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Uncovering the Mystery of Life Insurance Annuities
Uncovering the Mystery of Life Insurance Annuities
By: Wilmington Trust

Determining whether you should invest in a life insurance annuity can be a difficult and confusing process. Much of the confusion lies in the wide variety of annuities currently available. A quick explanation of annuities and how they work will help you decide if this investment option is suitable for you.

What Is a Life Insurance Annuity?
A life insurance annuity is a financial contract purchased from an insurance company, designed to provide a source of retirement income. It combines many of the benefits of traditional investments and retirement plans. Unlike traditional investments, however, an annuity can offer an individual tax-deferred earnings until the assets are withdrawn and the ability to choose certain guaranteed payout options. And, unlike traditional retirement plans, annuity contributions are not tax deductible but they are unlimited. When choosing the type of annuity that most closely meets your objectives, investors are faced with three important choices.

Timing of Payout:
The first decision an investor must consider is whether to choose an immediate or deferred payout option. With an immediate payout option, the investor begins to receive payments immediately upon investing. This type of contract would typically suit an investor seeking current income from his/her retirement assets. The biggest benefit to an immediate payout is that the payments are guaranteed for the lifetime of the annuitant, thereby eliminating the possibility of the investor outliving his/her assets. In exchange for a lower payment, an investor can build certain guarantee periods into the payout in case the investor does not live to his/her life expectancy.

A deferred annuity accumulates earnings on a tax-deferred basis until the investor decides to begin receiving payments, usually at retirement. Deferred annuities are typically best suited for those investors who have maximized the use of traditional retirement vehicles such as IRA and 401(k) plans. The compounding of interest in a tax-deferred investment can, over time, offer a substantial advantage over traditional investments.

Investment Type:
Fixed or variable investment options are available. Fixed annuities offer a guaranteed rate of return over a selected time frame, which can vary from one to ten years. The issuing insurance company, not a government agency, guarantees principal and interest. Therefore, choosing an insurance company with strong financials is important. Rating agencies such as Moodys and Standard & Poor's can provide such information, making it easier for consumers to compare companies.

Variable annuities can offer an investor a menu of investment options to accommodate different objectives, time frames, and risk levels. Access to investment asset classes, such as stocks, bonds, and money market funds, can enable the investor to customize the investment portfolio. Variable investments carry with them the potential for higher rates of return but can also result in the loss of principal. Therefore, investors should invest carefully, employing the same risk management strategies available with traditional investments, such as diversification and dollar cost averaging. Some of the risks of investing in a variable annuity can be reduced by the fact that most contracts allow for heirs to receive the greater of the value of the contract or some minimum stated rate of return. This guarantee applies to death benefits, but will only protect heirs from the risk of poor market performance.

Liquidity:
Most annuities ask you to commit your money for a specified period of time, typically seven years. Withdrawals prior to maturity are subject to a surrender penalty for amounts exceeding the allowable withdrawal. For instance, some annuities allow an investor to take all interest or up to 10% of principal each year without penalty. Any amounts withdrawn in excess of this allowable amount are subject to a penalty, which usually decreases over the life of the annuity. Keep in mind, too, that the IRS treats withdrawals from annuities much like withdrawals from an IRA. An investor withdrawing money from an annuity prior to age 59½ will pay the usual income taxes due plus a 10% penalty. Therefore, investors choosing annuities should carefully consider their liquidity needs before committing money to an annuity investment. If the annuity owner dies before the annuity payments are to begin, there are usually no surrender charges levied upon the heirs. An additional benefit to consider is that the proceeds are distributed according to a beneficiary designation, thereby avoiding the costs and delays of probate.

Once an investor has determined the appropriate type of annuity based on payout, investment type and liquidity needs, the search can be narrowed to the contract that offers the best array of features or "bells and whistles." A thorough search can be exhausting, which is why most investors rely on a trusted advisor to explain the various enhancements offered by insurance companies. An investor should begin by determining which additional features are most important and focus on those that best suit his/her needs. Remember that each added feature typically carries some internal cost. However, under the right circumstances, the advantages of investing in an annuity can far outweigh the additional costs.

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.

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