What is a two-tiered annuity?
Annuity issuer uses two different interest rates to credit cash surrender value
A two-tiered annuity is a type of fixed annuity in which the interest rate credited to the annuity varies depending on the distribution option that you choose. Typically, if you elect not to annuitize (and therefore maintain ownership of the money in the annuity), the annuity issuer will use a lower interest rate to credit your account. If you elect to annuitize and receive a series of annuity payments over a period of time, the annuity issuer will use a higher rate of interest to credit your account. The annuity issuer credits your account with a higher rate of interest to encourage you to elect a periodic payout of the annuity. The issuer wants to hold on to your money for as long as possible. The issuer (typically an insurance company) will then invest your money at a higher rate of interest and earn money off the difference between what they pay you and what they earn. If you maintain the ability to withdraw all of the money in one lump sum, the issuer loses the ability to invest your money.
Different types of two-tiered annuities
There are a variety of two-tiered annuities. Some, for example, use the higher rate of interest only if you select the life annuity settlement option.
Widely used to fund Section 403(b) retirement plans
Two-tiered annuities are commonly used to fund Section 403(b) retirement plans. A Section 403(b) retirement plan is a special type of retirement plan usually available only to teachers and employees of tax-exempt organizations.
When should you buy a two-tiered annuity?
Want to receive payout over long period of time
It usually makes sense to buy a two-tiered annuity only if you would like to receive the payout from the annuity over a long period of time. As noted, the annuity issuer will typically pay a lower rate of interest on the annuity if you do not elect the annuitized distribution option. Because of the higher interest rates, it may make financial sense in many cases to buy a two-tiered annuity only if you want the long-term periodic payout.
Compare interest rates
You should also consider a two-tiered annuity if the interest rate offered on the payout plan you are interested in is higher than what is being offered on a straight fixed rate annuity. It does not make much sense to buy a two-tiered annuity if the interest rate the issuer is using is less than what a comparable fixed rate annuity is paying.
Comparable to fixed-rate annuity
Finally, there may be other reasons why you would buy a two-tiered annuity that are similar to the reasons why you would buy any fixed rate type of annuity. For example, you might want a guaranteed rate of return on your investment, you might want the tax deferral of any annuity earnings, or you might want a supplement to your qualified retirement plan.
What are the strengths of a two-tiered annuity?
May offer higher interest rates for certain types of payout plans
A two-tiered annuity may offer a higher rate of interest than what is available on a straight fixed-rate annuity. As noted, to encourage people to elect the annuity payout over a period of time, the issuer of a two-tiered annuity may offer a higher rate of interest than if you were to select a lump-sum payout. The interest rate offered on the long-term payout may be more than what a comparable fixed rate annuity is paying.
Other strengths are comparable to other fixed rate annuities
The other strengths of a two-tiered annuity are essentially the same as the strengths of a straight fixed-rate annuity. For example, you will receive a guaranteed fixed rate of interest, the earnings will be tax deferred, you cannot outlive the annuity payout period, there are no limits on the amount you can invest in the annuity, and the proceeds will not be subject to probate.
What are the tradeoffs to two-tiered annuities?
Not a good choice if you want a lump-sum payout
Probably the main tradeoff to a two-tiered annuity is that if you receive the payout from the annuity as a lump sum (or elect other nonannuitized distribution options), you will receive a lower rate of interest. There may be financial or other reasons why you want to receive the annuity as a lump sum. A two-tiered annuity penalizes you for making this choice. For this reason, if you plan to liquidate the annuity in a lump sum, then a two-tiered annuity may not be a good choice.
Other tradeoffs are similar to tradeoffs for fixed annuities
The other tradeoffs to a two-tiered annuity are similar to the tradeoffs for a fixed annuity. Thus, the fixed rate of return on the annuity may not keep up with inflation, there are costs and fees to maintain the annuity, there are early withdrawal tax penalties, and there is no federal insurance (unlike a bank account).
What are the tax implications of two-tiered annuities?
Tax implications similar to the tax implications of fixed annuities
The tax implications of a two-tiered annuity are similar to the tax implications for a fixed annuity. For example, the earnings on a two-tiered annuity are tax deferred until you begin to withdraw money from the annuity. Furthermore, if you elect to annuitize the annuity, then any payments that you receive are partially a tax-free return of capital and partially taxable income. There may be, moreover, a 10 percent IRS tax penalty on withdrawals before the age of 59½, and the value of the annuity contract may be included in your taxable estate if you die before the annuity payments begin. Finally, the value of the annuity after the payout has begun may or may not be included in your taxable estate depending on the settlement option you choose.
A two-tiered annuity is a type of fixed annuity where the interest rate credited to your account varies depending on the distribution option you choose. This annuity structure is commonly used to fund Section 403(b) retirement plans and may offer higher interest rates for certain types of payout plans. It is essential to consider your financial goals, such as receiving a long-term periodic payout, before deciding to purchase a two-tiered annuity. Scarlet Oak Financial Services is here to help you navigate the complexities of two-tiered annuities and other financial planning matters.
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Source:
Broadridge Investor Communication Solutions, Inc. prepared this material for use by Scarlet Oak Financial Services.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances. Scarlet Oak Financial Services provide these materials for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
