Anyone who is familiar with annuities knows that they are considered to be a long term investment. Between the contract provisions and applicable tax rules, annuities rates should be held for the long term in order to optimize their benefits and maximize their tax advantages. But, people invest in annuities for many different reasons and to fulfill various types of investment objectives. So, the actual period of time they may hold an annuity may vary. To determine how long annuities should be held, really depends on individual circumstances.
How Long is Long?
Annuities have several features and provisions inherent in the contract that will dictate the minimum holding period for people. While annuities can be held for shorter periods of time, their costs, which include annual fees and surrender charges, can eat into the accumulate account to a higher degree, than if they were held for a longer period of time. And, any tax advantages gained in the early years can be largely negated by the payment of income taxes and a 10% IRS penalty if the withdrawal occurs prior to age 59 1/2. The holding period of an annuity is usually based on the investment need, the age of the investor and the specific withdrawal provisions contained in the contract.
For Maximum Tax Advantages
Annuities are purchased in large part due to their tax advantages. Funds that accumulate inside of an annuity are not currently taxed, so they can accumulate faster than an equivalent taxable investment. The real advantage of tax deferral is realized through the compounding of interest or returns over the long term that would otherwise be lost to taxes. Therefore, the positive effects of tax deferral are greater the longer the contract is held.
Many investors view the tax deferral as an offset to the annual expenses that are charged in annuity contracts. These expenses, charged as a percent of the account balance are highest in a variable annuity and lower in fixed and indexed annuities. In either case, they do come right out of the account balance which can obviously effect it growth. The tax deferral replaces those charges and much more as the growth compounds more quickly in later years. To really maximize the tax advantage, it is recommended that an annuity be held for at least 15 years, but, the longer the better.
Many investors hold annuities until they reach retirement age during which they anticipate a lower tax rate on their income. So, if they can defer income taxes during their high tax bracket years, and pay taxes at a lower rate, they have benefited even further from the tax deferral.
For Maximum Access to Funds
Most annuity contracts contain withdrawal provisions which provide investors with a way to access their account value at any time. In the early years of the contract withdrawals are limited to 10%of the account value without incurring a charge. Withdrawals that exceed 10% are charged a surrender fee. In most annuities, the surrender fee starts out fairly high, in the range of 7 to 12 percent. But, each year the surrender fee is reduced by a percentage point until they eventually vanish all together. So, with an annuity that charges a 7% surrender fee, the surrender schedule will run for at least 7 years, after which there is no charge for excess withdrawals. So, if maximum access to your annuity account is a concern, the minimum holding period of your annuity is the length of the surrender period. It is important to mindful that any withdrawal will reduce your account balance and slow down the compounding effect.
For Maximum Guaranteed Income
If an annuity is purchased with the intent to, at some point, convert it a guaranteed income, the holding period is based strictly on your timeframe for needing the income. When an annuity is converted to income the annuity owner doesn’t have to worry about surrender charges or IRS tax penalties (if annuitization occurs before age 59 ½). In fact, annuitization is one way to avoid immediate taxation on withdrawals and an IRS penalty if you are younger than age 59 ½. Because annuity income consists of both a return of principal and interest, only a portion of the income payment is taxed. So, in essence, your annuity earnings are tax deferred until they are received in the income payment.
When deferred annuities are purchased for income, they can be annuitized at anytime. So, the holding period is really based on when your need for income arises. Obviously, the longer you can defer your income and benefit from the tax deferred compounding of your returns, the more income your annuity will generate. One option might be to split your deferred annuity and convert a portion of it to income for a specified period of time and allow the balance to continue to grow. When the account balance on the income annuity is depleted, you can then annuitize the deferred annuity. In many cases, this strategy will generate more income from the same original annuity balance.
The ideal holding period for annuities is based on your financial objective or need. But, in all cases, your age is a factor (to avoid the 59 ½ penalty), your tax status is important (to maximize tax advantages) and your time horizon is your primary consideration (to maximize the tax deferred compounding). As a general rule, you probably shouldn’t consider investing in an annuity unless your time horizon is at least 15 years, and that is only if you’ll be over age 59 ½ in that period. Ideally, you can hold your annuity for at least 20 years which will produce the maximum benefits all the way around including the offset of expenses. One of the beneficial features of annuities is, that if your time horizon changes, or your circumstances require that you have access to your funds in the short term, they are available.