Because there are limits on how much you can place in a tax-sheltered retirement account, many investors choose to invest in variable annuities and receive the same tax-deferred treatment on their earnings as qualified retirement accounts. The Internal Revenue Service doesn’t limit the amount an investor can place in a variable annuity, which makes them a powerful tool for long-term retirement planning. While it’s easy to place money in an annuity contract understanding the tax benefits, it can be a little more difficult to project expected cash flows from the account.
1. Set variable P as the total principal invested in the annuity. This can either be a lump-sum investment, or the total of periodic contributions made to the annuity. For example, an investor contributes $100,000, so P = $100,000.
2. Determine the annual interest rate guaranteed by the annuity contract. Represent this as a decimal, and set that as variable R. In the example from the previous step, the investor receives a 6.5 percent return, so R = 0.065.
3. Calculate the number of payments the annuity contract will make each year, and set this number as N. In the example, the investor receives a monthly annuity payment, so N = 12.
4. Set variable T as the number of years the payments are made as outlined in the contract. Continuing with the example, assume the investor receives payments for 15 years, so T = 15.
5. Plug variable amounts into the annuity payment formula to determine the cash flow for the life of the annuity. Periodic cash flow = [(P x R/N) x (1 + R/N) ^ (N x T)] / [(1 + R/N) ^ (N x T) – 1] Example cash flow = [($100,000 x 0.065/12) x (1 + 0.065/12)^(12 x 15)] /[(1 + 0.065/12) ^ (12 * 15) – 1)
6. Solve the equation. In the example, the investor receives $832 monthly for the life of the annuity.
- When solving the equation, calculate it using the proper mathematical order of operations rather than solving it left to right. Calculate values inside each parentheses, first, and calculate values determined by multiplication and division inside parentheses before adding or subtracting the value.
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