Benefits of an Annuity
Tax Deferral
Perhaps the most attractive advantage of an annuity other than
providing an income for life is that the annuity owner can defer taxes
on the growth of assets within the annuity contract. Earnings credited
to an annuity are not taxed to the annuitant as income until withdrawn.
This tax deferment, along with the benefit of compounding, allows
annuities to outperform most other taxable investments. Because of tax
deferment, annuities experience a "triple compounding" effect that
produces more growth, more quickly. Triple compounding allows annuities
to accumulate growth on principal, growth on that growth, and growth on
the monies that did not have to be taken out to pay taxes. This creates
a higher effective yield.
Probate Avoidance
Probate means "to prove" and is the process used by individual states
to determine the proper transfer of ownership assets in an estate, as
well as to determine the tax liability on those transferred assets. If
the deceased has no will, he or she is termed to have died intestate,
and the probate courts will determine how the estate is to be
apportioned.
The probate process has three notable problems:
- Lack of privacy—The process of probate is a matter of public record. Notice is required to be given to all interested parties so that claims may be brought against the estate.
- Delay—It is not unusual for the probate process to require several years, depending on the size, complexity, and number of claims brought against the estate.
- Cost—Probate can be expensive. Court fees, attorney fees, filing fees, appraisal fees, and fees for executors and/or conservators are often charged. It is not unusual for such costs to amount to as much as 10 percent of the value of the estate, and in many cases much more. This may create circumstances in which it is necessary to sell assets of the estate to cover probate costs.
Taxes
on Social Security
In addition to deferring taxes and compounding the earnings (which
would normally have a tax liability) during the accumulation years, the
annuitant can also control the timing of the taxes that become due as
monies are withdrawn from the annuity. By controlling the timing of
annuity distribution, the annuitant can control the amount and rate of
taxation on his or her Social Security income.
When collecting Social Security, a calculation incorporates a formula
for all income, without exclusion for tax-free bonds and other sources
of income that may not be included in the normal calculation of taxable
income. If under this formula the annual income exceeds a certain
threshold amount, then up to 85 percent of the income from Social
Security may be taxed. Therefore, controlling the annuity income could
play an important part in the tax planning aspect of retirement.
Guaranteed
Income Stream
Annuities can provide a guaranteed income stream for a lifetime,
depending on the settlement option the annuitant selects. If the
annuitant selects an income stream for his or her lifetime, or for
multiple lives or joint life payout, then that income stream will
continue as long as the recipients of the income are alive. This is
true even though the principal in the annuity has been exhausted. A
life annuity maximizes the use of retirement funds and thus guarantees
the income stream to last a lifetime.
Tax-Favored
Income
With nonqualified annuities (annuities that are not part of a qualified
plan and are not funded with pre-tax dollar contributions), part of
each income payment is considered a return of premium, or the cost
basis in the contract, and is not taxed. This reduces the tax liability
of the income stream. Simply in the payout phase of an annuity, the
payments are normally split between the return of premium and the gain
in the contract. This is accomplished by using an exclusion ratio. For
example, assume that $100,000 had been paid in premiums to the annuity,
and that sum had accumulated to $300,000. The annuitant has selected a
settlement option with a monthly payment of $3,000. Of that amount,
$1,000 would be considered return of premium, or the cost basis in the
contract, and is not taxable. The remaining $2,000 would be considered
the gain in the contract and would be taxable.
The exclusion ratio varies depending on the settlement option the
annuitant selects.
