Annuities - the Basics
One of the attractive aspects to an annuity is that the interest and/or capital gains earned on your money are tax deferred until you begin to receive payments back from the annuity issuer. In this respect, an annuity is similar to a qualified retirement plan. Over a long period of time, your investment in an annuity can grow substantially larger than if you had invested money in a comparable, taxable investment. However, like a qualified retirement plan, there may be a 10 percent tax penalty if you begin withdrawals from an annuity before the age of 59½.
Two distinct phases
There are two distinct phases to an annuity: (1) the accumulation (or investment phase), and (2) the distribution phase.
- The accumulation (or investment) phase is the time period when you add money to the annuity. You can purchase the annuity in one lump sum (called a single payment annuity), or you can add a series of payments in an annuity. The payments may be of equal size over a number of years, or they may consist of a series of variable payments.
- The distribution phase is when you begin receiving distributions from the annuity. You have two general options for receiving distributions from your annuity.
Option 1: You can withdraw all of the money in the annuity in one lump sum, or you can withdraw the money over a period of time.
Option 2: Receive a guaranteed income stream from the annuity. This option is commonly referred to as the annuitization option. Under this option, the annuity issuer promises to pay you an amount of money on a periodic basis (monthly, quarterly, yearly, etc.). You can elect to receive either a fixed amount for each payment period (called a fixed annuity payout) or a variable amount for each period (called a variable annuity payout). You can receive the income stream for your entire lifetime (no matter how long you live), or you can receive the income stream for a specified time period (e.g., ten years). You can also elect to receive the annuity payments over your lifetime and the lifetime of another person (called a "joint and survivor annuity").
What types of annuities are there?
1. Fixed - Money in a fixed annuity earns a fixed rate of return tax-deferred from the life insurance company. You are guaranteed a fixed payout every month when you decide to begin receiving income.
Always check with your financial advisor regarding the consequences.
- Can be either a deductible or non-tax deductible contribution, with tax deferred growth and generally a taxable distribution (can be tax free in a Roth IRA).
- Fixed annuities offer a tax deferred fixed rate of return over a selected time frame and the accounts are guaranteed by the issuing insurance company.
- Tax-Deferred interest accumulation.
- The gains withdrawn from fixed annuities are typically taxable, and withdrawals for owners under 59 ½ are additionally subject to an IRS imposed 10% tax penalty.
- Fixed annuities offer preservation of Capital.
- Fixed annuities offer a guaranteed minimum interest rate; generally first year interest rate enhancement, with future rate adjustments.
- Some fixed annuities have some type of liquidity option, others have none.
- Generally, annuities liquidated and redeemed prior to the original terms of the offering have some type of withdrawal penalty.
- Typical Fixed Annuities have a Death Benefit.
- Some Fixed Annuities have a nursing home and disability waiver for penalty free withdrawals.
- Fixed annuities are issued by insurance companies and are state specific, what is available for the resident of one state might or might not be available for the resident of another state.
2. Variable - Money put in a variable annuity is invested in bond and stock funds, which you select. The value of the annuity and how much your money grows depend on how well those stocks and bonds perform. Like a fixed annuity, your money grows tax-deferred in a variable annuity. You can receive fixed or variable payouts from a variable annuity.
How can my annuity proceeds be distributed?
The terms "immediate annuity" and "deferred annuity" simply indicate when the distribution phase of the annuity begins. Both allow unlimited contributions, and both provide a continuous stream of payments for life.
Immediate annuities allow you to convert a lump sum of cash into an income stream. They differ from most annuities in several ways. First of all, immediate annuities do not have an accumulation period. They are funded with a single, lump-sum payment rather than a series of premium payments. An annuity option is chosen and the distribution period begins within 12 months after the purchase.
Immediate annuities have very limited flexibility. They may be appropriate if you have an immediate income need and you have a large sum of money to invest. They appeal to those who prefer the security of a fixed income and who are uncomfortable managing their own investments.
Deferred annuities are the "normal" type of annuity, and are much more common than immediate annuities. With a deferred annuity, you typically make a series of premium payments during the accumulation period. Deferred annuities may also be funded with a lump-sum payment. In either case, you begin taking distributions at some future time, typically in retirement.
Deferred annuities may be appropriate if you are saving for retirement, and will not need the money for several years. Remember, withdrawals prior to age 59 ½ may be subject to a 10% IRS tax penalty. For most people, a deferred annuity is a more appropriate choice than an immediate annuity.
What are some other tips on annuities I should know about?
- Participate in any retirement savings plan available through your employer. Then determine how much additional savings you can put aside for retirement.
- Talk to a licensed agent about what type of annuity may be right for your retirement portfolio.
- If you are purchasing a fixed annuity, find out the current interest rate being credited under the annuity, how often it changes, and the minimum interest rate guaranteed.
- Make sure you fully understand the annuity contract you are considering.
- Learn about the variety of annuity payout options. If you and your spouse need to supplement your Social Security and pension benefits with a steady stream of income, annuities provide a variety of options to consider.
- Make sure the company issuing the annuity is licensed in your state.
- Look for a company that is reputable, consumer-oriented, and financially strong. A number of insurance rating services rate the financial strength of companies, and such information can be obtained from your agent or from public or business libraries. Rating agencies include A. M. Best Company, Standard & Poor's Insurance Rating Services, Duff & Phelps Inc., and Moody's Investor Services Inc.
- If you have a complaint about your agent or the company issuing the annuity, contact the customer service division of the insurance company. If you are still dissatisfied, contact your state insurance department.