How an Annuity Works
An annuity provides a guaranteed stream of income. You make contributions—either over time or as a lump sum—to the annuity company in exchange for ongoing payments, often for life. If you die when you’re still contributing to the annuity, called the accumulation phase, your beneficiaries will inherit the assets.
However, if you die after you start receiving annuity payments—the annuitization phase—the assets go to the insurance company in most cases. Some investors view an annuity as a bet that they’ll live longer than the insurance company expects.
While the idea is to receive guaranteed future cash payments, 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 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. If the policy remains in effect 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 works differently. You pay into the annuity during the accumulation phase, then receive a guaranteed stream of payments. If a guaranteed-period option hasn’t expired at the time of death, the remaining payments may pass to a beneficiary. An annuity can help provide fixed 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 begin paying immediately while others start later.
- Lifetime vs fixed period – Lifetime annuities pay for the rest of your life. Fixed period annuities pay for a standard number of years like 10, 15, or 20.
- Single premium vs multi-premium – You can make one lump-sum contribution or multiple smaller contributions over time.
- Single owned vs joint owned – You can buy a single annuity for one person, or you can purchase an annuity with a partner—usually your spouse.
Everyone needs income when they retire. Some annuities provide a retiree a fixed return for life. Annuities have certain drawbacks; however, you can avoid some drawbacks through proper planning.
Here are a few upsides and downsides of fixed annuities:
- Pros – Annuities are guaranteed not only by the insurance company, but by state annuity guaranty associations.
- Cons – State annuity guarantees don’t provide complete protection. The exact amount covered varies by state.
- Pros – Your annuity earns a fixed interest rate for the guarantee period. This is a great benefit when the market is volatile.
- Cons – You don’t earn more if the market does well during the guarantee period. After the guarantee period expires, the insurer can change the rate according to the specifics in the annuity agreement.
- Pros – Relative to safe money, CDs and Bonds have long commitments. Annuities have protection from interest rates.
- Cons– A surrender charge applies to withdrawals made before the end of the surrender period. The surrender period varies by annuity but often lasts between six and eight years.
One of the main types of annuities available is a variable annuity. Part of the variable annuity is a self-directed investment product, and the other part is an insurance product. You decide which investments—called sub-accounts—your variable annuity will buy. The amount of money you earn in the variable annuity depends on the performance of these investments. You can choose from a pre-selected list of mutual funds, bond funds, and money market accounts. This allows you to control how aggressively you invest.
The insurance aspect of a variable annuity often 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, many variable annuities guarantee your beneficiary will still get the original contribution—a $50,000 death benefit.
All interest, dividends, and capital gains earned by a variable annuity are tax-deferred. You are only taxed when you receive payments or withdraw money from the annuity. Withdrawals before 59 ½ years of age incur an additional 10% tax penalty. Income from annuities is taxed as ordinary income rather than capital gains—which usually means a higher tax rate. Returns of principal—your original contributions—are only taxable if made with pre-tax money, such as through a traditional IRA.
There’s one important exception: an annuity funded through a Roth IRA is 100% tax free!
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 significant ongoing fees, and if you make an early withdrawal, there is a 10% tax penalty. Be to have a trusted financial advisor explain in detail how a variable annuity works and whether it is the right option for you.
Insurance companies typically offer a 10-day free look period option on variable annuities where you can receive a full refund without any surrender charges. However, not all states require free look periods, so always do thorough research before investing.
Indexed annuities are a popular long-term retirement product. They provide features from both variable and fixed annuities. Indexed annuities are like fixed annuities because they often provide a guaranteed minimum return or at least a loss floor. They resemble variable annuities because their rate of return is based on stock market performance. The exact terms and conditions of the payout are based on the annuity contract.
- Stock Performance: Indexed annuities provide potentially higher returns based on stock market performance. They also usually provide some protection against market decline because of guaranteed minimum returns and/or loss floors. However, high fees can lead to a lower-than-expected return. There is also a cap on the rate of return an indexed annuity can earn.
- Minimizes Risk: Indexed annuities offer a combination of risk and reward that many investors find favorable. One potential reason is that returns from these annuities usually exceed money market accounts, CDs, and most highly rated bonds; yet they tend to offer a guaranteed minimum return or loss floor to limit losses.
- Surrender Charge: There is often a surrender charge for any withdrawal during the surrender period. Surrender periods range from three years to sixteen years. The average surrender period is often between six and eight years.
- Rate Cap: Indexed annuities cap the rate of return—your annuity will earn less of a return than the index itself if the return exceeds this cap. It’s possible for a 15% increase to result in a 5% return. Also, returns for indexed annuities are often calculated using a participation rate. This means the rate of return 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 provides an 8% return. Any rate cap still limits the rate of return.
- Taxation: Income 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. Returns of your original contributions only count as income if they were made with pre-tax dollars. Annuity income is taxed at ordinary tax rates—normally a disadvantage. Annuities funded through a Roth IRA do not incur any taxes.
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). You can name a beneficiary who receives any money they’re entitled to under the specific annuity in question.
An immediate annuity turns a lump sum contribution into a stream of income right away, usually within a month. In other words, the contribution phase ends and the annuitization phase begins almost immediately. You’ll receive payments for the length of time specified by the annuity. Taxes work the same way as other annuities.
If you are looking to purchase an annuity, work with a reputable financial advisor. Also, make sure you purchase an annuity from a solid and financially stable insurance company. Finally, ask a lot of questions before your purchase.
What is the Surrender Period?
The surrender period is the amount of time during which you’ll be charged a surrender fee if you withdraw money from your annuity past a specified amount. It usually lasts anywhere from six to eight years after you buy the annuity.
How Are Annuities Taxed?
When someone obtains an annuity, they are often confused about what to expect from the IRS. Many annuitants make the wise decision to consult with a tax professional so they file and pay correctly.
Though annuities provide tax deferral, receiving payments usually cause tax implications. The main tax benefit of an annuity is growing tax-free until funds are withdrawn.
Payments are usually considered income by the Internal Revenue Service and they will be taxed as such. Withdrawals of principal only create income if the annuity was funded with pre-tax dollars, but withdrawals of an annuity’s return generally result in taxable income. State taxes may also apply, depending on where you live.
Qualified or Non-Qualified?
The type of annuity affects income tax treatment. A qualified annuity means the money used to open the account has never been taxed, such as with a 401(k). Receiving payments or withdrawals from a qualified account will generate taxable income.
Non-qualified annuities are purchased with after-tax dollars. Taxable income generated by non-qualified annuity payments is the amount that exceeds the tax-free portion. To calculate the tax-free portion, multiply the total payment by the exclusion ratio. The exclusion ratio equals the amount paid into the annuity divided by the expected return of the annuity at the start date. Calculating the exclusion ratio often requires knowing your life expectancy based on tables provided by the IRS.
Benefits of Owning an Annuity
There are several key benefits to owning an annuity and many people use them as an investment tool. Depending on the type and terms of an annuity, benefits include:
- Guaranteed future income
- Generally, less risk than the stock market
- Predictable interest earnings
Understand annuities thoroughly before investing to make a wise financial decision for your circumstances. If you do not feel confident purchasing an annuity on your own, consult a personal finance advisor who can help you understand your options. An annuity can play an important role in securing your financial future.
Disadvantages of Owning an Annuity
While annuities make sense for many people, there are also several drawbacks to consider before deciding.
- 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 many annuities provide guaranteed income, you may lose the opportunity to fully experience major growth if the stock market performs well during that time. It’s really a matter of how your assets are diversified and what your risk tolerance level is at your stage of life.
- Fees are involved: Annuities typically come with significant fees and/or commissions, often charged as a percentage of your payment. This can reduce the amount of 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 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 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 can pass an agreed-upon amount to their heir upon death.
A potential annuity owner may be able to work with an insurance company to create a custom contract. Working with the insurance company can help ensure the annuity terms—including a potential death benefit provision—suit your financial situation.
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 also 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 chooses the beneficiary. The beneficiary will not receive any annuity payments 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. They can also choose more than one beneficiary.