11 Aug The Ultimate Guide to Fixed Indexed Annuities
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Fixed indexed annuities are often purchased by those looking to put their money in an investment vehicle where they can earn more than the current fixed rates, but want less risk than the stock market.
While fixed indexed annuities may sound like the perfect choice, they aren’t right for everyone.
If you aren’t aware of the pros and cons – including tax consequences and death benefit options – you may end up locked into a contract that could cost you WAY more than you bargained for.
Keep reading for a deep-dive into fixed indexed annuities so you can make an educated decision on whether or not they are right for your goals and objectives.
What Are Fixed Indexed Annuities?
Fixed Indexed annuities 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. They’re often referred to as a fixed indexed annuity, or an equity indexed annuity.
Indexed annuities offer potentially more return (due to the risk) than a fixed annuity, but less returns (and less risk) than a variable annuity.
With a fixed index annuity, you cannot lose your principal investment because it’s guaranteed by the insurance company.
The longer the duration of the contract, the higher the interest rate will be. The most common fixed index annuities are 3, 5, or 10 years.
Rates vary from contract to contract. To find the best rates, research multiple sites that update indexed annuity rates. Also, make sure you compare caps and participation rates.
How Do Fixed Indexed Annuities Work?
With fixed indexed annuities, 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.
Let’s say you have a fixed indexed annuity with a cap of 3% on the performance of the S&P 500 for a 12-month period.
Here’s how the interest is applied:
- If the index is up 2.5% during that year, you will get 2.5% interest. This is what was earned.
- If the index is up 5% during that year, you will get 3% interest. This is the cap.
- If the index is down 1% that year, you will receive zero interest – but you are protected from losses.
Here is an example of a fixed indexed annuity with a participation rate of 25% on the performance of the S&P 500 index for a 12-month period, and how interest will be applied:
- If the index is up 15% during that year, you will get 3.75% interest (15 x .25% the participation rate).
- If the index is up 30% during that year, you will get 7.5% interest (30 x .25% the participation rate).
- If the index is down 1% that year, you will receive zero interest. (You are protected from losses.)
Who Is an Indexed Annuity Right For?
Annuities are made for someone who is trying to earn a little more than fixed interest rates and wants less risk than being in the stock market.
Benefits of Indexed Annuities
While there are numerous advantages, that doesn’t mean indexed annuities are a right fit for everyone.
- Tax-deferred growth: You will pay no income taxes on the earnings from your annuity investments until you begin making withdrawals or receiving periodic payments. Note: 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.
- 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. With pre-tax money, you still have the annual contribution limits.
- No Required Minimum Distributions: If you have a non-qualified annuity, there are no RMDs at age 72, unlike IRA annuities.
- Multiple investment options: Index annuities allow you to participate in the gains of indexes, like the S&P 500, without the risk.
- Limited losses: With fixed 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.
- Death benefit: Since these are insurance contracts, there are different death benefit options that may be available to your heirs, if you pass prematurely.
- No probate: Another huge benefit is that most annuities will bypass probate and be paid to your beneficiaries directly.
Disadvantages of an Indexed Annuity
- High and/or long surrender charges: Most annuities will have different terms as far as their surrender charges. Many states will limit these to 10 years or 10% penalty if you cash out your annuity before the end of the term.
- If you are expecting stock market-like returns, DON’T! You most likely won’t get them. The indexed annuities will pay you gains up to your cap or participation rate each year.
- Uncertain returns: Unlike fixed annuities, Indexed annuities don’t have a guaranteed rate of return each year. Yes, they may have a fixed rate as an option, but these are usually lower than a traditional fixed annuity or a MYGA (multi-year guaranteed annuity).
Indexed Annuity Withdrawal Options
Once your Indexed annuity reaches the end of the term – or matures – you have several options to withdraw your money:
- You may withdraw the principal and all interest earned in a lump sum.
- You may be allowed to renew the contract at the then current rates.
- You may roll over or exchange the indexed annuity for another without paying taxes on the gains – that is, if it’s done properly with either a direct transfer (IRA money) or with a 1035 exchange (non-qualified money).
Note: Some individual insurers may have other withdrawal options. Please be sure to read the fine print and ASK before signing on the bottom line.
Are Indexed Annuities Safe?
Yes, fixed indexed annuities are safe.
When you open an indexed annuity contract with an insurer, you will be guaranteed your principal first, and then your gains each year are locked in as your new account value.
Insurers must belong to state guaranty associations, and if they default, the guaranty associations must pay you up to your state’s limit (Average is $250,000).
What Are the Risks?
Since indexed annuities are backed by the issuing company (the insurer), your main risk is with the claims paying ability of this company. In other words, can they make good on all their claims?
This is why we encourage consumers to research the ratings of these companies prior to purchasing an annuity.
Here are a few places to research insurers:
- AM Best: https://www.ambest.com/
- Fitch ratings: https://www.fitchratings.com/
- Moody’s: https://www.moodys.com/
- Standard and Poors: https://www.spglobal.com/ratings/en/sector/insurance/insurance-sector
Indexed Annuity Death Benefit Options
Each annuity contract, as well as any annuity insurer, will have specific contract language regarding death benefit options – so read your contract details closely.
Indexed annuity death benefit options are usually defined in two main categories: lump sum or income options.
- Lump Sum Death Benefit: When the insured passes away, beneficiaries may receive the full account value in one lump sum. Some insurers may allow you to take a 5-year payout of this lump sum to lessen the tax burden.
- Annuitized (or Income Stream): Some insurers will allow you to create an income stream from the death benefit, and have it dispersed over your lifetime. NOTE: With the new inherited IRA rules, qualified accounts must be liquidated in ten years maximum.
If you are a spouse of the deceased, you may have different death benefit options, including the right to continue the contract in your name to full term.
If you have a current advisor, have them run the scenario to see if this option makes sense versus transferring the assets into your name with a new annuity.
How Are Indexed Annuities Taxed?
Indexed Annuities are taxed based on if the funds used to purchase are qualified or non-qualified.
- Qualified Funds: If you use qualified funds (like from an IRA, 401(k), etc.), you will be taxed when you withdraw the funds. It will be considered income and will tax both the principal and interest earned.
- Non-Qualified Funds: If you use non-qualified funds (like cash from your bank account), you will be taxed only on the interest earned.