What Are Annuities – Guaranteed Income, for Life
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Retirees have an important decision to make: whether to take their money out of their retirement accounts and spend it, or leave it in their retirement accounts and let it grow. For many individuals, the latter option is more advantageous. With a traditional retirement account, your money grows tax-free while you earn interest on it. If you choose to take the money out of your retirement accounts, you will be taxed on it. Having access to these funds when needed is important, especially for older individuals.
Annuities are among investment options used by people to help build a nest egg, meet other financial goals or investment objectives
. They provide guaranteed income payments for as long as you live. You can receive this money as a lump-sum payment or as a series of payments.
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What is an annuity and how does it work?
An annuity is a contract that provides an income stream for the rest of your life. Annuities are typically purchased as a form of retirement planning. Immediate annuities are a type of annuity that provides a steady payment as soon as you purchase it. Deferred annuities are a type of annuity that pays out at a later date, such as after you retire or reach a certain age.
There are two stages of an annuity contract:
- Accumulation: The accumulation phase is the time period you contribute money. This can be anywhere from 10 to 30 years, depending on your contract.
- Annuitization: This is when you'll begin receiving regular payments.
When you buy an annuity, you are guaranteed to receive a regular payout of income for life, no matter how long you live. You can choose to receive this payment as a lump sum or after a certain time period in equal installments. Payments are made automatically to the beneficiary of your choice. You can set up an annuity to provide payments to your spouse, children or other loved ones. You can also choose to receive payments for yourself instead of making other arrangements for your beneficiaries. Some annuities provide for a spouse to receive the benefit if you die before you do.
Annuities can be a powerful estate planning tool that can help you control the distribution of your assets after your death. If you have a substantial estate, owning an annuity can help you avoid high estate taxes. An annuity can also be used to supplement your retirement income and give you greater flexibility in structuring your payments.
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Types of annuities
There are many annuity products to choose from, and the type of annuity you choose determines your annuity payments. For example, if you'd like to receive immediate payments you'll choose an immediate annuity
. But if you'd like to begin receiving payment sometime in the future, you can choose deferred annuity.
Here are a few main types of annuities.
Fixed annuities
The fixed annuity provides payments for a fixed period of time – usually one or two years. After the period ends, the payments continue as long as you live. This type of annuity works best if you need a steady income stream for a specific period of time, such as while you are paying off your mortgage. But a fixed annuity is worth considering if you want to accumulate assets for retirement because it offers tax-deferred growth.
Variable annuities
A variable annuity provides the opportunity for higher returns than other types of annuities. Unlike a fixed annuity, a variable annuity is not backed by a financial institution and the value of the investment may fluctuate over time. But keep in mind that most variable annuities have limits on how much you can withdraw from your account each year without paying a penalty.
For example, many variable annuities have a withdrawal limit of 10% of your account value each year. So if you withdraw more than 10% of your account value in one year, you will have to pay a penalty on the excess amount. Many variable annuities also have a cap on earnings on the account. This means that if your account earns more than the limit in a given year, you will either receive a bonus or have to pay a penalty on the excess amount.
Indexed annuities
An indexed annuity pays out a certain percentage above a specified index (such as the S&P 500) each year. So even if the market goes up by less than the stated rate, you will still earn at least the stated rate of return. Like other types of annuities, an index annuity is tax-advantaged and provides growth potential for your retirement savings. Some fixed indexed annuities come with optional riders including living benefit riders for guaranteed lifetime income or enhanced death benefits to help with legacy planning.
Fixed indexed annuity
A fixed indexed annuity combines elements of both a fixed annuity and a variable annuity. It offers many of the same advantages of a traditional fixed annuity – a guaranteed interest rate and fixed periodic payments
– but it also allows you to participate in the growth of the underlying market without sacrificing any upside potential. The growth of your initial investment is not guaranteed, but your rate of return will be based on the performance of an index like the S&P 500. Fixed indexed annuity do not participate directly in the stock market.
How to buy an annuity
There are several ways to invest in an annuity. They are insurance products, which means you can buy annuities from insurance companies. This also makes them less prone to volatility. Most financial institutions offer annuities as part of a comprehensive financial package that includes bank accounts, insurance and other financial services.
The most important thing to consider when shopping for an annuity is to shop around and find the best option for you. Compare the different options available from different providers and choose the one that best suits your needs. Also consider factors such as costs, potential earnings, and the flexibility you may need as your financial situation changes in the future.
It’s a good idea to take some time to research your options so that you can make an informed decision. Talk to a few different providers and decide which ones you consider to be the most appealing. It’s also a good idea to ask around and see which company other friends and family members have purchased annuities from in the past. This can give you some insight into their experience with that particular provider and what kind of service they provide.
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Annuities and taxes
People buy annuities because they can help you reduce your tax bill. When you contribute to a traditional IRA or 401(k), you're required to pay income tax on the amount that you contribute. An annuity is a type of qualified retirement account that allows you to defer paying income taxes on your contributions until you make withdrawals in retirement. This means that more of your money is available to you for investments and growth, and you get to keep more of what you earn along the way.
As noted, annuities provide tax-deferred growth potential. That means you won’t pay taxes on your investment until you start to withdraw money in retirement. You can withdraw your contributions at any time, but doing so will generally result in the loss of any interest you’ve earned up to that point. However, you can choose to withdraw the interest without having to surrender any portion of your investment. This is known as a "non-qualified withdrawal" and will result in the payment of regular income taxes and a 10% federal tax penalty. In order to qualify for this withdrawal, you must retire and begin receiving income from the annuity within five years of the initial purchase date. Any withdrawals made prior to that time will constitute a nonqualified withdrawal and be taxed accordingly.
Understanding annuity fees
In order to really understand the costs associated with an annuity contract, you'll have to dig into the fine print. The annuitant's life expectancy is factored in when setting annuity premiums. This is different from life insurance, where mortality of the insured influences rates.
Generally, you can expect to pay these costs:
- Commissions: Regardless of the type of annuity you choose, you'll be charged a commission. This fee doesn't have a separate line item and is usually baked into the price. Depending on the annuity, commissions can range between 1% and 10% of the contract's total value.
- Administrative fees: This is charged yearly to manage and administer your annuity. It could be a percentage tied to the contract's total value (typically 0.3%) or a flat fee of $25 to $30 per year.
- Surrender charges: This fee is charged if you withdraw money more than the scheduled payment amounts before a certain time period. If you do so, you'll be on hook for up to 7% of the annuity first-year value. You won't be charged this fee in year seven.
- Mortality expenses: In order to compensate the issuing insurance company which is undertaking the risk, a mortality expense may be charged, which can be between 0.5% to 1.5% of the policy value each year.
- Investment expense ratio: Exclusive to variable annuities, service fees can range from 0.6% to over 3% each year.
- Other fees: In addition to aforementioned fees, transfer charges, third party transfer charges, distribution charges, contract fees, redemption fees and underwriting fees may be charged as well.
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The bottom line
Annuities provide a relatively safe and steady source of retirement income that is guaranteed to last as long as you live. It's important to compare your options before you settle on an annuity to ensure you get the best deal for your needs. If you are in a position to take advantage of the tax incentives offered with an annuity, they can be a great option for providing guaranteed income for you and your spouse while also building a nest egg for retirement.
Many investors choose to use annuities in combination with their other retirement vehicles such as an IRA or 401(k) in order to take advantage of the tax benefits associated with both types of accounts while still getting the benefit of a tax-deferred investment to grow their money over time. But before you go down this road, it's a good idea to speak to a financial advisor who specializes in retirement planning to ensure that you choose the right product to meet your needs.
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Writer
Jasir Jawaid is Joy Wallet's Assistant Editor. He has more than 13 years of experience as a journalist covering Wall Street, equities, financial policy and regulation, and cryptocurrency and blockchain.
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