Is an annuity the missing piece to your financial plan?

There are many things that can feel out of your control in life, and that can include economic factors that impact your finances. Inflation, fluctuating stock markets, economic shifts and unexpected expenses like health care costs can throw a wrench in even the most well-thought-out plans. The risk of running out of money during retirement is a real concern for many, but one way to add some financial control may include the use of an annuity.

An annuity is an insurance contract that you can use to create and protect a guaranteed income stream that is tax deferred. Critics argue they can be complicated and costly, but with the right strategy in place, an annuity could play a critical role in your financial goals. They can provide a sense of security for your future by adding some guarantees into your financial plan. But annuities aren’t for everyone or every situation, so it’s important to do your research first to find out which kind of annuity — if any — may be a good fit for your overall portfolio.

Understanding annuities.

It’s important to understand how each type of annuity works and understand any risks associated with them. Annuities come in all shapes and sizes. Some start to pay a stream of income right away, while others will delay income payments to a future date. There are many different types of annuities and ways to utilize one as part of your investment portfolio, with some of the most common being fixed, variable and fixed-indexed annuities. For example, a fixed annuity can guarantee you payments at a specific date. With a variable annuity, you’re taking on more of a risk in the hopes of a larger payout.

As you learn more about different types of annuities, you’ll likely also hear about different types of riders available to you. A rider is an optional enhancement that is available on your annuity contract — but it can also come at an additional cost. Some of the most common riders are living benefit, death benefit and long-term care. For example, a living benefit rider gives you benefits while you’re alive, whereas death benefit riders are typically used more for wealth planning and wealth transfer purposes.

Different variables play a role in the right annuity strategy.

Your financial advisor can help you customize a strategy to fit your specific needs and goals. Time horizon — the amount of time your investment will work toward your goal — plays an important role.

“As long as you have a time horizon of more than three to five years, there’s generally an annuity product out there that can fit most circumstances and needs,” said Steve Gambino, financial advisor and assistant vice president for Commerce Brokerage Services, Inc. “A variable, fixed indexed or fixed-rate annuity can be a good piece of a well-diversified investment portfolio.”

Market environments can also play a large role in determining which annuities are most beneficial and at what time.

“Just a year and a half ago, I wasn’t selling or offering many fixed-rate annuities at that guaranteed fixed rate, because they weren’t paying much interest,” Gambino said. “However, now I’m doing a lot of them for clients as an alternative to a CD (certificate of deposit) because they’ll sometimes pay higher (interest) than what banks are currently paying for a CD.”

Fixed indexed annuities fluctuate with the stock market while still allowing for tax-deferred growth. They offer full downside protection and are popular during a volatile economy because of fluctuations in the stock market — it’s a way to mitigate and protect against losses and have a safety net.

“Indexed annuities have a higher growth potential to help you keep the pace with inflation but with none of the market risk,” Gambino said. “The growth potential with our current market has been resonating with my clients because these annuities take away all the volatility of your investment,” Steve said. “If the market goes up over the next month, great. If it goes down, you still have time for the market to recover and gain again.”

Purchasing an annuity through your IRA is also a strategy gaining popularity. Many retirees rely on their IRA or 401(k) to supplement their income when they retire. There are living benefits you can attach as a rider to your annuity contract that will give you a guaranteed income for the rest of your life.

“It can provide income that you can’t outlive, and it’s there to supplement any income you might have in the future,” Gambino said.

According to The Wall Street Journal, this can be a tax-efficient way to pass assets to future generations.

Choosing a variable annuity with living benefits can guarantee a lifetime income stream. With an annuity housed in a Roth IRA, withdrawals will come out tax-free. If the annuity also offers a death benefit, any value remaining in the account at the owner’s death can be passed income-tax free to the next generation, too. Your tax advisor can help you understand what might be best for your specific situation.

Laddering is another popular approach. This involves purchasing several different annuities over a period of time to get the most out of changing market conditions. The goal of laddering is to maximize your return by dividing your principal among a variety of annuities at different times. Say you have $500,000 of your portfolio to invest in annuities. Instead of buying all at once, you could invest $100,000 per year for each of the five years, essentially laddering your investment over time.

“If you choose a laddering approach, you may have a three-year fixed and a five-year fixed annuity that will provide some funds coming due in three years,” Gambino said. “As your situation changes, you can move it to something else. The concept can be very similar to what you might see with CDs.”

A similar option is the bucket strategy, which entails dividing your money across multiple annuity contracts using an approach that allocates funds for short-term, immediate and long-term expenses. For example, one of the contracts could be set up to start payments now, another in five years and a third in 10 years, when you expect higher health care bills. This allows you to receive money for more immediate needs while the deferred annuities will continue to grow and provide higher payments later.

Use a 1035 exchange if you change your mind.

Depending on your situation, using a strategy like the ones mentioned above can be a great place to start your journey with annuities. But situations change, and there may be instances where you want to adjust your approach. If you initially purchase an annuity for a specific objective but it’s no longer needed, you can change it as long as you’re out of your surrender period, which is a set period of time that typically lasts several years after you purchase your annuity.

“You can go from an indexed annuity to variable or a variable to fixed,” Gambino said. “You just have to be cognizant of fees that you would have if you moved it out. It’s important that you’re out of your surrender period before you make any change.”

A 1035 exchange allows you to transfer to another annuity without any taxable consequences. The primary benefit is that it lets the contract or policy owner trade one product for another with no tax consequence. This also lets you preserve your original basis, even if there are no gains to be deferred. Make sure to consult your tax professional to understand what would be best for your specific situation.

Let’s say you invested $100,000 in a non-qualified annuity, but due to market conditions its value dropped to $75,000. The original contract’s cost basis of 100,000 becomes the new contract’s basis, although only 75,000 was transferred.

What to keep in mind before investing.

As with any investment, it’s important to do your research and make sure you choose an annuity that works in concert with your overall financial strategy.

“You need to be mindful of what you’re purchasing,” Gambino said. “An annuity is a contract — and once you enter it, there can be penalties to get out of it.”

For example, it is essential to know what your surrender period is. You never know what unexpected twists and turns may come your way, so try not to tie your funds up for an extended time.

“I try to keep my clients in products that I know don’t go over seven years,” Gambino said. “Plus, if you’re adding a living or death benefit on, a seven-year annuity makes sense because it allows more flexibility.”

One common misconception is that you don’t have access to your money with an annuity, when the reality is that you may. Each company’s policy states what the penalty-free percentage is per policy year. This is the surrender charge schedule, which will show you what a charge would be in a specific year and how long the surrender charges last. If you’re still in the surrender charge period and go over the penalty-free amount for that policy year, you may have a fee.

It’s important to be mindful of other costs that could come with an annuity. Of the three major types of annuities (fixed, variable, fixed indexed), variable typically has the highest fees. Some fixed and fixed indexed annuities will have fees, but not all. There are also some annuities that have mortality and expense costs, which can be quite high. When you add on a living and death benefit you may not need, you could be paying substantial costs that come out of your investment every year. Essentially, you could be paying for something you most likely wouldn’t need.

“I often see people in their 50s purchase an annuity with a living benefit and hold on to it for 10 or 15 years,” Gambino said. “Then when they’re 66 and have just retired, they realize they have enough money coming in from Social Security that they don’t really need this annuity with a living benefit. So why pay for it? In this case I would adjust their strategy and change it to a new, more cost-effective product without a living benefit.”

Additionally, keep in mind the various tax implications that can come with annuities. This will vary depending on what type of annuity you have and how you take the money.

A qualified annuity is one that is funded with pre-tax dollars. It only becomes taxable once you begin receiving the funds from your annuity. A non-qualified annuity is one where you’ve already paid income taxes on the funds. In this case, you’re only taxed on the earnings of your investment, so any gains or interest you have will be deferred until you take the money out of the annuity.

If you were to shift strategies and move from one annuity to another, using a 1035 exchange would allow you to keep deferring paying taxes on any of the gains or interest you have within the annuity itself. There are also tax-deferred accounts, but anything coming out of an IRA is fully taxable.

Not all annuities are taxed the same, and there are some fundamental tenets of annuity taxation, so make sure to reach out to a trusted advisor to understand the tax implications of the annuity you’re considering.

Annuities: the missing puzzle piece?

Annuities can be an integral part of your holistic financial plan, but keep in mind there is no one-size-fits-all solution.

“I use annuities as a protected, guaranteed piece in a growth portfolio or investment account,” Gambino said. “The annuities are the bucket we have to make sure that we have the funds later on down the road — regardless of what the stock market does.”

If you need income, there are income annuities. If you’re looking to maximize the amount you have to pass on to beneficiaries, you can utilize a death benefit. If you strictly want to grow your funds with a guaranteed rate, you can do that. Or, if you want to grow your funds and participate in the market without any risk, you can do that as well.

“Annuities allow us to put some protection on a portfolio,” Gambino said. “I love using them because it really allows me to provide my clients some peace of mind, get through the hard times and ride the waves of the economy.”

Each situation is unique, but your CommercePremier Banker can help and connect you with a Commerce Brokerage financial advisor to understand your options. Contact your Premier Banker today!

Additional resources:

• Fixed annuityopens in a new window
• Variable annuityopens in a new window
• Explore ways to generate and protect retirement incomeopens in a new window