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Understanding Annuities: 4 Common Rules


Like with any other investment option, it’s important to understand what you’re getting before you sign on the dotted line. That is one of the reasons why so many people shy away from annuities; they can be rather complex. But just because they can be complicated doesn’t mean you should count them out. Here’s a look at some of the more common rules associated with annuity products, according to a recent article from Madison.com.

Rule #1: Annuities don’t offer an immediate tax deduction.

Traditional IRAs and 401(k)s are so attractive because you get an up-front tax break for contributing. With a 401(k), you deposit straight from your paycheck, pre-tax, where with an IRA, you fund your account and then get to deduct that amount on your tax return.

Annuities are different. When they are purchased outside of an IRA, they are funded with after-tax dollars (no tax-break there). But the money in your annuity gets to grow on a tax-deferred basis, so you don’t pay taxes on any gains until you begin taking withdrawals. Score!

Rule #2: Annuities come with early withdrawal penalties, just like traditional retirement accounts.

One of the most commonly cited “drawbacks” of purchasing an annuity is the lack of liquidity. But the purpose of an annuity is to provide a stream of income in retirement, so it’s understandable why you can’t just cash out whenever you want. Similarly, you’d face early withdrawal penalties for prematurely removing funds from traditional retirement savings accounts too. It’s just how they work.

Just like with most rules, there are exceptions. If you happen to become permanently disabled, or worse, pass away, you may be able to access your money early, without penalty. In general, however, it’s best to avoid touching your annuity before reaching 59 ½ years old. Not only will you have to pay a penalty, but that money won’t be there for you when you need it most.

Rule #3: Canceling your annuity generally comes at a cost.

Think of your annuity contract like a lease on an apartment. When you sign a lease, you’re agreeing to pay rent for the specified amount of time. If you move out early, you’re still responsible for the remaining rent balance. The same holds true for an annuity. If you break the contract, you could face hefty surrender charges, based on the amount you ultimately withdraw. Surrender charges typically start around 7% during the first year of your annuity and then drop 1% each year.

Again, just like with early withdrawals, there are some exceptions to this rule. You can usually remove up to 10% of your annuity’s value each year without having to pay a surrender charge. Similarly, if you become terminally ill or disabled, or if you pass away, the surrender charge for accessing that money early is typically waived. Finally, if you end up with buyer’s remorse and change your mind about your annuity right away, you generally have a 30 day grace period to surrender without charge.

Rule #4: Annuity withdrawals are (at least partially) taxable.

Just like the money you withdraw from a traditional IRA or 401(k), your annuity withdrawals are also subject to taxes. The way they are taxed is a bit unusual however. If you take money out on your own schedule, annuities are taxed on a last-in, first-out basis. This means that when you take your withdrawals, they are initially considered to have come from the earnings portion of your account, so will be taxed. But once the value of your annuity falls below the amount you paid in premiums, your withdrawals will no longer be taxable.  If you convert the annuity to a stream of payments, then the portion of each payment representing earnings will be taxable, while the portion representing your initial premium payment will be tax-free.

Annuities are definitely not for everyone, but for those looking to secure guaranteed income for life, it’s an option worth exploring. Understanding the products is the first step, and as always, talking to your trusted financial advisor is always recommended.

Written by Rachel Summit

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