The recently passed SECURE Act makes it easier for organizations to offer annuities as an investment option in defined contribution plans, including 401(k) plans. It’s not that they couldn’t be offered before, but the employer’s fiduciary responsibilities could have left them liable if the issuer couldn’t meet its obligations.
Now they have the option of safe harbor protection. It’s not likely to open the floodgates, but we should see at least a trickling of additional annuity options in 401(k)s and other defined-contribution plans. Understanding annuities, their features, benefits, and uses in retirement plans may serve useful in your retirement planning.
What Is an Annuity?
Annuities aren’t some new thing. They date to Roman times and have been available to the public in the U.S. since 1812. Most commonly, when we think of a stream of income payment such as a pension, we’re dealing with a form of annuity.
An annuity, from a technical perspective, is simply a periodic stream of payments. In the U.S., most annuities are issued by insurance companies.
In exchange for a lump sum of money, you can purchase a stream of payments. If the payments begin right away, you have an immediate annuity. If they begin at some point in the future, you have a deferred annuity. So far, so good.
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An annuity is a contract issued by an insurance company and is a tax-deferred investment vehicle. When placed inside of a retirement plan, that tax deferral is redundant; you gain no additional tax advantage.
As a contract issued by an insurance company, it has costs. Since it has costs and gains no additional tax advantage when placed into a tax-deferred plan, many advisors have steered clients away from using annuities in these plans.
Others, however, use them nearly exclusively. Both sides consider the other as not acting in the best interest of their client. It’s one of the big controversial topics among advisors. Let’s dig into the details and see what the real story is.
Annuity Basics
We know it’s a contract issued by an insurance company. It can be an immediate annuity, which begins a stream of payments now or in the very near future. Or it can be a deferred annuity, which theoretically provides a stream of payments at some point in the future.
I say theoretically as this isn’t defined up-front, neither in time nor in specific method. It’s available, but you may or may not use it and you have a variety of choices in terms of how that all works.
You can purchase an annuity outside of a retirement plan. This would be a non-qualified annuity. You have a tax basis equal to the sum of your contributions. Or you can purchase an annuity within a qualified plan or IRA. Here you will generally have no cost basis. Either way you have tax deferral, although with a qualified annuity you would have it without using the annuity.
Annuities can also be classified as fixed or variable. Fixed annuities pay an interest rate, typically referred to as a market rate because it is tied to an index. There is also usually a floor — a rate below which the interest rate cannot fall. The rate resets at specific intervals; it doesn’t fluctuate from day to day.
Variable annuities have investment options, and for practical purposes work a lot like a typical 401(k) in which you have a variety of different investment options to choose from. We’ll come back to this later.
Annuitant, Owner, and Beneficiary
An annuity is set up to pay a lifetime income, the series of payments, to someone, often the same person whose life it is based on. The person whose life the annuity is based on for payment purposes is the annuitant. The annuitant may or may not be the owner.
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The owner of the contract has the rights to the contract and receives any payments from the annuity during their lifetime. But the owner could predecease the annuitant, leaving payments still to be made. Any principal or payments remaining at the owner’s death flow to the beneficiary.
The owner can generally change the beneficiary, but cannot change the annuitant. When we’re talking about using an annuity to build retirement assets within a retirement plan, the employee contributing to the plan would be both the owner and annuitant, naming whomever they chose as beneficiary.
Taxation of Annuities
Let’s break this down into two pieces. Let’s look at qualified annuities within a retirement plan first. For a qualified annuity, your tax implications are going to be the same as for the plan. Your tax deferral as a result of having an annuity is redundant; the tax deferral is provided by the plan.
Any money you remove from the plan is subject to tax rules as you’re likely familiar with. Removing money from the annuity wouldn’t be a taxable event if the money stays within the qualified plan.
This is important. You could have money in an annuity within a 401(k) and at some point move it to another investment and not have tax consequences.
You have to be careful about other charges, see the costs section that follows. You could also move money from a different investment within the qualified plan into the annuity with no tax consequences. Your tax ramifications are the ramifications of the plan containing the annuity. There’s nothing additional or new.
For a non-qualified annuity, it’s completely different. You make contributions in after-tax dollars and build a tax basis of those contributions. You get tax deferral; your growth isn’t subject to taxation until you take the money out.
For contracts issued today — and any since August 14, 1982 — funds come out on a last-in-first-out (LIFO) basis. Basically this means if you make a partial withdrawal, you will take the growth before you take any contributions. Growth hasn’t yet been taxed, your contributions have.
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You have to take the taxable before you can get to the money you can get back without tax. This will be different if you’re taking a stream of income; this is for a lump sum withdrawal, partial or full.
But keep in mind that for annuities within qualified plans there’s nothing complex, nothing new taxwise.
And for any of the annuities, whether qualified or not, you have the IRS at hand for tax and a premature distribution penalty if you are tapping in before age 59½, with some minor exceptions.
Costs of Annuities
Here’s the downside to annuities. They cost a lot. You may also get a lot, but it’s not cheap. Here are the typical costs associated with a variable annuity:
- Contract Charge: typically an annual charge, applied monthly to the account; this is an administrative fee.
- Mortality and Expense (M&E) charges: a cost for the insurance component of the annuity, protecting that your payments can be made even as people continue to live longer, etc.
- Investment management fees: similar to the charges you would incur investing in a mutual fund. Annuities use subaccounts that work for all practical purposes like a mutual fund, but are within the annuity. Management fees apply to all the variable accounts, not the fixed account.
- Surrender charges, or possibly a sales charge: Annuities typically have a declining surrender charge that eventually disappears. In many cases you won’t incur this charge, but you need to know it’s there.
- Rider fees: apply to any special riders or other optional benefits associated with the contract.
When you purchase a fixed annuity, you don’t see most fees; they aren’t unbundled. For a fixed annuity, the fees are embedded in the contract.
Guarantees and Other Options
If costs are the downside, here’s the counterbalance: An annuity is designed to be an investment you cannot outlive. If you annuitize an annuity, that is, turn it into a stream of payments, most payment options provide you with a guaranteed income for your life no matter how long you live. Guaranteed.
With people generally being underfunded in their retirements and living longer and longer, this is huge.
This is the reason those financial advisors who advocate using annuities advocate so strongly for them. They can provide an income you cannot outlive. You can set yourself up to always have money coming in.
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There can be other guarantees as well, with some newer options gaining traction. Some annuities provide floors to your investment returns or to prevent losses on their variable investments.
Typically this is done where you receive a percentage of the upside, but not less than some minimum. You pay a premium for this; it is one of those riders for which you pay extra. It’s not available on all annuities. And the specifics of participation and costs vary from company to company and contract to contract.
Payout Options
When it comes time to take money from your account you have several options. Here are the basics:
- Lump sum: You have the option to take a lump-sum payout. This would get you all the money at once, but it’s probably a bad idea. You’re going to have all the tax consequences at once.
- Interest only: You can withdraw just the interest and leave the principal intact. This could be done to provide you a little extra income on top of other incomes. You could switch to a different method later if your needs change.
- Period certain: A period certain payout is an annuitization of the contract that is based on a set number of years instead of on your life expectancy. For example, you might want a 10-year certain to use early in retirement, leaving other investments for later. At the end of the period, you would have nothing left, the annuity would be done. You exchange your principal for the stream of payments. Once elected, this election is irrevocable; you can’t change it.
- Life certain: A life certain payout is a payout based on your life expectancy. It may or may not also have a guaranteed period. It could, for example, pay for your life but not less than 20 years. Any guaranteed period will reduce the payout, there’s a cost involved. This election is also irrevocable; once you’ve annuitized the contract you can’t undo it.
The Bottom Line on Annuities
Our quick little overview isn’t exactly quick or little, but it is just an overview.
Annuities are complex investment vehicles —they have a lot of costs, higher than other investment vehicles that may do similar things.
But nothing, no matter how similar, is the same. Annuities have the option to provide you with guarantees you cannot get outside of an annuity. They’re fiercely advocated for by some advisors because those advisors feel strongly about those guarantees and how they can help you in your retirement.
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The never-annuity crowd of advisors can also make a solid case. During your accumulation years, using an annuity within a tax deferred account costs you money for something you’re getting anyway. Note that in some cases you may also be able to have additional guarantees during your accumulation years, but not always.
The never-annuity advisors advocate building your wealth without using an annuity, as you could always purchase one at the time of retirement if you need or want the guaranteed payout option.
Both the pro-annuity and never-annuity camps can make a pretty solid argument. But that doesn’t really matter. What matters is that if you’re considering an annuity, you understand how it works and what you are getting in exchange for what you’re paying. And that knowing that, you make the decision that’s best for you.
Other people can believe whatever they want. Their money, their choice. You just do what’s best for you.
