Indexed annuities are a type of fixed annuity in the US whose interest rate is tied to a stock market index, offering the potential for market gains without downside risk. The “ratchet and reset” principle means that the base value of the index is reset on the anniversary date of the annuity. While insurance companies may set caps on interest rates, indexed annuities enjoy favorable tax treatment. In contrast to other savings vehicles, accrued interest is not subject to tax until paid out.
An indexed annuity is a special type of annuity, which is a contract between an insurance company and a buyer that provides a guaranteed income, usually for life, to the beneficiary or annuitant. Income need not start immediately after purchase, and in fact many annuities are deferred annuities, i.e. they grow in value as part of a retirement planning portfolio, with the decision to convert to guaranteed income – or annuity – deferred until at one point in the future. It is the method by which value is accumulated that sets indexed annuities apart from all other annuities.
Most fixed annuities grow in value by earning interest at a rate declared annually by the issuing insurance company. An indexed annuity, however, is a type of fixed annuity in the United States whose interest rate is tied to the performance of a stock market index such as the Standard and Poor’s 500 (S&P500). The attraction of fixed annuities, including indexed annuities, is that there is no possibility of loss of principal. If the market index on which an indexed annuity’s interest rate is based falls during the measurement period, it simply won’t earn any interest for that period. Conversely, if the shares in which the capital of a variable annuity is invested fall in value, the owner’s account loses the capital & emdash; a variable annuity has no downside protection.
While the attraction of an indexed annuity is that its owner can participate in all market gains without incurring any downside risk, an equally attractive feature is the “ratchet and reset” principle. This means that the base value of the index, against which the gain or loss is calculated as a percentage, is reset on the anniversary date of the annuity. For example, if the principal of a variable annuity is invested in stocks worth $100,000 US dollars (USD) at the date of purchase and those stocks lose 20% of their value in the first year, the annuity has lost $20,000 USD and it is now worth $80,000 USD. If, in year two, the shares of variable annuity principal is invested at a gain of 25%, or $20,000, at the end of the year, the variable annuity is worth $100,000, exactly where it started.
Using the same figures for indexed annuities yields significantly different results. The initial value is $100,000 USD and at the end of the first year the underlying market index has lost 20%, for example from 2,000 to 1,600. The value of the indexed annuity is still $100,000 – no principal has been lost because even though the interest rate is tied to the market, the principal itself has not been invested in stocks, but at the end of the first year, the line basis for calculating the change in the value of the market index is reset to zero &emdash; now it’s 1,600. In the second year, the market index increases by 25% and ends the second year exactly where it started, at 2.000. The interest rate for the index-linked annuity is set at 25% and the new value of the indexed annuity would be 25% higher than it was at the beginning of the year, or $125,000 USD. The same amount of money and the same market, but two different types of rent and two totally different results.
Of course, a volatile market can be highly unpredictable, and insurance companies sometimes set caps on the interest rates paid by indexed annuities. A stake rate, for example, determines what percentage of the market gain will be applied. A 75% stake rate would mean that the 25% experienced by the market index in the example would result in an interest rate of 18.75%, or $18,750 USD. Additionally, most insurance companies will also place a cap on annuities indexed to the interest rate they can earn in any given year. Prudent consumers considering an indexed annuity will ensure that the interest rate and interest cap are not so large that any market gains are insignificant.
Like all other annuities, indexed annuities enjoy favorable tax treatment, with accrued interest not subject to tax until paid out. Conversely, certificates of deposit, money market funds and interest accrued by other savings vehicles are taxable in the year they are credited, thus decreasing their compounding power. On the other hand, when a beneficiary inherits an annuity on the death of the owner, even if the probate is usually circumvented, income tax is immediately payable on the entire tax-advantaged portion of the annuity – interest income and, if tax-qualified, capital as well. In many cases, this can push a beneficiary into a higher tax bracket, resulting in higher taxes owed than if the annuity had been annualized or paid off before the owner’s death.
Smart Asset.
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