Annuities

The four types worth knowing

What an annuity is genuinely good at

The problem annuities solve is not returns — it is uncertainty about how long you will live and what markets will do in the first few years after you stop working. A retiree drawing from a portfolio during a bad opening decade can run out of money even if the long-run average return was fine. That is sequence-of-returns risk, and no amount of diversification eliminates it.

Guaranteed lifetime income removes that risk for the portion of your spending it covers. The practical exercise is straightforward: total your genuinely fixed retirement expenses — housing, utilities, food, insurance, taxes — and see how much of that is already covered by Social Security and any pension. If there is a shortfall, that shortfall is the natural size of an income annuity. The rest of your portfolio can then take investment risk without threatening your ability to keep the lights on.

Reading the contract before the brochure

The single most misunderstood feature in the category is the income rider roll-up. A contract advertising a “7 percent roll-up” is not paying you 7 percent. It is growing a hypothetical benefit base used solely to calculate a future income payment, while your actual account value grows at the crediting rate. Both numbers appear on the statement, and confusing them leads people to believe they have far more accessible money than they do.

• The surrender schedule — how many years, and what percentage in each year
• The free withdrawal provision — usually 10 percent of account value annually
• Whether a market value adjustment applies to early withdrawals
• The rider fee, charged annually against the account value
• The distinction between account value and benefit base — only one is yours to withdraw
• The guaranteed minimum cap or participation rate, not just the current one
• The insurer’s financial strength ratings from the independent agencies

Annuities and taxes

Growth inside an annuity is tax-deferred. When you withdraw, gains come out first and are taxed as ordinary income rather than at capital gains rates, and withdrawals before age 59½ can incur an additional 10 percent federal penalty. Money that is already inside an IRA does not gain further tax deferral from an annuity — if an annuity belongs in an IRA, it is for the guarantee, not the tax treatment.

Annuities do not receive a step-up in basis at death the way many taxable investments do, which matters if legacy is a priority. We are not tax advisers; we will flag these points and tell you when the conversation belongs with yours.