Annuities: Know the Pros and Cons

Some love annuities, some hate them, but there’s no denying that many find them useful, and they often form part of an estate plan. Before making a decision, it’s a good idea to learn more about them and how they might be able to help you.

Annuities are contracts—sold by insurance companies—that return a series of guaranteed periodic payments over your lifetime. If you choose to take annuity payments over your lifetime, you will have a guaranteed source of income until your death. They are seen as effective investment vehicles for retirement and sometimes for planning for a child’s college education. Better yet, earnings that occur during the term of the annuity are tax-deferred. You aren’t taxed on them until they are paid out. Because of this deferral, your funds have a chance to grow more quickly than they would in a taxable investment.

The two primary reasons to use an annuity as an investment vehicle are to save money for a long-range goal and to obtain a guaranteed stream of income for a certain period of time.

A negative aspect of annuities is that you cannot get to your money during the growth period without incurring taxes and penalties. It only makes sense to put your money into an annuity if you can leave it there for at least 10 years.

If your annuity is to continue after your death, other taxes may apply to your heirs, who are subject to income tax on the same principles that would apply to payments collected by you. However, there’s no 10% penalty on withdrawal under age 59½, regardless of the recipient’s age or your age at death.

The present value of the remaining annuity payments at your death is an asset of your estate and subject to estate tax with other estate assets. Annuities passing to your surviving spouse or to charity would escape this tax.

One fairly simple way to control the flow of money to an heir is to buy an annuity to make payments to a beneficiary you name. Annuities can be owned jointly by two people—most often they are spouses. If one spouse dies during the annuity’s accumulation phase while it’s growing but before payouts begin, the other partner becomes the sole owner of the annuity and can reregister it to continue using it for long-term, tax-sheltered growth.

If the death occurs after payouts have begun, the surviving spouse can take ownership of the contract and continue receiving income. Alternatively, if the spouse also is the beneficiary of the contract, it might be advantageous to take a death benefit payout instead. This avoids a potential tax penalty if the survivor is younger than 59 1/2.

For policies that aren’t jointly owned, naming a beneficiary is a crucial step in the process. Like the beneficiary of a life insurance policy, the annuity’s beneficiary will receive any outstanding funds in the contract at the owner’s death. This is paid directly without the time and expense of probate. The money must be taken either as a lump sum, as five equal payments or as a lifetime income. It’s taxed as ordinary income under each of these scenarios, rather than as capital gains.

If there’s no surviving beneficiary when the annuity owner passes away, the contract’s death benefits are paid into the estate and go through probate in the conventional fashion.

If you’d like to retain control of your annuity’s final destination, you can avoid this by naming contingent beneficiaries to receive the proceeds if your primary beneficiary is deceased. (If your beneficiary dies first, the funds go to your beneficiary’s heirs.) You also can name a trust or charitable organization as your beneficiary.

Despite the usefulness, annuities have their detractors, and some financial planners say there are less expensive ways to get the same results.

If you’re interested in learning more, please contact us at (805) 963-7811, and we’ll further discuss annuities and other options with you and how they may fit into your estate plan.