from a life insurance policy are income tax-free to the recipient(s), an annuity death benefit may be taxable.

Waivers

There may also be various waivers included with a fixed indexed annuity. For example, if there is a chronic and/or terminal illness waiver, funds may be accessed from the account without penalty – even if the annuity is still within its surrender period.

A long-term care waiver could also be included on an FIA. In this case, if the annuitant must reside in a nursing home for a specific period of time – such as a minimum of 90 days – he or she is eligible for penalty-free access of money from the annuity.

Protection from Creditors

In some states, the account value of an annuity is protected from creditors. This is the case, even if you have filed for bankruptcy or have been sued. (It is important to check with a legal professional to determine whether or not this is the case in your state of residence).

No Annual Maximum Contribution Limit

There are also no maximum annual contribution limits with fixed index annuities. Unlike an IRA or 401k plan – where you are limited to the amount you can contribute each year – annuities do not impose this restriction.

So, if you are looking for a way to add to your tax-advantaged savings, and you have already “maxed out” the contribution(s) to your other plans, an FIA could be a viable option for increasing the tax-deferral in your overall retirement portfolio.

Are There Fees on a Fixed Index Annuity?

Like most other financial vehicles, there are some items to be mindful of before you purchase a fixed index annuity. This includes various charges and fees, such as:

Rider(s)

If you add additional benefits through one or more annuity riders, you may be charged an additional amount of premium for these. So, prior to committing to these added features, make sure that they truly add value and are worth the higher cost.

Surrender Charges

Most insurance products will impose surrender or withdrawal charges if you cancel the contract or withdraw more than a maximum amount each year during the surrender period. Typically, the amount of a surrender charge will decrease over time, until it is eventually reduced to 0%.

IRS 10% Early Free Withdrawal Penalty

If you make withdrawals from a fixed index annuity before you have reached age 59 ½, you can incur a 10% “early withdrawal” charge from the IRS. This is in addition to any taxes and/or surrender charge that you owe.

Therefore, it is important to consider an annuity a long-term financial commitment – and as such, it should be funded only with money that you do not anticipate needing for financial emergencies going forward.

Fixed Index Annuity Pros and Cons

Fixed index annuities can offer a long list of enticing benefits. Even so, there are also some attributes that may be considered drawbacks. Because of that, make sure that you are aware of both the pros and cons before making an FIA annuity purchase.

Advantages:

  • Potential to generate indexed linked growth (by tracking the S&P 500 index and/or other index options for interest crediting purposes)
  • A fixed interest account option
  • Principal protection in any type of stock market environment
  • Tax-deferred growth
  • Guaranteed income payments for a set number of years (or even guaranteed income for life)
  • Some liquidity
  • May add certain riders (some riders are free, and others can be added at an additional cost)
  • Protection from creditors (depending on your state of residence)

Disadvantages:

  • Limited upside potential
  • Surrender charges
  • IRS early withdrawal penalty
  • Limited amount of liquidity

Is a Fixed Index Annuity Right for Your Portfolio?

Even with all of the advantages to owning a fixed index annuity, this financial product might not be right for you and your specific needs and retirement goals. In order to determine whether or not a fixed indexed annuity is right for you, there are several factors to consider, such as your age, risk tolerance, and time until retirement.

Additional considerations should be:

  • Estimated retirement income needs (including guaranteed income for life)
  • Other retirement income sources (such as Social Security and/or employer-sponsored pension)
  • Marital status (for joint income needs)
  • Percentage of your portfolio to be used for buying the annuity
  • Financial strength and claims paying ability of the offering insurance company
  • Length of the annuity’s surrender period
  • The additional cost of any riders or other add-ons
  • The interest rate that could be earned on other financial products available in the market

Benefits of Working with an Independent Annuity Financial Professional

Planning for retirement can be somewhat tricky. When doing so, you need to ensure that you will have enough income to last for a potentially long time. A fixed indexed annuity can help you to achieve this goal through its lifetime income feature.

But not all annuities offer the exact same benefits. There are actually a lot of “moving parts” on a fixed indexed annuity, so it is recommended that you walk through the process of narrowing down the best annuity with a retirement income specialist who is also an independent financial professional.

That way, he or she can go out into the marketplace and find the annuity and insurance carrier that fits your specific objectives the best, and that has the financial strength to make good on your future income. If you would like to get a quote for a fixed indexed annuity, or you still have questions about these financial tools, feel free to contact Insurance Geek and talk with an experienced financial professional.

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