What Are Annuities?
If you look up “Annuity” in the dictionary, it says “a fixed sum of money paid to someone each year, typically for life.” But when it comes to personal finance and investing, “annuity” refers to a financial product that can offer protected lifetime income and even potentially grow your money. An annuity can offer a stream of income payments, but it also can offer much more. This lesson is about annuities as a financial product, and a few things you need to know if you’re considering one for your retirement portfolio.
What is an annuity?
An annuity is simply a contract between an insurance company and an individual or married couple. Depending on the type of annuity, you can purchase one with a portion of your retirement savings in either a single purchase payment or multiple purchase payments over time. Annuities are one of the only financial products you can purchase that allow you to do this through a process called annuitization. The investment part offers the opportunity to potentially grow your purchase payments over time. You’ll pay a fee for the insurance part and investment fees if your annuity includes investment options.
Types of Annuities
There are a number of different types of annuities, designed for different situations, needs, and risk tolerances. Below are the main types of annuities:
- Fixed annuities are often purchased by those who are close to retirement or uncomfortable with the market’s ups and downs. Fixed annuities protect your principal, or the purchase payments you make, from market downturns, offer a fixed rate of interest for growth, and allow you to turn your assets into guaranteed, fixed payments.
- Indexed annuities protect your principal from some or all market downturns, and in exchange may limit your growth potential a bit. They may offer a minimum crediting rate with the potential for additional interest based on the performance of market indices, such as the S&P 500, as well as the ability to turn your assets into income payments. Indexed annuities may be attractive to those who would like to avoid at least some market declines but are looking for more upside potential than a typical fixed annuity.
- Variable annuities offer the potential to grow your money through a variety of market investments, but also include the potential for market declines. You will have the potential for greater gains, but also for loss, in this case. Variable annuities offer the option to turn your assets into a stream of income payments. They may be attractive to those who are looking for more growth potential than either fixed or fixed index annuities can provide. They also often come with optional benefits that can be added to provide guaranteed growth, guaranteed income, or guaranteed withdrawals for a certain amount of time or for life.
When do annuity income payments begin?
Annuities can either be immediate or deferred.
Immediate annuities are just that. You make a purchase payment, and your income payments begin shortly thereafter. Your purchase payment does not grow and is not liquid or available to you. Instead, you are guaranteed to receive income payments for a specific time frame or for as long as you live.
Deferred annuities give the purchase payments in your account the chance to grow. Your income payments are delayed until a later date and either the insurance company invests them (fixed or indexed annuities) or you invest them in the annuity’s available investment options (variable annuities).
What are the different payout options available?
If you decide to annuitize, or turn your assets into guaranteed income payments, you typically have choices:
- Income for life — You’ll receive guaranteed income payments for as long as you live, no matter how long that is.
- Income for two lives — You and your spouse can receive guaranteed income payments for as long as both of you live.
- Income for a specific period of time — You can choose from income payments for time periods such as 10, 15, or 20 years.
- Income for a specific period of time, with a guaranteed amount of time — You can choose a time period for which to receive income, but if you die before that time period is up, your beneficiary can receive the remaining payments.
In most cases, once your specific time period is over or you pass away, the payments will stop. However, if your annuity comes with a death benefit, or you purchase one with the annuity, your named beneficiary will receive the amount specified — typically the amount of your purchase payments.
Please note: In all cases, you will need to be at least age 59 ½ before you start taking income payments from your annuity. Otherwise, you will pay an additional IRS tax penalty on top of the taxes you’ll owe on investment gains.
Tax-deferred earnings
Similar to tax-advantaged accounts like a 401(k) or individual retirement account (IRA), annuities offer tax deferred growth, meaning taxes aren’t paid on any investment gain in an annuity until they are withdrawn. However, unlike those other retirement vehicles, there is no cap on the amount you can invest in an annuity (subject to potential maximums from the insurance company the annuity is purchased from). You can either fund your annuity with pre-tax money or after-tax money. Either way, you receive the benefits of tax deferral and compounding interest over time.
Access to your money
Nearly all annuities allow you to withdraw money — up to 10% of the amount or earnings on the contract (whichever is greater) — during the first few years of the contract, which is known as the surrender period. This surrender period varies by company and contract, so be sure to ask your financial professional for specifics. Some annuities even give you immediate access to your funds or allow you to choose the level of access for an additional cost. This includes providing for withdrawals without surrender charges if an unexpected event occurs such as a loved one needing long-term care.
Keep in mind that annuities are designed as tax-deferred, long-term products for retirement. So if it’s likely you will need access to your money right away or will need more than 10% of your money each year, an annuity might not be right for you. And it’s generally not wise to invest all of your money in an annuity; only invest the portion you need to help meet your overall objectives.
Conclusion
While annuities aren’t for everyone, they can be one way to accumulate assets for retirement and/or generate retirement income that is protected and could last as long as you live.