Annuity Basics
What Is an Annuity?
An annuity is a financial contract between an individual — the annuitant — and an insurance company — the issuer. It can be structured in a lot of different ways with a variety of custom features, including death benefit payments and inflation protection.
Despite the range of structures, all annuities share a fundamental similarity. They involve an upfront payment by the annuitant in exchange for a series of income distributions from the issuer.
The size, timing, variability and duration of the income distributions depend on how the contract is structured. For many people, this is determined as part of their retirement plan.
How Do Annuities Work?
There are many different types of annuities. Fundamentally, all annuities work in a similar fashion. An annuity contract entails a lump-sum purchase in exchange for a series of immediate or deferred income distributions. The size, timing, variability and duration of the distributions depend on how the contract is structured, which should be aligned with your investment objectives and tolerance for risk.
How Are Annuity Rates Set?
Annuity rates vary from issuer to issuer, depending on the structure of the contract and the leniency of the issuer. So, an annuity rate is usually reflective of a few key factors, including the current interest rate environment, the life expectancy of the annuitant and the inclusion of customized features, such as inflationary adjustments, lifetime payments and death benefit payments.
How Much Income Does an Annuity Pay Out, on Average?
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, given the protections they offer.
What Are the Benefits of Annuities?
Annuities offer investors several worthwhile benefits.
- Tax-deferred growth
- Annuities facilitate tax-deferred growth, which can have a powerful compounding effect on your savings. But unlike 401(k) plans and individual retirement accounts, there are no contribution limits for annuities.
- Guaranteed stream of income
- Annuities provide a guaranteed stream of income, which is invaluable for retirees.
- Stability
- Annuities offer stability during turbulent economic periods. The downside protection is ideal for conservative investors that are unable to withstand market shocks.
3 Benefits Annuities Offer
In addition to these prominent benefits, some annuities offer the potential for joint life payments, death benefit payments and inflation protection.
What Are the Drawbacks of Annuities?
Annuities are very popular for conservative, hands-off investors, but they aren’t appropriate for everyone.
- They are complex
- Annuities are complex financial contracts with lots of intricate terms and conditions. This can be overwhelming for the average investor. You should consult with a fiduciary investment advisor before purchasing an annuity.
- They are illiquid
- Annuities are illiquid investments that often have lengthy accumulation periods before distributions begin. This is problematic for people with significant near-term cash needs.
- They have commissions and fees
- Some annuities have costly commissions and fees. Excessive charges can eat into your hard-earned savings and diminish your income stream.
- They offer modest returns
- Annuities offer modest returns, which are relatively low compared to stocks, real estate and higher-yielding bonds. This makes them an inferior option for investors with long time horizons; the opportunity cost is simply too great. Annuities are more appropriate for older investors and retirees, given the stability and guaranteed income they provide.
Potential Drawbacks of Annuities
What Are the Most Popular Types of Annuities?
There are many different types of annuities. The variations exist to fit the diverse needs of investors, especially retirees. At the highest level, annuities can be identified by the following three categories.
- Fixed annuities
- Offers a guaranteed rate of interest for a set period. They are extremely safe and have highly predictable, but modest, income streams.
- Fixed indexed annuities
- Offers investors 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
- Offers higher return potential than fixed indexed annuities, but they are exposed to downside risk. These vehicles are comprised of a portfolio of underlying investments, and they can exhibit a high degree of volatility.
Types of Annuities
Is an Annuity a Good Investment?
An annuity is not an inherently good or bad investment. It 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.
How Are Annuities Taxed?
The taxation of an annuity depends on whether it is a qualified annuity or a non-qualified annuity. A qualified annuity is a tax-deductible investment (made with pre-tax dollars), while a non-qualified annuity is an after-tax investment. Qualified annuities allow for a tax deduction in the year of purchase — non-qualified annuities do not provide for a tax break. The interest income earned by both types of annuities is allowed to grow on a tax-deferred basis.
What Happens to My Annuity When I Die?
An attractive feature of many annuities is the death benefit. Upon death, it allows an annuitant to transfer any remaining assets in an annuity to a spouse or surviving beneficiary. Without the death benefit, all remaining assets are surrendered to the issuing insurance company upon the annuitant’s death.
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Buying an Annuity
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?
Annuities are issued by insurance companies, but most contracts are not sold directly to consumers. Most 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.
Is My Annuity Guaranteed?
Annuities are insurance products backed by insurance companies. However, an annuity is not insured in a literal sense. It is backed by the financial strength of the issuing company. In the event of a default, state guaranty associations offer additional protection, but it may not be enough to make you whole. Therefore, you should strive to buy annuities from insurance companies that are in excellent financial condition.
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.”
The top providers include American Equity Investment Life Holding Company, American National Insurance Company, AIG Life, John Hancock, Lincoln Financial Group, MetLife, Midland National Life Insurance Company, Mutual of Omaha, Nationwide, New York Life, North American, Pacific Life, Prudential, and TIAA.
Why Invest in an Annuity vs. a Mutual Fund?
There are a number of factors to consider when deciding between an annuity and mutual fund. The top thing to consider is your investment horizon. Generally, the younger you are and the longer your horizon, the more risk you can tolerate. Conversely, the older you are and the shorter your horizon, the less risk you can tolerate.
Ultimately, this means younger investors should favor investing in assets with higher returns and greater growth potential, like stock mutual funds. On the other hand, older investors and retirees are more well-suited for annuities. Annuities’ long-term returns are very modest compared to stocks, but they offer stability and guaranteed income.
Why Invest in an Annuity vs. a Certificate of Deposit?
Annuities and certificates of deposit (CDs) are both relatively safe investment vehicles that offer guaranteed interest income over a specified period of time. However, CDs are better suited for short-term investors with a simplistic need for interest income. Annuities are better suited for long-term investors that seek tax advantages and customized features.
What’s the Difference Between Immediate and Deferred Annuities?
An immediate annuity contract disburses a stream of income payments within 12 months of the initial purchase, but, typically, within a month. Deferred annuities offer a guaranteed payout stream that begins after an accumulation period, which can span several years.
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Taxes and Fees
What’s the Difference Between a Qualified and Non-Qualified Annuity?
A qualified annuity allows for a tax-deductible purchase (with pre-tax dollars), while a non-qualified annuity involves a purchase with after-tax dollars. When you receive a distribution from a qualified annuity, the entire amount — principal and earnings — is subject to ordinary income tax. With a non-qualified annuity, since you already paid tax on the money used to make the purchase, only the earnings are taxable.
Another important distinction relates to the money used to purchase the annuity. A qualified annuity can only be purchased with money from another type of qualified vehicle, such as a traditional 401(k) plan or a traditional individual retirement account (IRA). An annuity purchased with non-qualified sources of money is automatically classified as non-qualified.
Are There Any Fees Associated With Purchasing an Annuity?
Different kinds of annuities charge different fees. Generally, the most common fees are as follows.
Common 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. They are largely associated with variable annuities.
- Surrender charges are another potential fee. They protect the insurance company against the risk of an annuitant making premature withdrawals. Oftentimes, surrender charges are costly, but they can be largely avoided by wisely planning prior to buying an annuity.
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.
How Soon Can I Withdraw From My Annuity Savings?
Annuity owners can begin withdrawing money from their annuity by the age of 59 1/2 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 his or her annuity account. If money is withdrawn before that time, a surrender charge is levied.
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).
Incidentally, the exclusion ratio is not applicable to a qualified annuity, because both the principal and interest income associated with this type of vehicle are fully taxable.
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