[ad_1]
Indexed annuities are a type of fixed annuity whose interest rate is linked to the performance of a stock market index, providing the owner with the ability to participate in market gains without downside risk. The reference value of the index is reset on the annuity’s anniversary date, and limits may be placed on interest rates paid. Indexed annuities enjoy favorable tax treatment, but income tax is due immediately on the entire tax-advantaged portion of the annuity upon the owner’s death.
An indexed annuity is a special type of annuity, which is a contract entered into between an insurance company and a purchaser that provides a guaranteed income, usually for life, to the beneficiary or beneficiary. There is no requirement that income begin immediately upon purchase, and in fact many annuities are deferred annuities, that is, they grow in value as part of a retirement planning portfolio, with the decision to convert to a guaranteed income, or annualize, deferred until some 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. However, an index annuity is a type of fixed annuity in the US whose interest rate is linked 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 principal loss. If the market index on which an index annuity’s interest rate is based falls during the measurement period, it simply does not earn interest during that period. Conversely, if the stock in which the principal of a variable annuity is invested decreases in value, the owner’s account loses the principal & emdash; a variable annuity has no downside protection.
If the attraction of an indexed annuity is that its owner can participate in all the market gains without suffering any downside risk, an equally attractive feature is the main “ratchet and reset.” This means that the reference value of the index, against which the gain or loss is calculated as a percentage, is reset on the annuity’s anniversary date. For example, if the principal of a variable annuity is invested in $100,000 United States Dollars (USD) worth of shares on the date of purchase, and those shares lose 20% of their value in the first year, the annuity has lost $ 20,000 USD and is now worth $80,000 USD. If, in the second year, the principal stock of the variable annuity is invested at a 25% profit, 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 dramatically different results. The starting value is $100,000 USD, and by the end of the first year the underlying market index has lost 20%, say from 2,000 to 1,600. The value of the index annuity is still $100,000: no principal was lost because, although the interest rate is linked to market performance, the principal itself has not been invested in stocks, but at the end of the first year, the baseline for calculating the change in value of the market index is reset & emdash; now there are 1,600. In the second year, the market index increases by 25% and ends the second year right where it started, at 2,000. The interest rate of the indexed annuity, linked to the index, is set at 25%, and the new value of the indexed annuity would be 25% higher than at the beginning of the year, or $125,000 USD. The same amount of money and the same market; however, two different types of annuity and two totally different results.
Of course, a volatile market can be very unpredictable, and insurance companies sometimes place limits on the interest rates paid for index annuities. A participation rate, for example, determines what percentage of the market’s profit will be applied. A 75% participation rate would mean that the 25% experienced by the market index in the example would translate to an interest rate of 18.75%, or $18,750 USD. In addition, most insurance companies will also place a limit on the interest rate indexed annuities you can earn in any one year. Prudent consumers considering an index annuity will ensure that the participation rate and interest cap are not so large that any market gains are meaningless.
Like all other annuities, indexed annuities enjoy favorable tax treatment, with interest earned not taxed until actually paid. By contrast, certificates of deposit, money market funds, and interest income from other savings vehicles are taxed in the year they are credited, diminishing their compounding power. On the other hand, when a beneficiary inherits an annuity upon the owner’s death, although probate is generally omitted, income tax is due immediately on the entire tax-advantaged portion of the annuity: interest earnings and, if you qualify for taxes, principal as well. In many cases, this can push a beneficiary into a higher tax bracket, resulting in more taxes owed than if the annuity had been annuitized or paid off before the owner’s death.
Smart Asset.
[ad_2]