Fixed Annuities May Fit Your Tax Plan

Savers have benefited from rising interest rates. Yields on bank accounts are increasingly attractive.

But bank accounts are taxable. Say you get 5% on a five-year certificate of deposit. That's about the average as of Wednesday, according to Bankrate.com.

You'll probably owe tax on that interest. That will be the case unless your CD is in a retirement plan.

In a top 35% tax bracket, you'd clear only 3.25% after paying the IRS. Your state may tax you, too.

One way to defer the tax on your savings is to invest in a fixed annuity instead. These non-FDIC-insured contracts are sold by insurers and other financial firms. You can make one payment or a series.

The interest earned by a fixed annuity is tax deferred until you take the money out. That's like a withdrawal from an account such as a regular IRA. So these deals are even more attractive if you expect your tax bracket to drop in retirement. Fixed annuities had $572 billion in total assets as of the end of 2005, according to the trade group LIMRA International.

One type of fixed annuity acts like a bank CD. You lock in an interest rate for a certain number of years.

The average yield on an annuity with a five-year guarantee is now about 4.5% net of fees, according to Beacon Research, Evanston, Ill., which sponsors the Web site called Annuitynexus.com. To lock in a higher yield, averaging 4.9%, you can agree to an eight-year contract.

When the term is up, the interest rate will be reset. A bank CD acts the same way.

Why go with an annuity instead of a CD? After all, some $25,000 minimum deposit CDs have rates of 5.3% and up, as of July 12. Why lock up your money longer for little additional yield?

One reason is that the Federal Reserve appears to be at or near the end of its interest rate hikes. Savings interest rates could be at or near their peak. Soon they could start to fall. Before long, CD rates might be well below what you could lock in with a longer-term annuity.

Tax-Free Exchange

What if an insurance company, at the end of an eight-year term, resets the rate on your fixed annuity at 3% when market rates are 5% or 6%? You can exchange this annuity for an annuity from another issuer.

Tax rules permit such exchanges without triggering income tax. But some insurance firms impose an exit fee if you surrender your contract within a specified period.

Some are on a sliding scale. You might owe a 7% fee if you take your money out after one year, 6% after two years and so on.

"Some fixed annuities let you match the rate guarantee with the surrender period," said Jeremy Alexander, president of Beacon Research. An annuity that sets its rate for five years might have a surrender charge that ends after five years.

"Another option is to find an annuity with a window for waiving the surrender charge," said Alexander.

Say you buy a fixed annuity with a five-year rate guarantee and an eight-year surrender period.

At the end of five years, there might be a 30-day window for withdrawals without a fee.

That would allow you to exchange for a higher-yielding annuity if you found one. You could avoid a surrender charge.

Another type of fixed annuity gives you stock market participation. These are equity-indexed annuities (EIAs).

You can get a superior return, linked to equity markets, up to a specified cap. Or you get a minimum guaranteed return. You get whichever is higher.

EIAs have different terms. You could get the return of an index like the S&P 500. But no more than, say, 8.75% a year.

So your contract value would grow by 8% in a year the S&P 500 is up 8%. But you would not get a return higher than 8.75%, even if the S&P 500 goes up 20% or 30%.

Another insurer might offer you 90% of a specified index's return, with a 9% annual cap.

There is a minimum return, too. In many EIAs, the calculation of that return is complicated.

"You might wind up with an annualized return in the 1% to 2% range," Alexander said. And you'd probably have to hold your EIA for the entire contract term to get that guarantee.

The terms of an EIA may change from year to year. A contract with an 8.75% cap this year could have an 8% or 7% cap in a future year.

Comparison Shop

One way to compare EIAs is to see what the company has done in the past. Ask your agent or the insurer for its history.

"A company that has maintained its cap or dropped it slightly probably has done a good job of meeting investors' expectations," Alexander said. He prefers such an annuity issuer to one that has set a high initial cap but dropped it sharply.

So complexity can be a challenge when buying fixed annuities. And there may be other drawbacks.

Some have high surrender charges that remain in place for many years.

Withdrawals are taxable. And there is a 10% penalty tax on withdrawals before age 59 1/2.

So you shouldn't buy a fixed annuity if you might need the cash before that age. And you should read the contract carefully, no matter how fine the print becomes.