Annuities Part I: The Basics
By: Suzanne Lako
The Henssler Financial Group Position Paper

The Henssler Financial Group does not typically recommend annuities, other than Tax-Sheltered Annuities (TSAs) available through nonprofit employers. In order to understand why, you must first understand what annuities are and how they work. The upcoming series of articles on annuities will cover the basics, various types of annuities, payout options, expenses, and summarize the firm's position on annuities. This article highlights the basics of an annuity.

What is an Annuity?

An annuity is a product or contract that is created and sold by insurance companies or through investment houses such as Charles Schwab, Vanguard and T. Rowe Price.

Annuities guarantee a fixed or variable payment to the individual receiving the benefits (the annuitant) either for life or some specified period of time. Many investors use annuities to accumulate assets for retirement, as well as a way to manage the risk of living too long, or outliving assets. Annuities allow for tax-deferred growth on assets as well as an insurance element.

The insurance element of an annuity is not what one would think of as traditional insurance. The "insurance" is that you will have a "guaranteed" income until death, or for some stated period.

How does an Annuity work?

Remember, that this is a general discussion of annuities; therefore, the terms of individual annuity products and/or contracts may differ.

When you purchase an annuity contract, you make a principal contribution, also known as a premium, either in a lump-sum or over a specified period. When an individual purchases an annuity, that company will actually invest the money in one of its portfolios.

There are two basic forms of deferred annuities: fixed and variable. With a fixed annuity, your money will earn interest during an accumulation phase. At time of issuance, an interest rate is fixed for the first year. This interest rate is the current rate. For the second and all subsequent years, the insurance company uses what is referred to as a renewal (or base) rate. The renewal rate is initially determined by what the insurance company has projected it should be in the second year. A note of importance — this renewal rate is NOT guaranteed for all subsequent years, and in many instances can be lower than the originally projected rate for the second year.

In contrast, variable annuities, and therefore their payouts, can fluctuate in value based on the underlying investments in the sub-accounts chosen by the investor.

These types of annuities will be discussed in length in future articles.

Taxation of Annuities

An annuity acts very much like a nondeductible IRA in the following regards:

• An annuity contribution is made with after-tax dollars (money you have already paid taxes on). You do not get a tax deduction for contributing to an annuity.
• The earnings in an annuity contract, whether interest, dividends or capital gains distributions, grow tax-deferred until you begin withdrawing.
• With annuities, you are not taxed in the year the income is earned, but rather when you withdraw or annuitize. When money is withdrawn from an annuity, the "earnings" are assumed to be withdrawn first and are taxed as ordinary income.
• Early withdrawals of earnings are not only subject to ordinary income taxes, but also a 10% penalty if you withdraw before age 59 ½.

Major Drawbacks of Annuities

Some of the general arguments against annuities include:

• A great deal of the time, annuities are sold to the elderly, however the elderly may not be the most suitable investor because most annuities carry long-term surrender charges. The elderly tend to buy because the product has a guarantee, or constant income. Most of the time, they do not understand the fees and expenses, or how an annuity contract actually works. Usually, entire amounts of savings are contributed to an annuity, which is then tied up for years because there are large surrender charges. If this money is needed, a withdrawal will constitute ordinary income taxes, which potentially could be higher than the 15% capital gains rate applied if the funds had been held outside an annuity or IRA.
• Annuities can have exorbitant and long-term surrender charges, fees and other expenses. These fees and expenses usually outweigh the benefits of the tax-deferred status. These will be discussed in greater detail in future articles.
• There is no step-up in basis for estate planning. This means that when passed to heirs, taxes will be owed on gains from time of the annuity inception, as compared to other types of investments that would receive a full step-up in basis.

Remember, the above was a general outline defining annuities. In the coming weeks, I will outline some of the more common types of annuities, payout options, and expenses, including more on taxation associated with annuities.

If you are planning to invest in an annuity, I recommend you consult your tax adviser and/or financial adviser before doing so. It is extremely important that you understand the investment vehicles you choose. If you do not understand your investment vehicle, do not invest. For more information regarding this topic, please contact The Henssler Financial Group at 770-429-9166 or comments@henssler.com.