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Annuities for Children

by Redeeming Riches on June 14, 2012

In order to decide if an annuity for your child is a good idea, you should start by having a basic understanding of how annuities work. An annuity is a contract, or policy, between the policy holder and an insurance company. Annuities must have a beneficiary, or a person who receives all the money in the annuity when the annuitant dies. The annuitant is the person being insured. The owner and the annuitant can be (and often are) the same person; however, the annuitant and the death beneficiary cannot be the same person. An annuitant can annualize their annuity by receiving a monthly income for life. This income amount would be determined by the annuitant, or insured’s, age. The higher the age, the more money would be paid out to the annuitant.

The owner of an annuity can choose between a few different options. For those purchasing an annuity for their child, the parent may decide to purchase an annuity such as a Single Premium Deferred Annuity, or SPDA. With the SPDA, the owner deposits a lump sum in the policy, and taxes are deferred until the money is withdrawn. This annuity guarantees a specific interest rate for up to 7 years; the longer the guarantee, the lower the interest rate will most likely be. This type of annuity allows the owner to keep the money safely set away. The owner would designate how much money is to be given to each beneficiary. Upon his death, those designations will become active.

annuities for children

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Annualizing an annuity

If the owner decides to annualize their annuity, they can do so by choosing to receive a monthly income stream for the rest of their life, with the income streaming ending upon their death, or they can choose to receive a monthly income stream for the rest of their life and have the stream continue to their beneficiaries for another 5-10 years. This may not be the best idea for an annuity because if the annuitant dies while the children are young, the income stream will not last very long and will not provide as much of a benefit for them.

Benefits and drawbacks

One of the benefits to an annuity is that the money is considered a retirement account. Therefore, if the child decides to attend college, the money in the account will not be looked at if the child decides to seek financial aid, even if they are required to list their parent’s assets. This allows a parent to save for their child’s retirement without harming their chances of receiving financial assistance for higher education.

While this seems like an easy way to leave money to a child, there are some tax considerations to be aware of, as well as annuity costs

Money withdrawn from annuities is considered ordinary income. As of 2013, ordinary income will be taxed at rates between 15% and 39.6%. Money that is invested in vehicles such as mutual funds or stocks is considered capital gains income, which for 2013 will be taxed at rates between 10% and 20%. Therefore, with all other things being equal, there is a considerable tax “penalty” for choosing an annuity over a mutual fund, index fund, or stocks. While the money in the annuity is not taxed while it is growing, it is heavily taxed upon withdrawal, so the tax benefits of the annuity are reduced.

Finally, there are costs and fees to consider when purchasing an annuity

Some of the more common charges include “surrender charges” if the annuity is cashed in early, mortality and expense charges to cover the costs of the insurance guarantee and broker commissions, and management fees. Expenses and fees can add up to over 2% of the amount, as opposed to 1.15% for a mutual fund or other investment vehicle.

An annuity for your child can be an excellent vehicle if properly managed; it is highly recommended that professional financial expertise be sought before purchasing one to ensure it is the best option.

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