You may want to add annuities to your retirement portfolios.

If you participate in a retirement savings plan where you work, you may find that your employer includes a fixed or variable annuity, or both, in the menu of plan choices. When annuity contracts are offered through a qualified plan, such as a 401(k), they are considered qualified annuities. In this case, qualified means subject to the federal rules that govern how the plans operate. Among these rules are limits on the amount you can defer to your account annually.

Participating reduces your current taxable salary while allowing you to accumulate tax-deferred earnings on your account balance. But, as with other qualified plans, you must begin taking distributions when you turn 70½ and take at least the required minimum each year.

An annuity contract purchased to fund an IRA or employer sponsored plan will not provide tax-deferral benefits beyond those provided by the IRA or plan itself. Investors should consider whether an annuity’s features and benefits, in addition to those provided by tax deferral, are appropriate for their retirement needs.

Nonqualified annuities

If your employer plan doesn’t offer an annuity, you’re not enrolled in a plan, or you want to save more than you can with a qualified plan, you can buy what’s known as a nonqualified annuity from the insurance company that issues the contract, a brokerage firm, or a financial adviser.

Among the key ways that nonqualified annuities differ from their qualified siblings are that you pay the premiums with after-tax income, you can save more than the federal limit for qualified plans, and you can postpone taking income until much later in your life if you wish. In addition, while you must purchase qualified annuities with earned income, you can use income from any source to buy nonqualified annuities. Despite these differences, though, qualified and nonqualified annuities function in very much the same way—accumulating earnings that can be converted to income.

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Another approach

In addition to the annuities available through employer plans and those you can purchase directly from their providers, you can buy an annuity within an individual retirement account (IRA) you hold at a bank, brokerage firm, or investment company. Or, you can open an IRA with an annuity provider.

In that case, IRA stands for individual retirement annuity In that case, the annual contribution limit that applies to all IRAs applies to the annuity, and you must purchase it with earned income. In addition, you must begin to take required minimum distributions (RMDs) at 70½ unless you have selected a Roth IRA, from which distributions are not required.

There are potential limitations to using annuities in an IRA. You are adding a layer of additional fees to your account. That could make it harder to achieve the same return as you realize if you allocated your account similarly using low-cost mutual funds. On the other hand, some of the fees pay for a guaranteed death benefit, the option of a guaranteed lifetime income, and locked-in minimum earnings.

Nonqualified vs qualified annuities

Nonqualified annuities

Qualified annuities

Post-tax, or after-tax, dollars are what’s left of your earnings after taxes are taken out. Contributions to nonqualified retirement plans are made with after-tax dollars. When you eventually take money out of nonqualified plans, you don’t owe tax on the portion of the withdrawal that’s considered return of principal. It has already been paid. Pretax dollars are what you earn before federal and state taxes are deducted. When contributions to qualified retirement plans are made with pretax dollars, it reduces the current income tax you owe because your taxable income is reduced by the amount you invest. Eventually, though, you owe taxes both on the investment and the earnings when you take money out of the plan.
Tax-deferred earnings Tax-deferred earnings
Early withdrawal penalty Early withdrawal penalty
Invest after-tax dollar Invest pretax dollars
No contribution limits Contribution limits
Income from any sour Earned income only
Flexible withdrawal ruIes Required withdrawal rules

The user they serve

Because nonqualified annuity contracts may offer greater flexibility than investments offered in some employer plans, using them may allow you to add diversification to your overall portfolio.

For example, if you’re part of a plan that makes matching contributions in company stock, you might select a fixed annuity for the regular income it promises to provide. Or, if your defined benefit plan will pay you a fixed amount after you retire, you might choose a variable annuity or a fixed index annuity to take advantage of an opportunity for your annuity gains to outpace inflation.

One approach to using annuities in this way is to invest the maximum allowed in your employer’s plan before contributing to a nonqualified annuity. Among the reasons this may make sense are that the annuity premiums you pay are never deductible, so that the amount you save doesn’t reduce your current taxable income.

Making changes

If you want to exchange your nonqualified annuity for another annuity with a different insurance company, you can do that with a tax-free transfer known as a 1035 exchange. The new contract may offer features that you find attractive, including new investment options and different ways to access lifetime income. Some annuity providers may also offer contracts that are less expensive than the one you currently own or provide a more generous death benefit.

You don’t own tax on any account earnings at the time of the transfer, but you may owe surrender charges on the contract you’re leaving if you’re still in the surrender period. You may also be subject to a new surrender period under the new contract.

There are other factors to consider as well, which is why you may be required to sign a form acknowledging that you understand the differences in features and cost between the two contracts and are clear about the ways in which the transfer will benefit you. It may be the case that features you’ll be giving up in the transfer are more valuable overall than the ones you’ll be gaining.

With a qualified variable annuity, you can generally change the way you have allocated the money you’ve deferred to your account at least once a year without charge and, in some contracts, more frequently. Again, there’s no tax on earnings you transfer among investment funds, but there may be fees for moves you want to make, especially from a fixed income fund.

Surrender charges may apply, however, if you wish to move plan assets you hold in an annuity contract to non-annuity investment options within the plan.

Choosing The Best Annuity. Complete Guide by Inna Rosputnia

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