Checks and Balances TV: America s #1 Source for Balanced Financial Advice

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1 THE TRUTH ABOUT FIXED RATE ANNUITIES Annuities are like magnets. Most people seem to be either attracted to them, or repelled. As you sit down to read this, where do you stand? In my experience, it s rare to run across someone who doesn t already have an opinion about annuities. The key word there is opinion. Is what you know based on fact, or is it based on what someone told you? Here we ll give you facts only. Then, you decide. The truth about annuities is that they are like every other financial product out there; they have advantages and disadvantages. There are no bad financial products (as long as they are registered and approved for sale in your state), only improper or poor use of them. All products have perceived positive and negative aspects to them. If you know the advantages, then you can begin to know whether or not it would be of interest to you or help you financially. If you know their disadvantages, then you can be aware of the negative aspects of these particular products, as well. Ultimately, you will need to weigh out the pros and cons, the pluses and minuses - what we call the Checks and Balances - of this particular product to determine if this product, or any other financial product for that matter, is in your best interest, or if it s really just in the best interest of the person selling them to you. The Basics Annuities come in many different varieties. Because there are so many different kinds of annuities, there is a lot of confusion. When someone tells you annuities are great, what KIND of annuity is he/she referring to? Or what if someone tells you annuities are terrible investments and you should NEVER own one? Same thing; which type of annuity is he/she referring to? Let s look briefly at the history of annuities. Annuities date their use all the way back to the Roman Empire; however, in modern times, annuities, as we now know them, began in 1759 by a Pennsylvania company for the benefit of Presbyterian ministers and their families. Over the past 250 plus years, annuities have gone through many changes, but their original premise holds true: favorable accumulation, and guaranteed income. There are no other products quite like an annuity. At its most basic, an annuity is an interest bearing account issued (only) by an insurance company Checks and Balances TV, LLC

2 In exchange for your lump sum deposit or periodic deposits, the insurance company can and will guarantee either an immediate or deferred income. If the income is going to start as soon as the annuity is purchased, it s called an IMMEDIATE ANNUITY because the annuity income will start right away. If the income is not going to start until some, as yet undetermined, time in the future, then it s called a DEFERRED ANNUITY. One of the many advantages of an annuity is that the interest earned in a deferred annuity is tax-deferred until it is withdrawn, thereby, giving the owner the benefits of triple compounding interest! Triple Compounding Interest Fixed and Variable annuities have a tax advantaged benefit not seen in other investments; we call it triple compounding. Triple compounding of interest simply means your initial investment or principle earns interest; your interest earns interest, and the dollars you would have paid in taxes earns interest. This basic fact about accumulating wealth suggests that you are better off paying taxes on your money when you are ready to use it, not while you are attempting to grow it! The 4 Basic Annuities Available Today There are four main choices when it comes to annuities today Immediate, Fixed, Variable and Indexed. Each has its own pluses and minuses, pros and cons. It s important to understand how they work, their place in an individual investment plan, and if you should consider depositing any of your hard earned savings into them. In this report we will focus on Fixed Rate Annuities. Deferred Annuities Think of a deferred annuity as something similar to a bank certificate of deposit. A deferred annuity is essentially a tax advantaged savings account issued by an insurance company. Deferred annuities always earn interest, not dividends or capital gains. Before discussing the different types of deferred annuities, let s look at the things that most deferred annuities have in common. Be Aware of Surrender Charges Most deferred annuities come with early withdrawal penalties called surrender charges. Usually surrender charges disappear after a period of time. They vary in length from as little as 3 years to as long as 20 years or even longer for some tax sheltered annuities that are offered to the employees of nonprofit institutions such as schools or hospitals Checks and Balances TV, LLC

3 Some annuities have what are known as rolling surrender charges. A rolling surrender charge means there is a new surrender period assessed with each investment you make. That means your surrender charges only end X years after your last deposit. I m not a big fan of these, and thankfully they are less common than they used to be. The amount of the early withdrawal charge is usually expressed as a percentage of the account value or of the original deposit. These percentages range from an average of 4% or 5% to as high as 20% or even more on some tax sheltered annuities (TSA s) that are sometimes offered to teachers and other employees of non-profit organizations. In non-tsa s the higher surrender charges, like 20%, are usually only found in annuities that credit an immediate up-front premium bonus of between 5% and 10%. Surrender Charges Have a Positive Benefit for the Policyowner Most people greatly dislike surrender charges and why not? Who likes to pay a penalty to access your money? In reality though, surrender charges serve several positive purposes. First, from the insurance company s perspective, these types of early withdrawal penalties allow them to invest your money for the long run knowing they won t have to return it to you in the short term. This is for your benefit; simply put, they can invest your money in a way that will earn you more money. The second benefit eliminates any future uncertainty about account losses! If you compare the maximum potential surrender charge in the first year of an annuity to the maximum loss you may have actually experienced in your investment portfolios over the years, you ll find you have probably lost a lot more than say, a 10% surrender charge. A surrender charge is there to discourage you from taking all of your money out early. The only reason you d likely do so is in some sort of an emergency, and emergencies come up when they come up. Their timing is usually terrible. If your emergency came up at a bad time and your money was invested in a stock market based account, you d have no control over how much you might be down at that moment in time. And there is no limit on how far down you might be. In your annuity account, however, you know in advance that your maximum penalty is X% in the first year, and then you know that those charges decline to zero over time. Penalty-Free Withdrawals Surrender charges in most annuities only apply to amounts that you withdraw that are greater than 10% of your account value per year. This is known as the penalty-free amount. It varies among annuity companies and policies, but a 10% penalty-free amount is very common. Surrender charges are also almost always waived if the annuity owner (or the annuitant) dies, becomes sick and needs to go into a nursing home or if diagnosed with a terminal illness. Some annuities even offer a waiver of surrender charges if the owner becomes unemployed. Finally, many annuities will waive the surrender charges if the owner decides to convert the annuity into an income stream over a minimum of five or ten years (i.e. immediate annuity) after the annuity has been in force for (typically) five years Checks and Balances TV, LLC

4 The Almost Painless Real-Life Surrender Charge I like to say that annuities are really a liquid account. Not as liquid as money in a checking, savings or money market account, but liquid in the fact that you can liquidate it or cash it out anytime you want. Now, you may incur a surrender charge or penalty on a portion of your principal or interest earnings, but you have access to it. With every annuity there are some simple rules of the game you have to be aware of. Let me give you an example of what I ve seen over the years. Rarely do people come into my office and tell me they need to completely cancel their annuity because they need all of the money. Usually, after the account has been in force for five years or so, they come in and tell me they need to take out a portion. Let s say they originally deposited $150,000 five years ago, and now they come in and need to withdraw $35,000 to buy a new car. Over the first five years, let s assume they earned $41,000 of interest increasing their account value to $191,000. The first 10% of their account balance of $19,100 comes out penalty free. This means the difference of $15,900 would be subject to a surrender charge. Let s assume that their policy had a 10% penalty in year one, declining 1% per year to zero over ten years, so in the fifth policy year they have a 6% surrender charge: 6% of $15,900 is $954. In other words, in order to access the whole $35,000, they paid a penalty of only $ 954 which is in reality only a 2.7% penalty on the total withdrawn amount. When you put it in those terms, it doesn t sound or feel nearly as bad because it s not! And by the way, that assumes they have no other accounts to take any money from. In this case, if they need $35,000 to buy the car, they could have taken the $19,100 from the annuity and the $15,100 from a different account in order to completely avoid all penalties. So far, we ve discussed what most deferred annuities have in common. Now let s look at 3 different types of deferred annuities: fixed annuities, variable annuities and indexed annuities. Let s start by discussing fixed annuities. Fixed Rate Annuities A fixed annuity is a savings account like policy issued by an insurance company that earns interest. The interest is declared by the company, just like a bank declares what the interest rates are on its certificates of deposit. Fixed annuity interest most often comes in two varieties. The first variety, called a Multi-Year Guaranteed Annuity, is also referred to as a CD-Type Annuity in which the issuing company declares the interest rate for a set period of time so you know what your interest will be every year over that period of time, just like a certificate of deposit. The second variety only declares the interest rate for the first year. After the first year, the company will declare a new rate for subsequent years Checks and Balances TV, LLC

5 In a traditional fixed annuity both your principal and all of the interest you earn are guaranteed 1. For example, if you invest $100,000 in a fixed annuity that earn 5% this year, at the end of the year you have $105,000, and you can never lose that money due to interest rate changes, stock market fluctuations or anything short of an early withdrawal penalty. Each year you earn interest, it is added to your account and accumulated value is guaranteed never to decrease. CD-Type Annuity or Annual Declared Rate? The advantage of the CD-type annuity is you know what you ll be earning each year of your policy. This account sets an interest rate that won t change during the period you bought (for example, 5% guaranteed for five years). The disadvantage is if rates increase over the next five years, you might have been better off with the annually declared rate annuity because as interest rates go up, the declared rate on your annuity may also go up. If you believe that interest rates are currently low and most likely over the next few years they will rise, then you might be better off buying the non-cd-type annuity. On the other hand, if, and when, you believe interest rates are currently high, and the greatest likelihood is they will stay the same or even decrease, then you should opt for the CD-type annuity. The Advantages and Disadvantages of Fixed Rate Annuities In short, fixed annuities are simple to understand, safe, secure and guaranteed. All of these things bring sleep-at-night peace of mind that can be especially valuable during times when your other savings may be losing money! There is a price to be paid for that peace of mind, however, and it s generally a lower return compared to accounts that are not as safe. Watch Out For The 10% Penalty Even if your annuity is not an IRA or other similar retirement account, early withdrawals from annuities before you are 59 ½ years of age may be subject to a 10% penalty tax on the interest gain within the annuity. Because the tax code gives annuity special tax benefits (like tax deferral), they want you to leave your money in them for the long run. But there are ways around that penalty tax, which a well trained, competent, professional annuity advisor can help you with Checks and Balances TV, LLC

6 Other Annuity Considerations: Section 1035 Exchanging Your Old Annuity for a New One Section 1035 of the IRS tax code allows you to avoid paying taxes when you move from an older annuity to a newer one that has better benefits. Why would you do that? Like a car, the car you re driving today may not have the options and features you want and need that ARE available on a newer vehicle. Same thing with annuities. A newer model annuity may have enhanced income benefits, or bonus features that your old policy just doesn t have. A 1035 exchange allows an insurance company to transfer your money out of an existing annuity into a brand new annuity, without paying taxes on any of the interest you earned in the first annuity. In fact, you can also transfer money from a cash value life insurance policy into an annuity as well. When you use section 1035 to exchange an annuity or life insurance policy for a new annuity, not only does your money transfer-so do the records of all your deposits or payments. How is a Fixed Rate Annuity taxed? The good news about a fixed rate annuity is that while it s in the deferred stage, your principal and interest earnings grow tax deferred. The bad news is that once you begin taking money out of this account, you will be paying ordinary income taxes on the gain or interest earned. (Of course you ll only pay taxes on the amount you pull out, not what you leave in the account.) Many stockbrokers and financial advisors like to say that you should have the bulk of your money in stocks or mutual funds, because they enjoy capital gains, not ordinary income tax rates. The tax rate comparison is true. But be careful, capital gains tax treatment could be considerably lower than your current tax bracket, or it might not be. It all depends on what income tax bracket you re in now and what tax bracket you may find yourself in the future. Also, to enjoy capital gains tax treatment you have to be willing to have your money at risk in the stock market. So, you might be stuck with potentially severe losses in the market from time to time, just to realize capital gains tax treatment, if you decide to sell some or all of this account sometime in the future. What About Required Minimum Distributions? If your fixed rate annuity is held inside of a retirement account such as a 401-(k), 403-(b), IRA, or other qualified account, then you will be subject to Required Minimum Distributions (RMD s). Which simply means that you will be forced to take out a minimum amount from this account every year, beginning Checks and Balances TV, LLC

7 in the year you reach 70 ½ years of age. The truth is, you could take this RMD every year from another qualified account if you had one, and didn t want to take any money out of this account. But either way you look at it, whatever money you have in a qualified account, Uncle Sam is going to get his tax money from it, at least by the time you turn 70 ½. Last But Not Least Annuity Maturity Dates Much has been said and written in the media regarding annuity maturity dates and just how bad and unfair they (maturity dates) are to the owner of the policy. There have been many negative comments and stories in the press regarding this topic. Here are the facts; you be the judge Because an annuity contract is a CONTRACT, the contract has to state there be a date in the future requiring the owner to elect an annuity settlement OPTION to begin receiving payments by way of annuitizing the contract (i.e., receiving a monthly income). All that happens on the Annuity Date or Maturity Date is that the client will receive a letter from the company advising him/her of the settlement options. In many policies, this maturity date is not even triggered until you re over 100 years old. This simply means you are not FORCED to take anything out of your annuity, if you don t want to, until this maturity date (However, please be aware that if you have a qualified plan inside of an annuity like an IRA, 401(k), 403(b), etc., you will have to take a RMD every year, starting at age 70 ½). The stated maturity date in an annuity contract DOES NOT mean you have no access to your funds until that date! Nor does it mean you have to wait until that date to begin annuity payments. Most annuity contracts allow the owner to change the Annuity Date and most companies will allow a client to annuitize the contract anytime after the first contract year. And, remember, as we discussed earlier, most annuity contracts allow you to take up to 10% of the current value every year, after the first year. Wrapping it all up Did you start reading this with an opinion about annuities one way or another? What do you think now? While there are no perfect investments, annuities included, annuities can be powerful tools in your investment tool chest that can provide valuable benefits when used properly. From being the only investment on the planet that can provide a guaranteed income for life, to offering you the upside (with risk) of variable annuities to the market-risk-free upside of fixed indexed annuities, as well as lifetime income riders, annuities are certainly worth a look! If you re going to consider an annuity, be sure you find a competent professional annuity advisor who can help you navigate through all of the different variations out there Checks and Balances TV, LLC

8 For more information regarding this topic or any other financial product or area of interest, us at Checks and Balances TV: Giving You the Truth You Need to Financially Succeed! Register Today for Full Access to CBTV! CBTV helps you achieve financial freedom by providing balanced insight and unbiased financial advice so you can make informed financial decisions. Visit our website to access all the resources we offer in our Checks and Balances Financial Decision-Making System, the new system for Financial Freedom! Your 3 Steps to Financial Freedom: 1. Watch the Show! Tune in each week to discover how today s financial headlines impact you and what you can do NOW to be financially secure. 2. Download Financial Tools! Access our FREE financial tools and reports and sign up for our FREE weekly e-newsletter. 3. Take Action Now! Implement the tools and strategies you learn from CBTV. Only YOU can make it happen! (But we re here to help.) CBTV shall have neither liability nor responsibility to any person or entity with respect to any loss or damage caused, or alleged to be caused, directly or indirectly by the information contained in this report. The information, methods and techniques described by the author are based on his/her own experience. Everyone s financial situation is different. This report is intended to be informational on the topic and should not be considered as legal, accounting or financial planning advice, and should not be used as a replacement to other professional services. CBTV shall be held harmless on the accuracy of the content within. Every effort has been made to ensure the information contained is complete and correct, however, in the event of an error or outdated reference, each report should be used only as a general guideline. Property of Checks and Balances TV, LLC, All Rights Reserved Checks and Balances TV, LLC

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