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Expert analysis using tax facts online.

Mike and Karin's problem is one that clients experience on a regular basis--they know what their retirement goals are, yet they aren't sure which financial products are best suited to helping them meet these goals. Also like most clients approaching retirement, they may have begun to realize that they don't like the idea of relying on a Social Security system where benefits are far from certain.

Tax Facts Online can help you advise clients with these types of concerns, because it explains the basic types of annuities, their benefits, and tax treatment. For example, Question 353 provides a general description of an annuity product and differentiates between the treatment of an immediate annuity contract and a deferred annuity contract.

Because Mike and Karin have not yet entered retirement, and want to ensure that their taxable income is not increased before they actually retire, they will likely want to purchase a deferred annuity product. Question 373 explains the basic treatment of a deferred income annuity, and tells us that payments under the annuity contract can be deferred until some point in the future--and that no taxes are incurred until the contract owner begins to receive payments.

The usual deferred annuity product, however, is designed to defer income far into retirement--typically payouts would not begin until Mike and Karin reach age eighty or eighty-five. The benefit of this type of product is that their investment is allowed to grow tax-free until they begin receiving payments, so if Mike and Karin purchase this type of "longevity annuity" today, they can invest a smaller portion of their retirement savings and still receive substantial monthly payments after the investment is permitted to grow for at least twenty years.

There are downsides to the longevity annuity, however. Mike and Karin should be aware of the risks inherent in locking an investment into a product that will not mature for decades. Once they have invested, they will lose access to these funds during the course of their retirement--and, of course, there is no guarantee that they will live long enough to need this type of annuity.

Many insurance companies have begun offering a modified version of this type of deferred income annuity product. These newer products continue to defer payouts until some point during retirement, but typically allow the client to begin receiving payments much sooner (often within five years of purchase). Interest on the client's investment in these products is still allowed to grow tax-free until the client begins receiving payouts, but because the growth period is much shorter, a larger investment is needed to create the same level of income as the longevity annuities.

However, this type of deferred annuity product can allow the client substantially more investment flexibility. Often, a deferred annuity will offer a dividend option--the client can choose whether to receive the dividends in cash or have it reinvested to increase the annuity value.

Because one of the primary downsides to annuity investing is the loss of access to the funds and lost investment control, many clients will seek a product that provides the dividend option. If Mike and Karin lock a substantial portion of their retirement savings into annuity contracts to create the type of private pension they're looking for, they might prefer a product that offers some investment flexibility. In a strong equity market, they might prefer to take the cash dividends and invest outside of the annuity product-- without jeopardizing the stream of annuity payments.

Unfortunately, deferred income annuities that offer dividend options typically do not normally allow the client the option of cashing out the annuity to receive a lump sum payout. Some clients might forego the dividend option because they prefer the possibility of accessing their entire investment in the event of an emergency.

Every client's financial goal is different, so, as with any financial product, the different benefits and downsides of each type of annuity product should be discussed to give the client a thorough understanding of what he or she can accomplish. With annuity investing today, the possibilities are so diverse that proper financial advice is crucial to the client's ability to make an informed decision.
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Publication:Tax Facts Intelligence
Date:Jan 1, 2013
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