How Do Annuities Work?

Annuities are secure financial tools used to help accumulate income and interest, tax-free, over a period of time. There are a number or annuity types, customizable depending on the financial need.

What is the Purpose of an Annuity?

Providing a secure financial future means more than saving enough money to build up your 401(k). Often, people choose to invest in other financial options to secure their family’s financial future, pay off excess debt and provide for loved ones long after their death. A common investment tool to aid in these endeavors in an annuity.

An annuity is a financial contract between you — the investor — and an insurance company, and is designed to help accumulate assets as an additional form of income. This long-term investment provides ongoing income payments for a fixed period of time or until your death, in exchange for a large lump sum or periodic premium payments.

Contracts can be customizable depending on you or your family’s financial needs.

An annuity is an ideal financial vehicle for individuals looking to build upon their retirement plan, save for tuition, pay for medical expense or alleviate ongoing debt. Annuities are unique in the sense that they accrue interest on the contributed investment tax free.

Comparing Types of Annuities

There are a wide variety of annuity options available, differing by payout options, benefits and how payments will start. Some of the more common types are immediate, deferred, fixed and variable annuities.

Immediate Annuity

An immediate annuity, also referred to as a single premium income annuity (SPIA), is a financial contract designed to provide steady income payments over a period of time.

This financial option is ideal for individuals close to retirement because payments are disbursed immediately or within a year of purchasing the contract. For example, if John is nearing retirement within the next year or few months, he may choose to invest in an immediate annuity. John will pay the lump sum value up front, and in exchange will begin receiving periodic payments for a set amount of years or until his death. Payments should begin disbursing within the same year of the annuity transaction.

Unlike many annuity types, immediate annuities do not require any miscellaneous maintenance or management fees.

Prior to being disbursed, immediate annuity payments grow tax-deferred, allowing interest to accrue over time. Annuity contracts include an accumulation stage, allowing annuity owners to gradually build up the cash value of their investment through periodic payments. An immediate annuity contract skips this stage because it is paid with a lump sum.

Deferred Annuity

Unlike an immediate annuity, deferred annuities are not disbursed until later in life. This annuity type is a customizable investment, allowing annuitants to choose when their payments are disbursed and how they are received. In a similar example, Jane wants to invest in her retirement early. She chooses to invest in a deferred annuity, customizing her contract terms to disburse periodic income payments after 15 years. If Jane is 45 prior to purchasing a deferred annuity, her payments will begin disbursing when she reaches the age of 60.

Deferred annuities include an accumulation phase and an income phase. Within the accumulation stage, annuity premiums are paid through a one-time lump sum or a series of payments, allowing the invested assets to accrue interest over time. The income phase allows the annuity owners to choose how and when they receive their income payments.

Assets are disbursed once an annuitant reaches the age of 59 ½, but they can access their funds through annual withdrawals.

Insurance companies allow investors to withdraw funds not exceeding 10 percent of the annuity account value. However, if an annuitant withdraws funds before the age of 59 ½, they may be subject to paying a 10 percent penalty to the IRS in addition to other income taxes.

Fixed Annuity

Jane is still paying premiums on her annuity, though she has less than 5 years to begin receiving payments. She is now 56 years old. Recently, an immediate family member has been diagnosed with a chronic illness, and Jane will have to help pay for the medical expenses. She wants to withdraw funds early from her annuity accounts, but has been approached with expensive surrender fees since she is four years shy of receiving monthly payments. Why is that?

A fixed annuity is a financial vehicle that will pay a guaranteed rate of interest. Though the interest and principal are guaranteed, early withdrawals will subject to high surrender charges, specifically if funds are withdrawn before the age of 59 ½.

Fixed annuity type contracts provide a number of payout frequency options in exchange for a lump sum or periodic premium payments. Some of the major payout options include:

  • Straight Life – Electing a straight life fixed annuity guarantees an annuitant receives a fixed amount of income until their death. At the point, all payments stop even if the payout does not amount to the initial investment value.
  • Joint Life – Similar to the straight life option, a joint life fixed annuity guarantees a consistent payout stream until the annuitant or their spouse dies.
  • Systematic Withdrawal – This payout option ensures an annuitant receives a fixed percentage or amount of the account value every year.
  • Lump Sum – A lump sum payout disburses an annuity in one large payment as cash, or allows you to transfer the money into another annuity account.

Variable Annuity

Unlike a fixed annuity, variable annuities are financial options that provide the opportunity to invest in subaccounts and generate a higher rate of return. They do not guarantee a fixed interest rate or consistent monetary amount. While a variable annuity guarantees an income stream, the amount will differ depending on the performance of subaccounts. For example, after investing in a variable annuity with a monthly payout of $5000, John may receive an added $300 or more a month if the subaccounts perform well.

Monetary contributions still grow tax-deferred, and this contract guarantees a death benefit in the event an annuitant dies before all assets have been disbursed. No matter how the invested subaccounts perform, variable annuities will ensure beneficiaries receive no less than the initial investment amount.

Annuity Pros and Cons

Though each annuity option offers a different set of benefits, they all share some of the same majors advantages and drawbacks. Some of the major benefits of investing in an annuity include:

  • Consistent Income – Annuities guarantee a stream of income payments over a long-term period, specifically if you elect a periodic payment method. In some cases, annuitants can customize their contract to provide ongoing payments until their death versus fixed term.
  • Tax-Deferred Status – Contributions to an annuity contract grow tax-deferred until payments are disbursed. This allows for all assets to accrue interest, and may significantly add to the investment value over time.
  • Asset Protection – Annuity owners can expect to receive payments equal to the initial value of their investment, no matter how assets are invested. This is specifically true for variable annuities. Within this option, assets are invested in subaccounts and can affect the consistency of the payout amount. If the accounts perform poorly, owners risk losing a portion of their investment. But if accounts perform well, they can expect a higher rate of return.
  • Death Benefit – In the event an annuity owner dies before the end of their contract term or before all assets have been disbursed, they can elect to include a death benefit in their contract. This added benefit ensures that all remaining assets transfer to a spouse or beneficiary. Without a death benefit, funds will be forfeited to the issuing insurance company.

As with any investment, annuities carry a set of drawbacks. Some cons of investing in this financial tool include:

  • Fees – Many annuity investments charge annual fees for maintenance and management. Other fees include commission, mortality and expense (M&E) and administrative fees.
  • Inflexibility – Though annuity contract provide consistent income, they can be difficult to change at the last minute. In the event of a financial emergency or unexpected debt, insurance companies may not allow you to change your contract terms to receive a higher payout or a lump sum.
  • Surrender Charges – In the event an annuity owner needs to withdraw from their annuity account before the disbursement period, they will be subject to paying surrender charges. This is especially true if an annuity owner has not reached the age of 59 ½, at which they will be subject to paying a 10 percent penalty fee to the IRS.

Annuity Payouts

Annuity investments offer flexible payout options. Upon settling the terms of an annuity contract, owners can choose the frequency of payments, the amount disbursed and how the payment is received.

The two most common payout options include the lump sum payout option and periodic payments. With a lump sum payment, annuitants can liquidate their assets for a one-time cash payment. While this option provides complete flexibility over annuity savings, it may incur a larger amount of taxes. Lump sum annuity interest will be taxed as ordinary income, and annuitants will be required to pay a larger sum of taxes all at once within the year of disbursement.

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A periodic payment guarantees a steady stream of income over a set period of time, or until an annuitant’s death. This payout option also allows assets to accrue more interest within the accumulation stage, providing more money over time. Owners can also choose to have payments transfer to a spouse in order to provide income for life. Periodic payments grow tax-deferred, but are taxed with every withdrawal or disbursement.

How Do Annuities Work at Death?

In the event an annuitant dies before the end of the annuity contract, remaining assets will be surrendered to the issuing insurance company if the annuity contract does not include a death benefit. This option ensures that a spouse or surviving beneficiary receives all remaining payments until their death or the end of the contract term. A death benefit also requires the beneficiary to assume all responsibilities and tax liabilities of the annuity contract.

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