Deferred Annuity versus Immediate Annuity
Fixed Index Annuities- Crediting Methods
Fixed Index Annuities are different from other types of annuities. The biggest difference is the interest crediting method that is used. Regular fixed annuities credit interest at a fixed amount that is stated in the contract. Fixed index annuities credit interest using formulas based on the changes in chosen indexes that are linked to the contract. The formulas determine how much interest, if any is calculate, earned and credited to the annuity. The amount of interest and when it is credited depends on the contract provisions in each individual annuity.
In a fixed indexed annuity, the insurance company purchases high rated bonds to cover the guaranteed part of the contract. The earnings from the bonds are used to cover company expenses and profits and purchase index call options. This allows the policyowner to participate in upward movements of the stock market but have none of the downside risk.
The first crediting method is the long term point to point. In this method, the index recorded at the policy effective date and at the end of a term such as one year, five years or seven years. The difference in the beginning and ending points of the index is the basis for the index gain or loss. This method works best when the market has steady growth over a period of years. Market fluctuations between the beginning and ending of the index period have no effect on the ending index calculation.
The high water method is decided by looking at various index values during the term period. The interest credit is based on the difference between the highest index value and the index value at the end of the term. The low water mark is measured by looking at the lowest point and the ending point of the term. Both of these methods credit interest at the end of the term.
With the annual reset method, the index at the beginning of the year is compared with the end of the year index. The ending rate then becomes the beginning rate for the next year and any credit from the previous term is locked in. Any previous years gains can never be lost and zero would be credited if the index declines.
Most of the crediting methods use a form of averaging. In some annuities, the average of an index is used instead of the actual value on a specified date. For example, in a monthly point to point index, the sum of each month’s performance is added together for a year. So even if the market had some bad months it is possible to end up with a gain. The opposite is also true. Months of good gains could be wiped out by one very bad month.
Most fixed index annuities have several indexes to select from. The Dow Industrial Average, Russell 2000, Standard and Poor’s 500 and NASDAQ 100 are just a few and sometimes your account can be allocated between different indexes and crediting methods allowing for more diversity and flexibility.
In summary, understanding and selecting a crediting method for fixed index annuities is very important. Terms can vary from one year to ten years so proper retirement planning is necessary. Make sure your agent clearly explains all the options that are available.
Non Qualified Annuity vs Qualified Annuity
Most annuities are technically non qualified annuity contracts, but if they are used to fund a qualified annuity account, they become qualified and any additional funds that are added must also be qualified. What exactly does qualified mean? Qualified annuity funds are funds that are placed in an Internal Revenue Service approved tax deferred annuity account. Qualified funds are pre tax dollars that are invested in a retirement program such as a traditional Individual Retirement Account, a Roth IRA, a simplified employee pension plan or an employer sponsored plan such as a 401(K). Non qualified funds are monies that have already been taxed and are invested as after tax dollars.
Any funds that are placed in a qualified index annuity account must be generated from earned income. These contributions are often tax deductible and can lower the annuity owners current taxes. Non-qualified funds can be from the sale of a home, an inheritance or funds from a savings account or mutual funds. Qualified funds are usually distributed after the owner retires and the owner controls when the withdrawals are made and the taxes are paid. In past times, the owner would usually be in a lower tax bracket so the taxes would be less. In our current economic environment, taxes will probably have to be raised so an owner may not always be in a lower tax bracket after retirement.
Money in a qualified or non qualified annuity can not normally be withdrawn before age 59 ½ without incurring a penalty. There are exceptions such as medical hardship but consult with a tax professional before withdrawing the money. The withdrawal is irrevocable and if it is not rolled over within 60 days, it is fully taxable. Direct transfers are allowed between retirement account trustees without any tax consequences. However, surrender charges could apply. Check the contract language for charges before doing a direct rollover.
Some financial planners suggest it is not wise to use an annuity to fund a retirement account because it is redundant. The earnings of the non qualified annuity are already tax deferred and so are the earnings of a retirement account such as an IRA. However, because the annuity usually offers a higher yield, no stock market risk, financial security and limited liquidity it makes sense to fund a retirement account with an annuity.
An employer who wishes to set up a retirement plan for employees must get the plan “tax qualified” by the IRS if he wishes for the contributions to the account to tax tax deductible. The IRS must approve a sample plan and a trustee must be established to handle the plan. The employer can be the trustee or he can choose a financial institution or a plan administrator to be the trustee. In all cases, the employer still has a fiduciary responsibility to the employees. A vesting schedule must also be set up with the plan. The vesting schedule shows the ownership rights the employees have to the plans assets depending on how long they have been employed. In most plans, the employer and the employee can make contributions to the employee’s accounts.
In summary, a qualified annuity or a non qualified annuity can be used to fund a retirement account. The difference in the account is the tax treatment of the contributions and the withdrawals. The annuity usually offers higher rates, lower risk and limited liquidity.