For those hovering just shy of retirement (mid-40 to mid-60 year olds), low risk investments are certainly enticing. After all, risk tolerance diminishes as we get older.
One product being touted as the ultimate no-risk vehicle is indexed annuities. As a financial planner, I seem to be fielding more and more questions about these complicated instruments and their potential in an overall financial plan.
It is important to remember that indexed annuities are actually an insurance product, not an investment product. As such, rules and regulations are different than non-insurance investments. Be sure you understand all fees, commissions, and early-surrender consequences when considering possible investment in an indexed annuity.
If reduced risk is more important than return, and you are comfortable with allowing your money to sit for a period of time (generally 10 years), there are some benefits to indexed security instruments.
Loss Limits
One of the biggest benefits of indexed annuities is that they limit your possible losses. However, they also limit your gains. If your investment strategy is motivated purely by safety, indexed annuities provide it in spades. The interest rate of an indexed annuity is tied to a stock market index. When the index rises, you make money. When it falls, you are protected from loss. Insurers put caps on your possible returns, so realize that even if the market index rises sharply, your gains will be limited by the cap.
Tax Deferral
Income in indexed annuities is tax deferred until withdrawal. As with most deferred products, the assumption is that your tax rate and, thus, liability, will decline as you enter retirement. It is important to remember that tax rates are always subject to change and your deferred benefit is dependent on the tax code in effect at the time of withdrawal.
Annuitized Payments
Holders of indexed annuities can opt to receive annuitized payments from these instruments upon maturity; essentially securing payments for life. Payments may include a death benefit if the holder dies before a specified number of payments have been made. Payments of deferred gains are taxed as ordinary income in the year received.
Emergency Loopholes
One of the downsides to indexed annuities is that they usually impose large surrender fees if an investor opts to cash out early. Many indexed annuities do allow for an annual withdrawal of up to 10% of the principal. Most states have now protected those purchasing indexed annuities from surrender fees under catastrophic circumstances, such as being diagnosed with a terminal illness or being forced to enter a nursing home facility.
Be sure you understand all the risks, as well as the rewards, before committing to an indexed security product.
More from this Contributor:
Questions to Ask Before Investing in an Annuity
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The Benefits of Staggering Investment Maturities