Annuity “Buckets”

For those who invested heavily in the stock market for their retirement in the last decades of the 20th century had a rollercoaster ride their first decade of retirement due to a volatile stock market from 2000 to 2009.  In fact, many of these new retirees lost up to half of their retirement savings in less than 10 years leaving them with not enough interest to live off of and having to live off the principal.  Then to add insult to injury, when the market finally decided to recover, they didn’t have enough principal left to maintain their lifestyle.  

Avoiding the Stock Market Swing

There is no doubt that an investor can make a sizeable amount by investing in the stock market.  However, the pendulum swings both ways and what goes up must come down.  Many investors do not want to gamble with their retirement savings.  A safer alternative to investing fully in the stock market is to break retirement into annuity buckets.

The annuity bucket formula breaks down retirement dollars into an immediate 10-year annuity, a 10-year deferred annuity, and a 20-year deferred annuity with an income for life provision.  This layering of annuities guarantees a monthly income for as long as a retiree lives.  The risk of market rates and sleepless nights worrying about retirement income is now eliminated.

Certificate of Deposit Versus Fixed Annuities

With a confusing annuity market, many individuals in the investing world shy away from annuities.  But in many situations, an annuity can be the perfect option to meet investing goals.  Annuities should not be overlooked.  One type of annuity is a fixed annuity which can be thought of as an alternative to a bank certificate of deposit (CD) which is considered the safest type of investment.

Similarities in CDs and Fixed Annuities

There are many similarities between CDs and fixed annuities.  First, they both pay a predictable amount of income to investors with no risk of loss of principal.  Both provide a range of time frames in which a person can invest.  Finally, both allow for full investment without any sales or management fees that eat into principal amounts.  

So, if they are both the same, they why choose one from another?  There are some key differences that investors should be made aware of before investing in either a CD or fixed annuity.

Principal Guarantees

The FDIC guarantees up to $250,000 per person on bank CDs at each bank.  If the bank fails, the FDIC will make up any losses up to $250,000.  Fixed annuities are not backed by the FDIC.  Rather, they are backed by the issuing insurance company.  In several states, guaranty funds are set up to repay some or all losses to annuity holders if the insurance company that issued the annuity fails.

The Tax Treatment

A bank CD is taxable unless it is held in a retirement account such as an IRA.  A fixed annuity generates income tax-free which means that taxes are not paid on the gains made in the annuity until they are actually withdrawn.

There can be tax penalties on fixed annuities of 10% if the funds are withdrawn before age 59 ½.  Many people close to retirement opt for fixed annuities because they are over the age 59 ½.  This eliminates any penalty for early withdrawal.

Changes when Renewing

When the term of a CD comes to an end, the holder has the option to renew the CD for another term.  However, the interest rate received during the first term is not guaranteed and they are at the mercy of the new interest rates.  

Fixed annuities also have a set timeframe for interest paid and the amount distributed.  However, when this time period ends, the annuity remains is existence.  The new rate is determined, not by the banks interest rate, but rather by the agreement made at initial purchase.  Some annuities state that the rate will not fall below a certain amount guaranteeing the owner a known amount of income even when the initial annuity time is up.

Early Access to Money

Bank CDs have early withdrawal penalties that vary with the length of the CD, but all carry some type of penalty for early withdrawal.  Fixed annuities, on the other hand, can include provisions that allow a person to access some portion of the principal without penalty.  But, be sure to read the annuity provision very closely.

Receiving Distributions

With a CD, there is a short window of opportunity after a CD matures to take the money out of the CD or add more money into the account.  If this window is missed, the CD usually generates a new renewal period based off of the initial time length and if withdrawals are made after this date, there can be heavy penalties for early withdrawal.

With many different withdrawal options, fixed annuities allow for free access to the money in the preset agreed upon amounts with no penalties or fees.  One advantage of a fixed annuity is that at any time, the contract can be annuitized, a fixed rate locked in, and set payments received for the rest of a person’s life.

Annuities are not the solution for everyone.  Education on the subject can go a long way in avoiding some common pitfalls.  If the structure of the annuity bucket formula is done the correct way, growth is maximized as well as a plan to receive the most income possible.

Fixed annuities have features that differ from bank CDs, so it’s important not to think of them as interchangeable. Some will favor annuities and others CDs, but you’ll need to figure out which features you find most valuable to decide whether a bank CD or a fixed annuity is right for you.

As with any major retirement income change, talking with a qualified and experienced retirement tax consultant is the best place to begin.  Go in knowing what your goals are for retirement and then find out the best way to reach those goals.

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