Insurance: A Great Investment Vehicle

The Darlings of Tax Reform

Since Tax Reform policies went into effect, the insurance industry’s deferred annuities have become on of the most attractive investment products around.

Deferred annuities can serve as an alternative for individuals whose incentive to continue to make IRA contributions was greatly weakened by Tax Reform. Although contributions to a deferred annuity are not tax deductible, earnings do accumulate tax deferred. Advantage over an IRA: There is no limit to the amount of money you can invest in an annuity.

The new variable annuity can serve as the ideal replacement for investments that used to receive the benefit of favorable long-term capital gains treatment. Long-term gains from investments in stocks can be sheltered in a variable annuity. That income is not taxed until you withdraw your money.

How Annuities Work

An individual buys and annuity from an insurance company, paying a lump sum or a series of payments over time. In return, the insurance company guarantees that the funds will grow at a certain tax-free rate. Then, beginning on a specified date, the individual receives regular income payments for life.

Payments depend on the amount of money contributed to the account, the length of time the funds are left in it, and the rate of return earned on the funds. Also a factor in determining the size of the payments is whether you include your spouse and other heirs as beneficiaries. Different options enable you to have payments continue to your spouses, or to your children, or for a minimum of, say, 20 years, regardless of who is there to receive them after you die.

Deferred annuities, therefore, can be considered part insurance and part investment. If you are willing to part with at least $5,000 (the minimum amount can differ from company to company) for five years or longer, you can be guaranteed a competitive, tax-free return on your funds. Because the earned income is not taxed until you begin withdrawing the money (presumably at a lower tax rate), your funds accumulate much faster than they would if they were taxed. The insurance component, of course, is guaranteed regular monthly income payments for the rest of your life-taking the worry and risk out of budgeting for your retirement income. Also, should you die before you begin receiving payments, your heirs are guaranteed to receive the full amount of your original principal.

Fixed Rate Versus Variable

There are two basic types of deferred annuity-fixed and variable.

Fixed annuity: The insurance company guarantees that your funds will grow at a specified rate for a specified period of time. Most companies guarantee a specific rate of return for at least the first year. Thereafter, the rate usually fluctuates at least once a year, according to the then-prevailing interest rates. Although the rates of return for fixed annuities may vary, your principal always remains intact.

Variable annuity: The rate of return is determined by the performance of investments you select from a broad range of mutual funds offered by the insurance company. Investing in a variable annuity is almost identical to investing in a family of mutual funds. You have the same exchange privileges and the choice of putting all your money into one fund or a blend of different funds, or even of dividing your money between a fixed annuity and a variable annuity. You can earn a much larger return than you might with a fixed annuity. However, if your investments perform poorly, your original principal may diminish.

The minimum investment for a deferred annuity is generally $5,000, although some single-premium annuities can require a one-time lump-sum investment of as little as $2,500. A flexible premium annuity, paid over time, may have an initial minimum as low as $1,000 and require small monthly payments.

Most companies levy an annual management charge of 0.5%-1.5% of total assets. If you invest in a variable annuity, you will also pay a percentage of your total assets to cover management costs for the mutual fund.

Insurance companies typically charge a declining surrender fee of 5%-6% (which usually falls to zero after five or six years) if you liquidate the principal of your annuity. And if you withdraw your money before age 59 1/2, the IRS will charge you a penalty.