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Published on: 03/01/2024 • 7 min read

How Does Annuity Planning Work?

Annuities are often a cornerstone of retirement planning, especially for individuals with a high net worth looking to manage their wealth more effectively. 

Annuities play a significant role in retirement planning, particularly for individuals with substantial assets seeking effective wealth management strategies. Annuity planning facilitates the conversion of a portion of retirement savings into a steady stream of predictable payments, which can offer financial stability throughout retirement and mitigate the risk of outliving one’s savings. 

This article delves into the various types of annuities available to high-net-worth individuals, their potential tax advantages, and their importance in comprehensive retirement planning services.

What is an annuity?

An annuity is a contract between an individual and an insurance company wherein the individual receives regular payments, typically monthly or yearly, in exchange for a lump-sum investment or a series of payments. These payments can start immediately, or they can be deferred to begin at a later date. The amount and frequency of these payments depend on the type of annuity purchased and the terms agreed upon in the contract.

The benefits of an annuity can include:

  • Guaranteed income
  • Potential tax advantages
  • The ability to customize the payout schedule to fit personal financial goals 

Annuities can also be a practical component of small business retirement planning, offering business owners and their employees a reliable income source in retirement.

What is the biggest disadvantage of an annuity? 

The most significant disadvantage of an annuity is the loss of liquidity. Unlike other investments, annuities are not easily accessible and usually come with a surrender period during which withdrawals are often subject to penalties. This lack of liquidity can make it challenging for individuals to access their money in case of emergencies or unexpected expenses.

Another potential drawback is the tax treatment of annuities. While annuities offer tax-deferred growth, meaning taxes are not paid on earnings until distributions are made, withdrawals from the account are taxed as ordinary income. This can result in a higher tax burden for individuals receiving large sums of money from their annuity and needs to be considered during any retirement tax planning.

How do annuities work?

Annuities function under a simple yet robust structure. The process begins with an individual, known as the annuitant, entering a contract with an insurance company as a way to shift some risk from themselves onto the insurance company. 

Here are the general steps involved:

  1. Accumulation phase: The initial phase is the accumulation phase, where the annuitant makes a lump-sum payment or a series of payments to the insurance company. This investment creates the foundation from which future payments will be drawn. During this phase, the money invested may earn interest based on the type of annuity chosen, be it fixed, variable, or indexed.
  2. Payout options: Upon contract initiation, the annuitant selects between various annuity payout options. Choices include lifetime payments for a consistent stream of income, joint-life payments that continue for a surviving spouse, or certain-period payouts guaranteed for a specific time frame.
  3. Payout phase: Following the accumulation period, the annuity enters the payout phase. This can be immediate, as with an immediate annuity, or deferred to a future date, which allows the investment more time to potentially grow. Once this phase begins, the insurance company commences disbursing regular payments to the annuitant. These payments are calculated based on the initial investment, the length of the payout period, and other contract terms.
  4. Death Benefits: Many annuities include a death benefit that protects the investment for the beneficiaries. If the annuitant passes away before receiving the full value of their annuity, the designated beneficiaries may receive a death benefit.
  5. Surrender Charges: Most annuities have a surrender period, during which early withdrawal beyond a certain percentage of the account value is subject to surrender charges. This discourages annuitants from pulling funds out prematurely and ensures the long-term nature of the investment.

What are the different types of annuities?

When evaluating annuities, distinguishing between qualified and non-qualified types is crucial for understanding their tax implications and suitability for individual financial planning. ​​Choosing between a qualified and non-qualified annuity depends largely on an individual’s current tax situation, future income expectations, and retirement planning strategy. 

Qualified annuities are often integrated into retirement savings plans such as traditional IRAs or 401(k)s. These annuities are notable for being funded with pre-tax dollars, which means taxes have not yet been paid on the money that’s being invested. Consequently, when distributions are made from a qualified annuity, the recipient is required to pay income tax on the entire amount received.

Conversely, non-qualified annuities offer a different set of tax advantages and regulations. These are funded with after-tax dollars, which means taxes have already been paid on the contribution amounts. For non-qualified annuities, the principal amount is not subjected to further taxation upon withdrawal, though any interest or earnings accrued will be taxed as income. A significant benefit of non-qualified annuities is the absence of required minimum distributions (RMDs) at any age, allowing more flexibility in planning and accessing funds. 

There are several additional types of annuities available, each with different features and benefits. These include:

1. Fixed annuities

Fixed annuities offer a guaranteed return on investment for a set period. This type of annuity is typically less risky than other options because the insurance company assumes all investment risk, providing a predetermined interest rate for the entire term. Depending on the terms of the contract, these annuities may offer a fixed rate for life or a set number of years.

2. Variable annuities

Variable annuities allow individuals to invest their money in different sub accounts that function similarly to mutual funds. These sub accounts can vary in risk and potential returns, giving individuals more control over their investment strategy. However, this also means that the investment is subject to market fluctuations and may result in a loss of principal, meaning the prospect of investing in variable annuities carries a higher risk. 

3. Indexed annuities

Indexed annuities offer features of both fixed and variable annuities. They typically guarantee a minimum rate of return while also providing potential for higher returns based on the performance of an underlying index, such as the S&P 500. This type of annuity can offer a balance between guaranteed income and market participation.

Continue reading: Where is the safest place to put your retirement savings?

What is an example of an annuity policy?

Let’s say that based on your retirement income planning, you decide to purchase a fixed annuity with a lump-sum payment of $100,000 at the age of 60. The insurance company provides you with a guaranteed interest rate of 4% annually. You opt for deferred annuity payments to begin at age 65, allowing the investment to grow during this period.

When you turn 65, your annuity value has grown due to the interest accumulation, and you begin to receive monthly payments based on your initial investment, the accrued interest, and the length of the distribution period you chose. Assuming you choose to receive payments for a guaranteed 20 years, the insurance company calculates the monthly payments by dividing the total annuity value by the number of months in the 20 years.

If you were to pass away before the 20-year period ends, your designated beneficiaries would continue to receive the monthly payments until they fulfill the contract terms.

Keep in mind that the tax implications for these distributions vary based upon the types of funds used (ie. qualified vs non-qualified) as well as whether it was funded with after-tax funds. In this case, there would be an exclusion ratio used to determine the non-taxable portion and taxable portions of each distribution made.

Build comprehensive strategies for a secure retirement with Avidian Wealth Solutions

As mentioned above, annuity planning involves choosing an annuity type, making an initial investment during the accumulation phase, selecting payout options, and then receiving regular payments in the annuity’s payout phase, often with added features like a death benefit and potential surrender charges. Annuities can also help control RMD and thus tax liabilities as the IRS respects pre-determined distribution schedules.

Are annuities a good investment for me? If you’re a pre- or post-retiree looking for retirement planning for high-net-worth individuals, our team at Avidian Wealth Solutions can help you assess your financial goals and retirement plan to determine if an annuity is a suitable addition to your portfolio.

Whether you’re looking for retirement planning in Austin or retirement planning in Houston, we provide personalized, comprehensive solutions through a boutique family office environment, allowing us to truly understand your needs and tailor our services accordingly. With a focus on risk management and long-term growth, we can help you build a well-balanced portfolio that includes annuities as part of your retirement income strategy.

To learn more, schedule a conversation with one of our advisors in Houston, Austin, Sugar Land, or The Woodlands today!

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