Indexed Annuities: Pros and Cons

indexed annuities

Indexed annuities are a type of tax-deferred annuity that is linked to the performance of an equity index, like the S&P 500. 

Many people purchase indexed annuities to get some gains from the market, while protecting themselves from losses and the ups and downs of the market. These products also provide safety and security and the ability to turn into income sometime in the future. 

Sounds good, right? 

Maybe not. Right now – in our current interest rate environment – they may not be the best choice for your financial needs and goals. 

Keep reading for more information on how indexed annuities work and the pros and cons of purchasing one.  

What Is an Annuity? 

An annuity is a contract between you and an insurance company. They are used for retirement purposes to protect and grow your money. And to ensure you don’t run out of money. 

You invest your money with an insurance company, and the institution will either issue a stream of payments for a specified period of time in the future or pay you income on a monthly basis, quarterly basis, or annual basis. Or, you can cash them out. 

[Related Read: Types of Annuities Explained]

What Is an Indexed Annuity? 

Indexed annuities are often called a fixed indexed annuity, or an equity indexed annuity. 

They offer a guaranteed interest rate combined with an interest rate that’s linked to a market index, such as the S&P 500, the Dow, or the Nasdaq. 

Indexed annuities offer potentially more return (due to the risk) than a fixed annuity, but less returns (and less risk) than a variable annuity

They are made for someone who is trying to earn a little more than fixed interest rates, and wants less risk than actually being in the stock market.

How Do Indexed Annuities Work? 

All indexed annuities track an index. The interest you earn will be based on the performance of a market index (like the S&P 500) up to the cap or participation rate of your contract.

You will not earn 100% of what that index does. 

Let’s look at 2 examples – one for cap and one for participation. 

Let’s say you have a indexed annuity with an annual cap of 3% on the performance of the S&P 500 index for a 12-month period: 

  • If the index is up 2.5% during that year, you will get 2.5% interest because that is what was EARNED. 
  • If the index is up 5% during that year, you will get 3% interest because that’s the CAP. 
  • If the index is down 1% that year, you don’t lose anything. You will receive ZERO interest, but you are protected from losses. 

Let’s say you have an indexed annuity with an annual participation rate of 25% on the performance of the S&P 500 index for a 12-month period:

  • If the index is up 15% during that year, you will get 3.75% interest. (Take the 15 x the .25% participation rate and that gives you your participation rate.)
  • If the index is up 30% during that year, you will get 7.5% interest. (30 x the .25% participation rate.) 
  • If the index is down 1% that year, you will receive zero interest. (You are protected from losses.)

Pros of Indexed Annuities

#1 Tax-deferred growth

You will pay no income taxes on the earnings until you begin making withdrawals or receiving periodic payments. If the funds you are using to purchase an annuity are already an IRA, this is not an additional benefit to you, as your IRA is already tax-deferred.

#2 Unlimited contributions

There is no limit to the amount of after-tax money you can put into an annuity, regardless of your income level or sources of income. NOTE: With pre-tax money you still have the annual contribution limits (think IRAs).

#3 No Required Minimum Distributions

If you have a non-qualified annuity, there are no RMDs at age 72, unlike IRA annuities.  

#4 Multiple investment options

Indexed annuities allow you to participate in the gains of indexes without the risk. 

#5 Limited losses

With indexed annuities, the insurance company may guarantee that you no longer have stock market losses. If the market goes up, you get a percentage of the gains up to your cap or participation rate. And, if the market drops, you get zero percent interest for that year. Remember, you will NOT make what the market earns. 

#5 Death benefit

Since these are insurance contracts, there are different death benefit options that may be available to your heirs, if you pass prematurely. 

#7 No probate

Many annuities bypass probate, allowing the money to pass to beneficiaries without issue. 

Cons of Indexed Annuities

#1 High and/or long surrender charges

Most annuities have different terms as far as their surrender charges. Many states limit these to 10 years or max 10% penalty if you cash out your annuity before the end of the term. Make sure you read the contract fine print before you purchase, as it differs from state to state and contract to contract. 

#2 You won’t get stock market-like returns

If you are expecting stock market-like returns, DON’T buy an indexed annuity! You’re not going to get high returns. Indexed annuities will pay you gains up to your cap or participation rate each year – not the actual market return. 

#3 Uncertain returns

If the indexes are down 3 years in a row, you aren’t going to lose money, but you won’t make any either. 

Indexed annuities may have a fixed rate as an option, but these are usually lower than a traditional fixed annuity or a MYGA, or a multiyear guaranteed annuity. 

If the indexes are down 3 years in a row, you aren’t going to lose money, but you won’t make any either. 

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