What Is an Annuity? An “instant annuity” denotes that payments begin immediately, whereas a “delayed annuity” suggests that payments begin in the future. An annuity is a contract where an insurance company commits to pay the annuity holder, either in a lump sum or through regular payments over time.
Definition and Examples of Annuities
Retirement plans called annuities are given unique tax treatment. Prior to the owner taking withdrawals or annuitizing the money, premiums paid into an annuity grow tax deferred. They also fall under the category of insurance products where the insurer agrees to pay the buyer either right away or at a later period.
Depending on how quickly you want to receive them, you can buy them with either a single premium payment or a series of premium payments income, which are available in two types: deferred and immediate.
Deferred annuities: There are two phases to this kind of annuity: accumulation and income. You contribute money to the annuity during the accumulation phase, and it grows tax-deferred. You have the choice to “annuitize” those funds during the income phase, which entails converting the lump-sum value of the annuity into a continuous stream of assured payments, such as lifelong income, or to make withdrawals without annuitizing. You still have access to the lump sum value through withdrawals.
Immediate annuities: In exchange for a lump sum payment that is no longer accessible, immediate annuities start paying an income soon after the premium is paid.
If annuitized, the income received is determined by the owner’s choice of the annuitant’s age, sex, and duration of payments. The annuitant and the owner can be the same person, but they don’t have to be.
Annuities can be qualified or non-qualified in addition to being either delayed or immediate. A pension plan or an IRA may contain qualified annuities. They are bought with pre-tax money and are subject to any restrictions those plans impose. Non-qualified annuities do not have contribution caps and are paid for with after-tax money.
Surrender Period
A significant surrender fee may apply if you cash in or cancel your delayed annuity within its surrender period, which is typically the first five to 10 years. Over time, this charge decreases and eventually vanishes after the surrender period is over.
Only licensed life insurance brokers may sell annuities. Before you make an investment, make sure your agent or advisor is registered with the insurance authority in your state. You ought to also be aware that sellers of most annuity products earn a commission for selling them.
Types of Annuities
Annuities are available in three investment styles.
Fixed
For a certain period of time, ranging from one year to the duration of the annuity policy, fixed annuities pay an interest rate that is guaranteed. The insurance company guarantees the annuity’s account value. The insurance firm invests the premiums in a portfolio of bonds and other investments in its general account. Fixed instant annuities provide the owner with a fixed income. Surrender penalties and optional rider fees are typically the only costs associated with fixed annuities. There may also be an annual contract fee, which is normally approximately $30.
Variable
Sub-accounts are a selection of investments offered by variable annuities that resemble mutual funds. The policy values are not guaranteed and instead reflect the performance of the funds. Instantaneous variable annuities pay income to the owner that rises and falls with the value of the funds.
Variable annuity fees and costs often include surrender fees, mortality and expense charges, fund management fees, administration fees, and optional rider charges. Fees and costs for variable annuities might range from 2% to higher.
Indexed
Indexed annuities offer a variety of financial indexes to choose from, such as the Russell 1000 or the S&P 500. The index’s performance serves as a gauge for the annuity’s account value. A part of the gain is credited to the account if the index is positive. If the index is down, there are no losses because the account value stays the same. The premiums are invested in the general account of the insurance company, not indexed mutual funds, even if the performance of the account is determined by the index used.
While still providing guarantees, index annuities might provide investors with more upside potential than fixed annuities. However, determining how the gain is credited can be challenging. For instance, common methods of limiting gains include caps, participation rates, threshold rates, and spread rates. These methods are frequently combined.
Surrender and optional rider charges are typically the only fees and costs associated with indexed annuities. There are no indexed instant annuities on the market right now.
Annuities & Riders
The optional extras that the insurance provider charges extra for are known as riders. Typical riders include:
Guaranteed Minimum Income Benefit (GMIB)
The GMIB rider, rather than using the general account value, provides a minimum guaranteed lifelong income at retirement based on a GMIB amount. Based on the initial investment amassed at the policy’s set interest rate, the minimum income is calculated. Like annuitization, once the option is selected the owner has no access to policy values. The GMIB can be based on one or two people.
Guaranteed Minimum Accumulation Benefit (GMAB)
In addition, the GMAB rider ensures a minimum account value regardless of investment results. The rider promises that after a holding term, such as 5-10 years, you can receive a portion of your premium payments, such as 90% or 100%.
Enhanced Death Benefits
The account value serves as the death benefit for ordinary annuities. Although some life insurance firms offer death benefits that step up or grow depending on a formula, the typical death benefit is free of charge. For instance, the rider might allow you to recurringly “lock in” investment performance or promise a death payout equal to the amount of your account plus a minimum rate of return.
What Does It Mean to Annuitize?
In exchange for a premium (which might be your contract value in some cases), the insurance provider agrees to give you an income when you annuitize the case of a deferred annuity). Once you pay the premium, you have no access to the money. Common annuitization options include:
Life Only
The insurance provider commits to providing lifetime income. When an annuitant dies, the payments cease; beneficiaries are not paid.
Period Certain and Life
The insurance provider agrees to provide income for a minimum of years or for the duration of life, whichever is longer. A 10-year life annuity period ensures that the insurance provider will provide income for at least 10 years. If you live for more than 10 years, it will provide your regular income for life; but, if you pass away within the first 10 years, your beneficiary will continue to receive payments for the remaining 10 years.
Joint And Survivor
The beneficiary of the account and the account holder both receive lifelong payments from the insurance provider. When the final living annuitant passes away, the income ceases. Since the payments to the survivor are an added benefit, the typical payment amount is lower than that from a life-only annuity.
Although annuitization rates differ by the insurance company and are frequently updated. Here is an illustration of what a couple in their 65s could purchase with their lifetime salary of $200,000 each month.
| Male Aged 65 | Female Aged 65 | Both | |
| Life Only | $ 694 | $ 652 | — |
| 10 Year Certain And Life | $ 682 | $ 644 | — |
| Joint & Survivor Life Only | — | — | $ 558 |
Other guaranteed income choices known as living benefit riders are offered by several indexed and variable annuities; some of them do not need principal forfeiture.
Do I Need an Annuity?
The typical American will live in retirement for 20 years. In actuality, retirees’ biggest worry is running out of money. A lifetime income can be ensured by a delayed or immediate annuity regardless of interest rates or market conditions.
Deferred annuities often work best for those between the ages of 40 and 65 who have a sufficient amount of liquid assets to handle any unexpected costs or emergencies. Here are a few examples you can use them.
Supplement Retirement Savings
A deferred annuity can be a smart choice due to the advantageous tax treatment if you are contributing the maximum amount to your employer-sponsored retirement plan or IRA (the account values of annuities grow tax-deferred). There are inexpensive annuities on the market that are only intended for accumulation.
Downside Protection
The downside protection features of indexed annuities or variable annuities may be alluring to some investors. A variety of living benefit riders are available with variable and indexed annuities to shield principal and retirement income from declining markets. Additionally, death benefit riders might safeguard the annuity’s value for the beneficiaries.
Lifetime Retirement Income
The only three sources of lifetime income that is guaranteed are pensions, social security, and annuities. If you are worried that you could run out of money later in retirement, annuities can provide a foundation for income. You can use your IRA or in some cases 401k to fund the annuity, as well as non-qualified money.
Estate Planning
Annuity death benefits bypass probate and are paid straight to the designated beneficiary. Some annuities come with increased death benefit riders that give the beneficiary extra security. Investors who are unable to purchase life insurance may find enhanced death benefits to be an appealing alternative.
Alternatives to Annuities
Although they are long-term investments and may have high fees and surrender penalties, annuities can be incredibly efficient financial tools. An annuity might not be the best option for you if you require the funds before the surrender penalties expire or if you don’t require the insurance features.
You can invest in mutual funds, stocks, bonds, CDs, and other financial instruments through qualifying retirement plans including Individual Retirement Accounts (IRAs), 401(k), and 403(b) plans, as well as through personal brokerage accounts. Everyone has different tax treatment, benefits, and limitations.
| Traditional 401(k), 403(b) | Traditional IRA | Roth 401(k) 403(b), IRA | Non-Qualified Annuity | Personal Savings Accounts | |
| Investment Menu | Stock market investments limited by the employer’s plan, but often many options are available. | Stock market investments. Life insurance, collectibles, and certain derivatives are prohibited. | Same as traditional | Mutual funds, indexes, fixed interest rate | Unlimited |
| Contributions Taxable | No | No | Yes | Yes | Yes |
| Contributions Limited | Yes | Yes | Yes | No | No |
| Tax on gains, interest, dividends | No | No | No | No | Yes |
| Withdrawals taxable | 100% at ordinary rates | 100% at ordinary rates | No | Gains are taxed at ordinary rates. No tax on the withdrawal of principal | No |
| Early withdrawal penalties | Yes | Yes | Yes, once withdrawals exceed contributions | Yes | No |
| Creditor Protection | Federal | Federal up to 1 million | Same as traditional | By State | No |
Other retirement vehicles lack several features that annuities have: In addition to offering lifetime income, indexed and variable annuities can shield savings against market declines. They might also be more expensive as a result of these factors. Before making a purchase, don’t be afraid to ask your financial advisor or insurance agent any questions if you believe an annuity might be a good fit for your savings or income goals. Additionally, make sure you are aware of the total annual cost of your policy, as well as the individual costs and added protection offered by any riders you are thinking about purchasing.
Check Also:
What Are the Different Types of Term Life Insurance?
What Is Term Life Insurance?
