How Do Annuities Work?

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.

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.

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.

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.

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.

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.

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.

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.

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.

Though each annuity option offers a different set of benefits, they all share some of the same majors advantages and drawbacks.

As with any investment, annuities carry a set of drawbacks.

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.

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.

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.