Annuities in Financial Planning

As investments, annuities have several unique properties that make them very versatile in addressing a number of financial and investment planning needs. Where an annuity might never have been a consideration by a particular investor, it may, in fact, provide the only real solution once his needs, objectives, priorities and risk tolerance are established. This is why investment decisions should always be based on an overall assessment of your financial profile that includes your tax situation, family needs, accumulation needs, tolerance for risk, and your investment preferences.

In the context of a financial plan, annuities can be a vital component of an investment portfolio adding stability, tax relief, asset protection, income security, general peace-of-mind, or all of the above depending on what it is you are trying to achieve. Here are a number of ways annuities can be applied to address specific financial needs:

Tax Deferral: If your adjusted gross income places you in the upper income tax brackets, you could benefit from a deferral of taxes on investment earnings. For example, if your combined federal and state income tax rate is 48 percent (i.e. 38 percent federal, 10 percent state), each dollar of investment earning not currently taxed, saves you 48 cents. When left to accumulate over time, those current tax savings can accelerate the accumulation of funds. While you will eventually pay taxes on your earnings, you are likely to do so at a lower income tax rate in retirement. Even, if your tax rate is the same, you can control your withdrawals so that more is taken during years of lower taxation and vice versa.

Additionally, unlike qualified retirement plans, in which a Required Minimum Withdrawal provision applies when you reach age 70 ½, there is no such requirement with annuities, so you can continue to defer taxes as long as you wish.

Reduce Social Security Taxation: Generally, Social Security benefits are received tax free. But, if your total income from all sources crosses a certain threshold ($32,000 for joint filers), a portion of your benefits, up to 85 percent, can become taxable. Included in the social security tax calculation is interest earned from tax exempt bonds. Annuity income is exempt from the calculation.

Maximize Retirement Income: There are several annuity strategies that can be applied to increasing your after-tax retirement income. The most widely used is called a “split annuity” which combines a fixed deferred annuity with an immediate annuity to generate a higher level of income. Generally, a split annuity is structured by splitting a lump sum of capital between an immediate annuity that pays an income for a specified period of time, and a deferred annuity that is left to accumulate over the same period. The amount of capital to be split between the two annuities is based on the projected return on the deferred annuity such that, at the end of the payout period, the amount accumulated is equal to the original lump sum. At that point, the lump sum can once again be split to repeat the strategy.

Here is an example of how a split annuity can generate a higher amount of after-tax income:

A 66 year-old man with a lump sum of $100,000 deposits $42,000 into an immediate annuity with a payment period of ten years. That would create a monthly income stream of $430, 80 percent of which would be a return of principal and, therefore, not taxable. Simultaneously he deposits $58,000 into a fixed deferred annuity. Assuming he earns an average rate of 5 percent over the ten year period, his account value would grow to $100,000. As long as he continues the strategy, he won’t be taxed on the earnings inside the deferred annuity.

Capital Preservation: In today’s volatile market environment, more investors are more concerned with the return of their principal than they are the return on their principal. Annuities are one of the few investment vehicles that can deliver on both. With the guaranteed death benefit investors can invest confidently without having to worry about their beneficiaries receiving anything less than their original investment. And, with indexed annuities, there is no risk of losing principal while gains are locked in. Even variable annuities offer downside protection with their minimum rate and minimum income guarantee options.

Achieving Optimal Diversification: Each of the three primary types of annuities – fixed deferred, indexed, and variable – are asset classes unto themselves. Optimal diversification requires a mix of asset classes with low correlation with one another so your portfolio is not overexposed to the risk of any one asset. Mixing asset classes has the effect of reducing the overall volatility of your portfolio producing more stable returns over time.

Protecting Assets:  Annuities are one of the few investments that may be exempt from creditors or legal actions against your assets. Each state has established its own rules and limitations on annuity exemptions, so be sure to check with the rules of your particular state.

Probate Protection: As with life insurance proceeds, annuity proceeds pass outside of probate which can protect them from the delays and expenses associated with probate proceedings.

The use of annuities to address any financial need should be considered only with the guidance of a qualified financial profession with experience in annuities. Also, the use of annuities generally has tax implications which should be reviewed with your tax advisor.