A Fixed Index Annuity (FIA) is a tax-favored accumulation product issued by an insurance company. The growth is bench-marked to the upside of a stock market index (e.g., Nasdaq, NYSE, S&P500, Janus SC, etc.) rather than a fixed interest rate. The FIA’s interest credit has 0% floor, which means you won’t lose when the index goes down.
In return for the safety of not being effected in down years, the interest crediting methods have either a cap, spread, or a participation rate. A ‘cap’ is the highest % you can earn in a crediting period. A ‘spread’ is a pre-specified % that will be subtracted from the index upside % before you get your interest credit. A ‘participation rate’ is the % of the index upside that you will receive as your interest credit.
To put it simply, the insurance company bears the risk of a stock market decline with this type of annuity, and therefore offsets the upside in one of the above mentioned ways. Many fixed index annuities also offer premium bonuses.
Every annuity is unique; therefore, you need a professional which understands well the annuity that works best in your financial situation.
Annuities Offer Guarantees
FIAs offer a high degree of safety. Your premium and earnings are guaranteed by the issuing insurance company. Insurance companies are legally required to set aside assets (known as “reserves”) to cover potential claims made by their policyholders. Insurance companies are monitored by rating agencies such as A.M. Best, Standard and Poor’s, and Moody’s.
Six Reasons to Consider a Fixed Index Annuity
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Protect Your Principal from Downturns in the Credit Markets
When interest rates trend upward, annuity accounts are insulated from loss of principal; increasing interest rates often negatively impact government bonds and bond mutual funds. Unlike bonds which lose principal value during periods of rising interest rates, the account value of a fixed index annuity is guaranteed. In addition to offering loss protection, you may be presented with higher cap rates or participation rates, reflecting increased prevailing interest rates. Simply put, your principal and earnings are protected no matter what direction interest rates may take.
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Earn Higher Interest Rates
FIAs may credit higher interest rates than bank CDs or fixed interest rate deferred annuities (MYGAs).
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Tax Deferral
One advantage that a FIA has over a mutual fund or a bank Certificate of Deposit (CD) is that earnings grow on a tax-deferred basis. This means there are no annual 1099s, and you pay no income taxes until you withdraw money from the annuity. This is especially important when you buy your index annuity with after tax – personal savings (also-called “non-qualified” funds). Index annuities can also be purchased using rollover funds, funds transferred from a tax-qualified plan (i.e. IRA), or with a lump sum distribution from a 401k or pension plan in which case there is no added tax advantage. Tax deferral also means that annuity earnings do not offset Social Security benefits as with earnings from bonds, CDs, and other investments. Income generated by tax-exempt municipal bonds (for which no federal income tax is due) must be counted to determine any offset to Social Security benefits. Investors with investments currently allocated as “cash” should consider annuities for their tax deferral benefits.
Investors who have already maximized contributions to their qualified retirement plans (i.e. 401k, IRAs and pensions) are permitted to contribute without limit to a tax-deferred annuity.
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Satisfy Required Minimum Distributions (RMDs)
Retirees over the age of 70½ are required to begin taking withdrawals from their IRA or Pension plans, known as Required Minimum Distributions (RMDs). The IRS penalty for not doing so is a substantial 50% of any amount that falls short of the Required Minimum Distribution. IRA funds rolled over into a fixed index annuity will be monitored for RMD amounts by the insurance company free of charge. This can save you the annual fee that your accountant or attorney would otherwise charge for making these calculations.
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Produce Lifetime Income
Today, a healthy 65-year-old male has a 25% chance of living to age 90; a 65-year-old woman is likely to live even longer. Retirees concerned about outliving their investments can protect themselves by creating a guaranteed lifetime income stream. By “annuitizing” your IRA or fixed index annuity, you can exchange its value for an “immediate annuity” income stream. Some FIAs offer optional income riders which provide withdrawal benefits similar to immediate annuities. This type of annuity provides you with a monthly check, guaranteed to remain constant over the duration of your lifetime.
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Create Probate-Free Inheritance
The legal process of going through probate was established to protect a decedent’s estate and to insure its proper distribution to designated heirs. Probate can be a time-consuming and expensive experience for heirs to endure. Purchasing an annuity is one way to protect your beneficiaries from having to undergo this costly delay in estate distribution. Your named beneficiary or beneficiaries are paid directly and promptly, as soon as the insurance company has been notified about your passing.
Premium Bonus
Many FIAs offer premium bonuses, which are credited to your annuity at the moment premiums are added. As alluring as these premium bonuses may seem, they often come with trade-offs. Some companies only pay the bonus if you annuitize with that company at some point in the future. If you choose to withdraw your money in a lump sum before the surrender fee period is over, the insurer may retroactively remove a portion of your premium bonus.
Expenses
Fixed index annuities do not have upfront sales charges. It would also be unusual for FIAs to charge maintenance fees. Because of this, 100% of your premium—without any deductions—goes directly to work for you in your account. Fees will only be applied if you surrender the annuity early, or if you purchase additional feature riders (i.e. income rider).
Penalty-free Withdrawals and Surrender Fees
Most insurance companies allow some level of penalty-free withdrawals during the surrender period without having triggering a surrender fee. Some allow penalty-free withdrawals up to 10% of your account value each year after the first year. If you want to withdraw more than 10% of your contract value, you will likely be charged an Early Surrender Penalty. This is assessed as a percentage of the amount that exceeds the Penalty-Free Withdrawal amount. These charges should not be confused with the 10% penalty the IRS imposes on gains withdrawn from an FIA before you reach the age of 59½.
Surrender penalties vary amongst insurance companies; they can be around 10% in the first contract year. Typically, surrender charges are reduced each year. Such fees are sometimes waived when the contract is “annuitized” under a payment option or in the event of the policyholder’s death. Many policies also waive surrender fees if the annuitant is confined to a nursing home or has a terminal illness.
Market Value Adjustment (’MVA’)
A withdrawal while in the surrender charge period may trigger a “Market Value Adjustment” (MVA) which may increase or decrease total penalties incurred on withdrawals in excess to the Penalty-Free withdrawals. A typical MVA is determined by comparing the base interest rate of the contract when issued with the interest rate (of a similar contract) when a withdrawal or surrender is requested. If the interest rate has declined during the period, the MVA will lower the surrender charge impact on the value of the policy. if interest rates are higher at the time of the proposed withdrawal, the MVA will add additional charges to the surrender fees deducted from the value of the policy.
Other Withdrawal Options and Annuitization
It’s essential to know what withdrawal options are available when your fixed index annuity is no longer subject to surrender penalties. You can keep your money with the same company at the current rate or switch your account to another insurer without incurring any tax liability (called a “Section 1035 Exchange”). Or, you can simply withdraw your money from the annuity in a lump sum, in which case you’ll owe federal income tax on the earnings in that year and if you’re younger than 59½ at the time of the withdrawal, you’ll owe an additional penalty of 10% of the amount that is taxable income.
Fixed Income Annuities (FIA) Vs. Modified Endowment Contract (MEC)- From The Investment Standpoint
While FIAs and MECs have many similarities. There are 3 notable differences.
- FIAs can be owned within a retirement account (IRA, Roth IRA) where a MEC must use after tax dollars.
- MECs provide better initial liquidity, up to 100% in many cases, without any penalties.
- MECs require a person with an insurable interest to the owner to be eligible for life insurance from a health perspective.
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