Indexed annuities offer a unique and attractive blend of safety, growth potential, tax advantages, lifetime income and liquidity. But, it’s important to understand the terms of your individual contract. Here are some questions you can ask your insurance agent before signing on the dotted line.
1) How long is the term?
Review the term of the contract, and make sure it fits with your lifestyle needs. Will you be able to start receiving money upon your retirement? Will the amount you can receive penalty-free meet your needs? If you can wait several years into retirement to begin receiving payments, by how much will that increase the amounts you can receive? Understand the long-term nature of an annuity purchase, and make sure you plan to keep the annuity long enough that any early withdrawal penalties, usually called “surrender charges,” don’t take a significant portion of your contribution. Typically, terms are around 7-10 years, but vary from contract to contract. Your insurance agent should work with you to determine whether or not an indexed annuity is suitable for you.
2) What penalties will I incur if I remove my money early?
All withdrawals made prior to age 59 ½ are considered a premature distribution and may be subject to a 10% tax penalty in addition to ordinary income tax.
Additionally, similar to fees associated with other financial products, insurance companies will often charge a surrender fee if the contract is ended before term. However, surrender or withdrawal charges are often waived if you (1) die; (2) become confined to a hospital or nursing home for a specified period; or (3) you choose to take a guaranteed income stream. In addition, most indexed annuities allow you take up to 10% of your contract value each year without incurring a surrender or withdrawal charge. See if these apply to the agreements you’re researching.
3) Which indexing method is used?
The indexing method means the approach used to measure the amount of change in the index. Annual reset, high-water mark and point-to-point are common methods. The method will determine when interest is added to your annuity, as well as how the interest is calculated.
4) What is an interest rate cap?
Indexed annuities aren’t designed to replicate stock market returns; they’re designed to protect your money. In a negative stock market year, fixed indexed annuities eliminate the effect of the loss and provide immediate, total protection of your account value. That’s incredibly valuable protection, and it’s expensive for the carrier to provide, which is why most indexed annuities have caps on your return. A cap places an upper limit on the amount of any index gain that will be credited to your contract. Ask your insurance agent what the cap is and think about how much of your retirement funds you want to keep protected in an annuity. It is the cost of the protection provided in a down year that prevents your insurance provider from being able to give you all of the index increase in an up year.
5) What is the participation rate?
A participation rate is similar to an interest rate cap in that it limits the amount of any index gain which is credited to your contract. Some contracts have either a participation rate or a cap, and others have both. The participation rate determines how much of the increase in the index will be used to calculate index-linked interest. This method credits a percentage or proportion of the index value change percentage as interest. For example, an 80% participation rate applied to an index value change percentage of 10% will yield a credit of 8%.