An annuity is a contract between the investor and the insurance company whereby the insurance company accepts a lump sum payment from the investor in exchange for a systematic stream of income payments to the investor usually beginning at retirement. Money invested in the annuity accumulates on a tax-deferred basis.

Annuities can be used to supplement your Social Security and pension payments. Annuities are best when used during life for retirement or other monthly income needs since the unused portion does not receive a stepped-up basis at the owner’s death. There are several different types of annuities to meet various financial needs that fall into two broad categories: deferred annuities and immediate annuities.

DEFERRED ANNUITIES

The term “deferred” refers to the fact that monthly annuity payments will begin at some future date. Income earned during the deferral period is not taxed until paid. For an additional fee, paid to the issuing insurance company, the annuity will provide a death benefit to a beneficiary of your choosing. There are three different types of deferred annuities: variable annuities, fixed annuities and market indexed annuities.

VARIABLE ANNUITIES

Variable annuities are invested in professionally managed stock and bond portfolios, called sub-accounts. The value of a variable annuity changes with the value of the sub-accounts. Since dividends, interest and capital gains remain invested until you make withdrawals, you control when income taxes are paid. Remember that withdrawals of taxable amounts will be subject to income tax, and prior to age 59 ½, may be subject to a 10% penalty tax. Variable annuities are by far the most popular type of annuity sold today.

FIXED ANNUITIES

In exchange for a lump-sum payment (or periodic payments) to an insurance company, a fixed annuity offers a competitive interest rate for a specified time period, usually 1, 3, or 5 years. Fixed annuities preserve principal and lock in a guaranteed rate of return.

MARKET INDEXED ANNUITIES

Market indexed annuities are tied to the performance of the market as a whole as typically measured by the “S & P 500.” Indexed annuities offer a guaranteed return in the event the market performs below the guaranteed target rate. The guarantee allows investors to participate in the upside growth potential of the market without the downside risk.

IMMEDIATE ANNUITIES

A lump-sum deposit establishes the immediate annuity, which provides payments, either at a fixed or a variable interest rate, typically on a monthly basis. With an immediate annuity, income stream payments begin right away. The first payment must be made within one year of purchase. Immediate annuity payments may be for a specified period, or for the greater of a specified period, or your lifetime.

REAL ESTATE

Historically, real estate has been an excellent hedge against inflation, and is a good investment if you are able and willing to undertake or continue the responsibility of ownership. The federal tax code accorded preferred tax status to your principal residence, allowing you to deduct mortgage interest and property taxes and forgiving the first $250,000 (single) or $500,000 (married) of gain on sale. Additionally, your principal residence is not counted for Medicaid eligibility purposes (see “Medicaid” in Chapter Twelve). The economic, tax and emotional advantages of owning your own home, condominium, or co-op are compelling. More than a mere investment, your home should be a permanent part of your investment portfolio.

Investment property such as apartments and commercial buildings can add diversification to your investment portfolio and provide protection against a down market. Investment real estate is often thought of as a “tax shelter” in that profits can be offset by the “depreciation deduction.” However, despite the investment and tax benefits or investment real estate, you may simply be unable or unwilling to take on the management responsibilities associated with ownership. Investment real estate is not like a stock or other passive investment. If you own investment real estate, you must be actively involved with its day-to-day management.

You should consider selling investment real estate inherited from your spouse if you are not equipped to manage it yourself or if your new life plan doesn’t include the active management such properties require. Your new stepped-up basis (see “Stepped Up Basis” in Chapter Two) will allow you to sell your investment real estate with little or no gain.

TANGIBLE INVESTMENTS

Tangible investments are those you can touch, such as gold, silver, coins, stamps and collectibles. Historically, these investments have been an excellent hedge against inflation. The reverse is also true: during periods of low inflation, tangible investments tend to perform poorly. Additional problems with tangible investments include lack of marketability, difficulty in determining value and inability to produce income.

A WORD OF CAUTION

Some investments are simply too risky for the vast majority of surviving spouses. You should not invest in limited partnerships, commodities and investments that are not publicly traded. You should respectfully decline any invitation to invest in any closely held (that is, not publicly traded) business. Such enterprises are not regulated and involve an inappropriate level of risk.

If a family member or close friend is asking you to invest, you should defer to your attorney, accountant or financial planner, and let them decline on your behalf. Don’t worry about being the bad guy. Worry more about being the poor guy.