Deferred annuities are gaining significant attention in today’s tax landscape as more people seek ways to secure their retirement income. In this type of contract, an individual pays a lump sum or periodic payments to their insurer in exchange for a guaranteed stream of income at a future date that could be years or even decades from the time of purchase. This long-term schedule allows the investor to benefit from compound interest.
Read on to learn more about tax-deferred annuity plans, how they can benefit investors, and their role in preserving retirement income.
History of Deferred Annuities
The history of tax-deferred annuities dates back to the early 20th century when the Pennsylvania Railroad introduced the first annuities to its employees as a retirement benefit. They were funded by both the employee and the employer.
In the following years, annuities rose in popularity among corporations and other large organizations to provide retirement benefits to employees. These annuities were often funded through salary reduction plans in which employees could elect to have a portion of their salary withheld and placed in the annuity.
How Tax Deferred Annuities Work
Before getting started with annuities, it’s essential for investors to understand how they work. Tax-deferred annuities allow investors to contribute pre-tax income. This income grows over time, and once the investor hits retirement age, they can start withdrawing money from the annuity, at which time it starts being taxed just like any other form of income.
Once the withdrawal period finally arrives, investors can choose to either receive income for a certain period of time or continue receiving money until death. Investors can also receive the money all at once, but many reject this option, as it often results in higher income taxes.
Types of Tax-Deferred Annuities
The two primary types of annuities are fixed and variable. Here’s a quick breakdown of the differences between them:
Fixed Annuities
A fixed annuity offers a guaranteed rate of return for a set period of time. The rate of return is determined when the annuity is bought and remains fixed throughout its life. The insurance company invests the funds in conservative, low-risk investments, such as bonds and other fixed-income securities, to generate the return rate.
Risk-averse investors looking for a stable source of retirement income can benefit most from fixed annuities. One of the main reasons for this is that the principal investment remains the same forever, and market fluctuations do not impact returns.
Variable Annuities
Variable annuities are invested in multiple types of assets, including mutual funds, stocks, and bonds. Unlike fixed annuities, variable annuities’ rates of return depend heavily on asset performance. As such, while this annuity comes with much higher risk, it also offers the potential for higher returns.
A major benefit of variable annuities is that they can be invested in many different types of assets, which allows investors to choose their level of risk based on their desired rate of return. As with a lot of things related to investment, this can be somewhat of a gamble, so it’s important for investors to do their research to determine the level of risk they are comfortable taking on.
Benefits of Tax-Deferred Annuities
There are several reasons that investors opt for tax-deferred annuities. In addition to tax deferral and the ability to withdraw money more flexibly, investors can take advantage of many investment options. Here’s an in-depth explanation of the benefits of these annuities:
Withdrawal Flexibility
As discussed previously, one of the main attractions of tax-deferred annuities is that they allow a great deal of flexibility in how funds are withdrawn from the account. For example, you can withdraw over a long period and receive income in a fixed stream, or you can request a lump sum payment.
Those nearing retirement age often find that their circumstances change, so investing in plans and accounts will allow you to withdraw as needed and most conveniently and cost-effectively. Changing things as your needs change is critical when determining how to manage retirement funds.
Better Estate Planning
It should come as no surprise that the flexibility offered by annuities leads to better estate planning. Annuity funds can be easily transferred to their beneficiaries when the investor dies. In many cases, they are made tax-free, allowing recipients to build wealth more efficiently.
In addition, many annuities avoid probate, meaning they are not subject to the judicial processes often required for other types of wealth transfers. The last thing anyone wants to be dealing with after the death of a loved one is a web of legal complexities, and tax-deferred annuities allow them to alleviate, if not eliminate, this burden entirely.
Tax Deferral
One of the main reasons that investors opt for tax-deferred annuities is that they allow them to avoid paying taxes on their investment earnings. Rather than throwing money away on taxes, those funds can be left to grow, which can result in significant gains in the long term.
Working with a financial advisor is essential to determine how much you can save over time by deferring taxes through an annuity. An advisor will be able to work with your unique situation and help you devise a plan for maximizing your return on investment and ensuring that you get your money’s worth when it comes time to withdraw funds.
Guaranteed Stream of Income
By establishing a fixed annuity, you’re creating a guaranteed income stream. Unlike other types of accounts, fixed annuities are unaffected by market fluctuations, making them a solid, reliable investment for those counting on having a certain amount of money by retirement age. You know how much money you’ll receive within a given period of time, making retirement planning much more straightforward.
On the other hand, if you are looking for something that offers more investment options with the potential for higher returns, you might consider a variable annuity. With variable annuities, you can choose between several types of investments, each with its own levels of risk and potential return.
Market Volatility Protection
Market volatility can be highly concerning to investors, especially those trying to save for retirement and who want access to a fixed amount of money. Market downturns can lower the value of your investments and throw a monkey wrench in your retirement plans. However, you can protect your funds against sudden market changes with a tax-deferred annuity.
Fixed annuities guarantee principal investments and offer investors the peace of mind of knowing exactly how much they’ll receive per month, year, etc. When planning for retirement, you want to be sure that your funds are secure, and annuities can help safeguard your investments from harmful fluctuations in the market.
Portfolio Diversification
A crucial but often overlooked benefit of tax-deferred annuities is how they impact investors’ portfolios. They can tremendously benefit any investment portfolio, offering market fluctuation protection, tax deferral, and more.
By branching out and diversifying their portfolios, investors can achieve stable and secure income from multiple sources. For example, they might make a more risky investment to maximize returns and implement a fixed annuity to guarantee a certain amount of money by the time they retire.
Choosing the Annuity That’s Right For You
There are many factors to consider when choosing a tax-deferred annuity. Investors should think about the level of risk they are willing to take on and how they prefer to receive their funds when it’s time to withdraw.
They should also consider the fees and related expenses associated with different annuities. In most cases, annuities come with higher fees than other types of investments, so investors should carefully weigh their options to determine whether the annuity will ultimately yield a worthwhile return on investment for them.
Ask about contribution limits and the other tax-free insurance services and products—if any—offered with the annuity. This would be best considering your company’s life insurance and how a tax-deferred annuity may impact it.
When in Doubt, Seek the Help of a Trusted Financial Advisor
While this guide is designed to provide an overview of tax-deferred annuities and help readers decide whether to invest in them, it’s always best to speak to a financial advisor to determine the best course of action for retirement planning. Tax-deferred annuities offer numerous benefits but also drawbacks, including high fees and limited access to funds before a specific date.
For this reason, it’s essential to sit down with a professional, consider your options, and work through any concerns you may have. Doing so lets you find retirement investment products that are right for you and your family.
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