This article was last updated on October 26
Annuities have been a viable investment option for many years. However, there is still a great deal of confusion on what exactly they are and how exactly they work. Understanding the concept of annuities can help you to determine if they are right for you, and if so, what type is best for your retirement financial planning.
What Are Annuities?
In its most basic sense, an annuity is a contract between you (an investor) and an insurance company in which the insurance company makes a series of regularly spaced payments to you in return for a premium or premiums you have paid. Annuities have been defined as having the ability to “provide an income that you can’t outlive.” However, although that is true in some cases, it really depends on the type of annuity you own.
When an investor purchases an annuity, they can make deposits in one lump sum, or in periodic amounts over time. The account can accumulate, either on a fixed or variable level. Then, when the account owner is ready to withdraw their funds, they will begin receiving an income from the annuity. How much income and for how long depends on several factors, including the type of annuity they own, and the way they have their payments set up.
Annuities also provide a death benefit (different to life insurance). That way, if the account owner passes away prior to receiving annuity income, his or her survivors may receive the death benefit proceeds from the account.
An annuity helps you accumulate money for future income needs. An annuity is not a savings account or savings certificate and it should not be bought for short-term purposes. The most appropriate use for income payments from an annuity contract is to fund your retirement.
Types of Annuities
There are basically two types of annuities. These are fixed and variable. Primarily the difference between the two types is in the risk tolerance.
The money in a fixed annuity account typically accrues on an annual basis, and the funds grow tax deferred until they are withdrawn. Most insurance companies offer a minimum guaranteed interest rate on the fixed annuities they offer.
Fixed annuities can provide a guaranteed income amount over a specific period of time. The insurance company that provides the annuity actually takes on the profit or loss on the annuity and cannot decline the guaranteed payment.
Since they are low risk and provide a guaranteed minimum amount of income, fixed annuities are a popular option for retirees. However, it’s important to note that there can be withdrawal penalties if you take the money out of the annuity prior to a specified time. Further, if inflation were to spike, fixed income annuity holders may get much lower expected (in real terms) than expected.
Variable annuities, at their core, have a similar framework to that of fixed annuities. In other words, deposits are made that grow tax deferred. And, if death occurs prior to income being paid out, survivors receive the death benefit proceeds.
The difference between fixed and variable annuities is in the way that the cash in the “investment” side of the account grows. Whereas fixed annuities are invested in low risk, lower return vehicles, variable annuities provide more access to equities, such as mutual or index funds. Therefore, although there is typically a small guaranteed amount of return, there is more risk with variable annuities in that the investment account can move up and down with the market.
On the upside, these investments can help the account meet or beat inflation. However, as with other equity investments, there is the very real risk that the account value may fall. In addition, variable annuities are known for the higher fees charged to investors, including account maintenance fees and surrender charges if you need to access your funds prior to a certain specified time.
There is also a hybrid of fixed and variable annuities known as indexed annuities. The payments received from an indexed annuity have a fixed and variable, based on the performance of an underlying index such as the S&P 500. The annuity’s principal investment is protected from losses in the market, while index gains are added to the annuity’s returns
While indexed annuities can certainly achieve higher returns that those of a fixed annuity and offer more downside protection relative to a variable annuity, the investor can still end up having a negative overall return based on the performance of the underlying annuity index.
Remember that you, the owner, or annuitant, bear the investment risk as the value of the variable annuity increases or decreases based upon investment performance of the security.
Costs and Taxes Associated with Annuities
The value of your annuity consists of the premiums you have paid, less charges, plus interest credited. This value is used to calculate the amount of benefits that you will receive.
Charges, which are front or back loaded. Front loaded charges are those costs that are charged to you in the beginning. Back loaded charges are costs during or at a later date of the annuity contract.
Most annuities allow you to surrender your annuity for its total accumulation value or withdraw a portion of the value if income payments have not yet started. However, a surrender charge may be deducted from the amount surrendered or withdrawn. This charge is usually a percentage of the accumulated value of the contract, the premiums paid, or the portion withdrawn.
If you made after-tax contributions to your pension or annuity plan, you can exclude part of your pension or annuity payments from your income. You must figure this tax-free part when the payments first begin. The tax-free amount remains the same each year, even if the amount of the payment changes. See the IRS website for more on annuity tax treatment rules.
Before buying an annuity you should know all of the charges and taxes that you will pay and when you will pay them. Also, you should understand how these charges might affect the actual amount of money that will accumulate from your premium payments
Receiving Income from You Annuity
The reason that most investors purchase annuities is for the income they can provide. Depending on your retirement income needs, there is likely an annuity income option that will be right for you.
If you wait until you retire to withdraw income from your annuity, you will have three primary methods of requesting payment. First, you may simply request a lump sum of the funds in the account. Or, you may decide to take money out at random times only when you need it.
The third option you could choose is to annuitize your funds and receive a set dollar amount each month for as long as you live. This income for life option guarantees you a set income for the duration of your life. You can generally spread the payments out over your lifetime only, or over your and another person – usually your spouse’s – lifetime. This joint and survivor option allows that, if you should pass away, your spouse or survivor can continue to receive an income stream.
Regardless of which type of annuity you choose, annuities should be considered an important part of your retirement and financial planning.