How an Annuity Works
An annuity provides a guaranteed stream of income. You make a lump sum contribution to the annuity company in exchange for ongoing payments or a larger lump sum later on. While the idea is to earn guaranteed interest on your cash, you’ll also have to pay fees and commissions that can eat into your future payments. It’s important to understand what charges to expect before choosing an annuity.
Some individuals are also awarded an annuity as part of a structured settlement after a personal injury lawsuit.
Annuities vs. Life Insurance
There are some major differences between annuities and a life insurance policy. With a life insurance policy, you pay a monthly premium for the length of the policy, which can either last for a set period of years or indefinitely until you pass away. When you die, your chosen beneficiary receives a death benefit in the form of a lump sum. It can help cover costs like funeral expenses, medical bills, lost income, and housing costs.
An annuity is structured in the opposite way. You pay a lump sum to the annuity company, then receive a stream of payments until you pass away. If a guaranteed-period option hasn’t expired at the time of death, the remaining payments may be passed onto a beneficiary. An annuity can help provide guaranteed income during retirement.
Types of annuities
There are several types of annuities. Knowing which one is best for your situation can go a long way in helping you accomplish your financial goals.
- Fixed vs variable – Fixed have unchanging interest rates and predictable income. Variable annuities can change based on the overall market.
- Immediate vs deferred – Some annuities can begin paying immediately, and others can be deferred to start at a later date.
- Lifetime vs fixed period – Some lifetime annuities pay for the rest of your life. Others can pay for a standard number of years like 10, 15, or 20.
- Single premium vs multi-premium – You can deposit one check or many over a period of time.
- Single owned vs joint owned – You can buy a single annuity for one person, or you can purchase an annuity for both partners.
Every person needs a source of income when they retire. An annuity can provide a retiree a dependable and reliable amount of dollars for the rest of their life. There are some drawbacks with annuities; however, some of those drawbacks can be avoided if you make some smart choices.
Here are a few things you should take into consideration regarding the upside and downside of fixed annuities:
- Pros – The premium that your insurance company invests as part of your portfolio is never lost. The company is often backed up with substantial funds to protect your money.
- Cons – The cost of this type of safety means limited growth potential. For some people, this isn’t good enough compared to other options.
- Pros – The interest of your annuity is protected against loss. This is a great benefit when the market is volatile.
- Cons – Since crediting only takes place once a year, your earning potential is dependent solely on how the market performs on a single day. This means you could have significant gains. On the other hand, you could get wiped out if the market is experiencing volatility.
Caps and Rate Spreads
- Pros – You have the option to track your performance. The cost of the option dictates how much of a gain is received. The yields are greater than any safe asset.
- Cons – Expectations may not be great. Look for the best options out there.
- Pros – Relative to safe money, CDs and Bonds have long commitments. Annuities have protection from interest rates.
- Cons– Experts often say you don’t need to lock money up for an extended period of time. It all depends on what you are doing with the money. If the withdrawal annuity isn’t enough to meet your needs, it’s not for you.
There are several types of annuities that are available on the market. One of the main types is a variable annuity. Part of the variable annuity is a self-directed investment product, and the other part is an insurance product. The self-directed investment part of a variable annuity, known as the sub-account, allows you to decide how your contributions are invested. The amount of money you can earn in this sub-account depends on the performance of the investments you choose. You can choose from a pre-selected list of mutual funds, bond funds, and money market accounts. You can also choose to be an aggressive investor, a conservative investor, or an investor that uses a combination of the two strategies.
The insurance aspect of a variable annuity means that the principal balance of your annuity will be paid to your beneficiary no matter how poorly your sub-account performs. For example, if you put $50,000 into a variable annuity and you pass away at a time when your sub-account is losing money, your beneficiary will still get a $50,000 death benefit.
Since a variable annuity is considered an insurance product, all the interest, dividends, and capital gains are tax-deferred. You are only taxed when you begin to receive payments from the annuity at retirement or when you withdraw money before you turn 59 ½ years of age.
Is a variable annuity right for you?
There are many benefits to owning a variable annuity, such as:
- Flexible investment options
- Tax-deferred investment growth
- Lifetime stream of income
- Allowing beneficiaries to avoid probate when they receive your assets
Unfortunately, a variable annuity is not for everyone. A variable annuity may not be right for you if:
- You are less than 10 years away from retirement or 59 ½ years of age
- You are wealthy and have other income-producing investments
- You have serious health issues
Do your due diligence
A variable annuity is a long-term investment that requires a thorough understanding of how it works. They have ongoing fees, and if you make an early withdrawal, there is a 10% tax penalty. Be sure to work with a trusted financial advisor and have them explain in detail how a variable annuity works and if it is the right option for you. Insurance companies typically offer a 10-day free look period option where you contribute to a variable annuity to see how it works. Take advantage of this free look period to study how the variable annuity works first hand to see if it’s compatible with your situation.
A popular long-term retirement product is an indexed annuity. It provides a combination of features from both variable and fixed annuities. This annuity is like a fixed annuity because it provides a guarantee of a minimum return. It resembles a variable annuity because its rate of return is based on stock market performance. It is possible to purchase an indexed annuity from an insurance company. The terms and conditions of the payout will be based on the annuity contract.
- Stock Performance: Indexed annuities provide those who own them with the chance to earn higher returns based on stock market performance. It also provides protection against any type of market decline. Those who have an indexed annuity often receive returns that are lower than anticipated. This is because deductions are taken from returns that are fee-related. There is also a cap on the maximum amount of interest an indexed annuity can earn.
- Minimizes Risk: Someone who wants to avoid risk may want to consider adding an indexed annuity to their portfolio. It is often very attractive to individuals who are working on their retirement or getting close to retirement age. One of the goals with buying an indexed annuity is to have a better return than other investment vehicles like bonds, CDs, or money market accounts and still protect the investment principal. In a typical year, the purchases of indexed annuities could represent over 29% of all annuity sales.
- Surrender Charge: The mechanics of indexed annuities are often very complicated. The returns an indexed annuity holder may receive could vary by a considerable amount based on the year and month they purchased it. There is often a surrender charge for any type of early withdrawal. Charge-free surrender periods could be as short as three years and as long as 16 years. The average surrender period is 10 years.
- Rate Cap: If the index increases by 15%, the holder of an indexed annuity won’t experience a 15% return. The indexed annuity interest rate will have a cap. It’s possible for a 15% increase to result in a 5% return. It’s also important to realize interest rates for indexed annuities are calculated using a participation rate. This means the interest rate is a predetermined percentage of the increase of an index. If an index increases by 10% and the annuity provides the holder with an 80% participation rate, the indexed annuity would provide an 8% return. This will happen as long as it is not more than the rate cap.
- Taxation: Any type of gains experienced from an indexed annuity is taxed the same way as a fixed annuity. Taxes are deferred until the holder of the annuity receives the money. Interest in a fixed annuity is taxed first and at the same rate as regular income.
Immediate and Deferred Annuities
A deferred annuity is a type of long-term financial planning. Payments come later and income tax is deferred until you start making withdrawals from the annuity. Plus, you don’t have to worry about contribution limits as you would with an IRA or 401(k). When you pass away, you can name a beneficiary who receives the remaining balance, including both contributions and investment earnings.
An immediate annuity turns a lump sum contribution into a stream of income right away, usually within a month. Taxes are only paid on investment earnings and continue until you pass away.
If you are looking to purchase an annuity, be sure to work with a reputable financial advisor. Also, make sure you purchase an annuity from a solid and financially stable insurance company. Finally, always be sure to ask a lot of questions before your purchase.
What is the surrender period?
The surrender period is the amount of time in which you’ll be charged a surrender fee if you withdraw money from or sell your annuity. It usually lasts anywhere from six to eight years after you buy the annuity. The surrender charge limits how much you earn from the annuity.
How Are Annuities Taxed?
There are different types of annuities and they can each be held to different taxation rules. When someone obtains or purchases an annuity, they are often confused about what to expect from the IRS. With such complexities involving taxation, many annuitants make the wise decision to consult with a tax professional, so they can be sure they are paying appropriately.
Although annuities are meant to offer protection against income taxes, it is essential for individuals to understand that holding an annuity does not necessarily mean they will be able to receive payments or withdraw money without any tax implications. The main benefit of an annuity is the ability of the account to gain interest while remaining tax-free until funds are withdrawn.
Taxes will not be due on an annuity until payments are received or a lump sum is withdrawn. Withdrawals and any lump sum distributions are considered income by the Internal Revenue Service and they will be taxed as such. State taxes may also apply, depending on where you live.
Qualified or Non-Qualified?
When it comes to income taxes being owed on annuity payments or withdrawals, one of the most important things to consider is the type of annuity. A qualified annuity means the money used to open the account has never been taxed, such as with a 401(k). Those receiving payments or withdrawals from a qualified account are going to be taxed as if they received income.
Non-qualified annuities are annuities that were purchased after taxes were already taken out. The amount of taxes that are owed on this type of annuity will depend on the exclusion ratio. To figure the exclusion ratio, one must know the principal amount that was used to purchase the annuity, the amount of time the annuity has been held by the annuitant, and the interest earnings that have accrued since opening the annuity.
Benefits of Owning an Annuity
There are many benefits to owning an annuity and more and more people are using them as an investment tool. The following are some of the benefits annuitants can expect when they begin to invest in an annuity.
- Guaranteed future income
- A sound alternative to the stock market
- Predictable interest earnings
- Can be passed on to heirs
Before investing in an annuity, it is important you understand the ins and outs of this investment tool, so you will be able to make the right decisions for your financial security needs.
If you do not feel confident purchasing an annuity on your own, you can gain assistance from a personal finance advisor who can help you understand what to expect and how to ensure you are getting the most for your money. With an annuity, your financial future can be made much more secure.
Disadvantages of Owning an Annuity
While annuities make sense for many people, there are also several drawbacks to consider before making a decision.
- Money is tied up: An annuity is a long-term contract and reduces your liquidity. It may be unwise to tie up a large chunk of cash if you don’t have other funds to use for an emergency.
- Potential for limited growth: While a benefit of an annuity is that you have guaranteed income, you also lose the opportunity to experience major growth if the stock market performs well during that time. It’s really a matter of how all of your assets are diversified and what your risk tolerance level is at this stage of life.
- Fees are involved: Annuities typically come with some type of fee or commission, often charged as a percentage of your payment. This can reduce the amount of actual cash you walk away with.
Who Buys Annuities?
Annuities are typically purchased by older individuals as a form of retirement planning. It’s usually not your only asset for retirement, but rather one component to help diversify your future income.
Some people are also awarded an annuity as a result of a structured settlement. This could result from a personal injury, wrongful death, or medical malpractice lawsuit, just to name a few.
What Happens to An Annuity After Death?
When someone is awarded an annuity through a structured settlement, they may receive payments for a specific time period or the rest of their life, depending on the terms of the settlement. Many of the terms of an annuity agreement can be negotiated and it is essential individuals learn about their options before they sign their agreement.
One of the provisions individuals need to consider for their annuity agreement is a death benefit provision. With this provision in place, individuals will be able to pass their annuity payments on to their heir, upon their death.
The owner of the annuity will be able to work with the insurance company to create their custom contract. Working with the insurance company will help to ensure the annuity contract is specific and will spell out what is done with any leftover payments or money after the annuitant dies.
In some cases, the arrangement can be set up so the beneficiary continues to receive payments just as the annuitant did before they died. Instead of annuity payments, the beneficiary could receive a lump sum payment that pays out the remainder of funds in the annuity account.
How Is the Beneficiary Chosen?
The owner of the annuity is the only one that can choose the beneficiary. The beneficiary will in no way receive any benefits of the annuity unless the owner passes away.
It is important to note that the owner of the annuity has the right to change beneficiaries at any time and they can also choose more than one beneficiary, at their discretion.