​NONQUALIFIED RETIREMENT 

One more checkpoint refers to your age.  The main virtue of a deferred annuity is tax deferral.  Therefore, you should be several years from retirement.  Usually a 10-year deferral period is necessary to make such investments worthwhile.  Investors in their 50s are likely to be less concerned about the 10% penalty ​tax on early withdrawals, which disappears at 591/2.

Suppose you're 50 years old and looking for extra income when you retire in 12 years, so you're interested in a deferred annuity. How do you begin? Pick your pay-in option:

  • Single premium: You can make one fairly substantial ( generally, $25,000 and up) premium deferred annuity (SPDA) may be a good choice if you now have sizable amounts in taxable investments and you're tired of paying income tax each year.  If you put the entire sum in at once, your tax-deferred buildup will be greater.
  • Multiple premiums.  If you're systematically saving for retirement, you can choose a multiple-premium deferred annuity and contribute as much as you want, each year.

​Now you have to choose how the insurance company will invest your money.  Pick your investment strategy from the following:


FIXED ANNUITY

This is the traditional choice.  Here, the insurance company quotes you a return for a given time period, often one year.

When that time period is up, you will earn a new fixed rate.  Rates on fixed annuities usually are comparable to what you'd earn on a medium-term Treasury bond.  Long term, you might wind up earning 5% to 6% per year inside the annuity contract.  A $25,000 single-premium might reach nearly $50,000 in 15 years, after expenses.

Fixed annuities appeal largely to conservative investors who don't want to risk losing money.  With a fixed annuity, you can choose a long-term guaranteed rate or opt for short-term guarantees that will be renewed at varying rates.  You may want to match the guarantee and the surrender period.  That way, you don't have to trust an insurance company's board of directors to set renewal rates fairly.

However, if interest rates rise, you will be locked into a below-market yield.  If that's a concern, you can buy a CD-type annuity.  Such annuities have a rate set for  a shorter period, usually one year, and no surrender charges thereafter.  When the year is up, you can scout the market and either renew the contract or choose another fixed annuity with more favorable terms.

One way to maintain flexibility is to buy annuities with different maturities, rather than buy one single contract.  Some investors divide their annuities into, say, five annuities with maturities of one, two, three, four and five years.


VARIABLE ANNUITY

When you choose this option, the insurance company will typically offer you a number of investment choices: growth-stock fund, bond fund, money market fund, have-a-pro-choose-your-asset-allocation fund and so on.  You decide how to allocate your premium dollars among these funds, and just as with a mutual fund family, you can switch around, within reason.

The result is virtually the same as if you had invested your money in a family of mutual funds, but you won't pay income taxes until you withdraw the money.  Variable annuities are increasingly popular.

In the past, about 70% of all mutual fund shareholders reinvested all their dividends-paying tax each year on money they never saw or touched.  Or they switched from one fund to another and incurred an immediate tax obligation.  If you're in that category, you might be better off  in a variable annuity, to postpone tax payments until you receive the income.

  • Recommendation: Don't invest in a variable annuity unless you intend to put most of the money into stocks.  A variable annuity is a long-term contract.  If you take the money out after a few years, you won't be able to enjoy the benefit of tax-free compounding.  (You may even lose money to sales commissions, surrender charges and tax penalties.)  Long term, a diverse portfolio of stocks will generally beat bonds or cash equivalents.  Conversely, there's no need to use a variable annuity for bond-type investments because you'll get similar results, without the big management fees, by investing in a fixed annuity from a sound insurer.  There is a case to be made for holding a (small) portion of your variable annuity funds in a money market fund, hedged because money market rates will move up.

​Some experts recommend holding zero-coupon bonds in a tax-deferred variable annuity, but do you really want to lock in today's interest rates for many years?

By making the right choices, you can earn a favorable annual return, tax-deferred.  Guess wrong  and your annuity fund can lose money-thereby shrinking your retirement income.

Again, if you're taking those risks now, through mutual fund investments,  you might consider shifting to a variable annuity, where you can time your tax payments instead of paying taxes annually.

The annuity tax laws now in effect were established in 1982, so some older contracts will have different rules.  For contracts bought since then, whenever you take money out of a deferred annuity(fixed or variable) through loans  or withdrawals, you will owe taxable income, up to the amount of the investment income.

Suppose you invested $25,000 in an SPDA, and the current balance is $60,000.  The first $35,000 worth of loans or withdrawals will be fully taxed, while anything after that will be a tax-free return of capital.

The rules are a little different if you annuitize a contract-that is, cut a deal with an insurance company for regular lifetime payments.  Then each payment is part taxable, part tax free.  


REBALANCING YOUR PORTFOLIO

Savvy  investment planning calls for you to sell appreciated asset classes (such as tech stocks in the late 1990s) and buy out-of-favor assets.  But there's a flaw in this sell-high, buy-low approach: taxes.  Rebalancing your portfolio means selling your winners.  If you had sold tech stocks in 1999 or 2000, you would have owed substantial capital gains taxes.

Using a mirror portfolio can facilitate tax-free rebalancing.  If you have a large IRA, perhaps after a rollover, that can be your mirror.  If not, buy a variable annuity with a wide range of investment options.  Inside a variable annuity, any investment income or capital gains remain untaxed.  Switching among subaccounts won't generate a tax bill.

Then, if you divide your overall portfolio between a regular taxable account and a variable annuity, you will be able to rebalance without  owing taxes.  If rebalancing means taking gains, you would take them inside the tax-deferred annuity and thus avoid taxes.  New money going into the taxable account can keep your portfolio in balance.


SHOPPING FOR A DEFERRED ANNUITY

Deferred annuities usually have a limited withdrawal privilege and a surrender charge.  For example, you might be able to withdraw up to 10%of your account per year, penalty free.  Larger amounts might be subject to a 7% surrender charge in Year 1, 6% in Year 2 and so on.  

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