Annuity Basics
What Is an Annuity?
An annuity is a financial contract between an individual annuitant and an insurance company that involves an upfront payment by the annuitant in exchange for income from the insurer. The size, timing, variability and duration of the income distributions depend on the structure of the contract.
How Do Annuities Work?
Annuities work by converting a lump sum payment into a series of immediate or deferred income distributions. If the income distributions are deferred, the annuity undergoes an accumulation phase before converting into income. What happens during the accumulation phase depends on the type of annuity you purchase.
How Are Annuity Rates Set?
Annuity rates vary from issuer to issuer, but generally they reflect the current interest rate environment, the annuitant’s life expectancy and any customized features of the contract, such as a cost-of-living adjustment or enhanced death benefit.
How Much Income Does an Annuity Pay Out, on Average?
A $300,000 immediate life annuity could pay approximately $1,834 a month or $22,008 a year for a 65-year-old woman. An annuity payout depends on several factors, including the amount of your investment, your age and life expectancy, the structure of the annuity and any features incorporated into the contract.
Generally, the younger you are and the longer your life expectancy, the higher the payout you can expect. Additionally, riders generally diminish payouts in exchange for the protections they offer.
What Are the Pros and Cons of Annuities?
The main pros of annuities are their tax-deferred growth, guaranteed income and reliable returns. The biggest drawbacks of annuities include limited liquidity, complex contracts, modest returns and potentially high fees.
What Are the Most Popular Types of Annuities?
The most popular types of annuities include immediate annuities, fixed annuities, fixed index annuities and variable annuities.
Popular Annuity Options
- Immediate annuities do not go through an accumulation period like other annuities do. Instead, these products immediately convert the premium to a stream of income.
- Fixed annuities offer a guaranteed rate of interest for a set period. They are extremely safe and have highly predictable, but modest, income streams.
- Fixed index annuities offer higher return potential than fixed annuities because they credit interest based on a market index, such as the S&P 500. They do not participate directly in the stock market, but they offer annuitants upside potential and downside protection via a guaranteed minimum rate of return.
- Variable annuities offer higher return potential than fixed index annuities, but they are exposed to downside risk. These vehicles comprise a portfolio of underlying investments and can exhibit a high degree of volatility.
What Happens to My Annuity When I Die?
When the annuity owner dies, the contract pays a death benefit to the named beneficiary. The ability to name beneficiaries so that the inherited annuity doesn’t have to go through probate is a key benefit for many annuity customers. If an annuity doesn’t have a death benefit, all remaining assets are surrendered to the issuing insurance company upon the annuitant’s death.
Buying an Annuity
Is an Annuity a Good Investment?
An annuity can be a good investment for a conservative investor with a relatively short time horizon, minimal appetite for market volatility and the desire for a hands-off, guaranteed stream of income.
However, it can be a bad investment for a growth-minded investor with a long time horizon, money to endure near-term market volatility and the ability to generate income from other types of investments.
When Should I Buy an Annuity?
Generally, the ideal time to buy an annuity is in your 50s or 60s. At this age, it’s essential to determine how you’ll generate income to cover your living expenses when you stop working. For a conservative, hands-off investor, an annuity can be an efficient, low-risk way to fund your retirement needs. In some cases, an annuity can serve as a prudent complement to other investments.
Who Issues Annuities?
Insurance companies issue annuities but do not directly sell most contracts to consumers. The majority of annuities are sold via intermediaries, such as distributors, brokerage firms, banks, mutual fund companies and independent agents. These intermediaries conduct most of the interaction with consumers, but the insurance company backs the annuity.
What Are the Best Companies That Sell Annuities?
The best annuity issuers have well-established track records of servicing their annuity contracts and insurance policies. Their financial strength is signified by an A.M. Best Company Financial Strength Rating of at least “A-: Excellent.”
Annuity.org’s picks for the top providers in 2024 include Lincoln Financial Group, Nationwide, MassMutual, F&G and Allianz.
Is My Annuity Guaranteed?
Annuities are insurance products backed by insurance companies. However, an annuity is not insured in a literal sense. The financial strength of the issuing company backs it. In the event of a default, state guaranty associations offer additional protection, usually up to $250,000 of an annuity’s value. You should strive to buy annuities from insurance companies that are in excellent financial condition.
How Soon Can I Withdraw From My Annuity Savings?
Annuity owners can begin withdrawing money from their annuity by the age of 59 ½ without having to pay an early withdrawal fee. Some annuity contracts contain a surrender period, which is the amount of time an investor has to wait before withdrawing funds from their annuity account. If they withdraw money before that time, the insurer levies a surrender charge.
Is There a Minimum Amount Required To Purchase an Annuity?
Most annuity companies require a minimum premium amount to purchase an annuity. However, some flexible premium annuities may allow you to make multiple premium payments during the annuity’s term.
Can I Cancel My Annuity?
You can cancel an annuity contract with no penalties during the free look period, which is usually 30 days but varies by state. After the free look period, surrendering your annuity will be subject to a surrender charge, usually expressed as a percentage of your annuity’s value.
Worried About Your Retirement Savings?
Annuity Taxes and Fees
How Are Annuities Taxed?
Annuities are tax-deferred products, meaning the growth on an annuity contract is not taxed until withdrawals begin. How the principal of the annuity is taxed depends on whether it was purchased with before-tax money, such as money from a qualified retirement account like a 401(k) or after-tax money.
What Is the Difference Between a Qualified and Non-Qualified Annuity?
A qualified annuity is purchased with pre-tax dollars, usually funds from a retirement plan like a 401(k) or IRA. A non-qualified annuity involves a purchase with after-tax dollars. When you receive a distribution from a qualified annuity, the entire amount, both principal and earnings, is subject to ordinary income tax. With a non-qualified annuity, because you have already paid tax on the money used to make the purchase, only the earnings are taxable.
Are There Any Fees Associated With Purchasing an Annuity?
There may be fees associated with purchasing an annuity, depending on the type of annuity you buy. Variable annuities typically come with the most fees.
Common Variable Annuity Fees
- Mortality and expense (M&E) fees are levied to support the insurance guarantees and selling expenses of the insurance company.
- Administrative fees are levied to cover ongoing servicing of the annuity contract.
- Investment management fees cover the costs of managing an annuity’s underlying assets.
Nearly all annuities come with a surrender charge that the insurer levies if the annuity owner tries to withdraw their premium before the annuity’s surrender term is up.
Will a Beneficiary Have To Pay Taxes on the Annuity?
Yes, annuity payments disbursed to a spouse or beneficiary will be treated as taxable income.
What Is the Exclusion Ratio?
The exclusion ratio is a percentage that represents the portion of a non-qualified annuity distribution that is excluded from gross income and, therefore, not subject to ordinary income tax. It exists because a portion of each non-qualified distribution is a return of your principal (which has already been taxed) and a portion is interest income (which has never been taxed).
