One of the most misunderstood financial products on the market today is the annuity. This guide will walk you through what annuities are, how they work, the different types of annuities, and how they're taxed. When you're finished reading this guide, you'll be much better prepared to decide if an annuity would be a good match for your financial situation
An annuity is a long-term investment product that is issued by an insurance company. It's designed to assist in protecting you from the risk of outliving your income. Unlike life insurance that pays out when you die, an annuity pays you while you live. Like life insurance, annuities can be structured to pay a beneficiary when you die. But, annuities are not insurance products.
When you annuitize (begin receiving payments after you've made a purchase payment(s)), you begin to receive periodic payments that can last for the remainder of your life. The payment amount depends on the sum you invest, the number of years you wish to receive payments, and the insurance company's interest rate calculation.
For example, according to the Bankrate Annuity Calculator, an annuity purchased for a lump-sum of $100,000 for a 30-year period in which you'd receive monthly payments, with an annual growth rate of 5%, would yield a monthly income to you of $534.59. You could choose a lifetime income option to guarantee you won't outlive the monthly withdrawal amount, which would lower the monthly payment you'd receive. If you decide to have a beneficiary receive a payment for the rest of their life, it would further reduce the monthly amount you'd receive.
You can receive payments monthly, quarterly, annually, or in a lump sum as an annuitant. Payments can start immediately or be postponed for years, even decades.
It can get a bit confusing when you are considering an annuity, and you see all of the different types you have to select from. Let's lessen that confusion by examining the five different types of annuities.
Fixed annuities are fixed interest rate investments that are issued by insurance companies. They pay guaranteed rates of interest that are typically higher than bank CDs. You can defer income or draw income immediately from a fixed annuity. These types of annuities are popular among retirees and pre-retirees that want a guaranteed, fixed investment.
Variable annuities allow you to choose from a variety of mutual funds (called subaccounts). These subaccounts' performance determines the account value, and a rider can be purchased to guarantee your income regardless of market performance. This can prove to be very beneficial if the market, and your subaccounts, underperform.
Variable annuities are not for the faint of heart. The stock and bond markets can be volatile, which means that you could see your principal rise and fall dramatically based on market performance. This can leave you open to having your monthly income fluctuate, which is not the ideal situation for retirees dependent upon their monthly payment to meet their monthly budgetary needs.
Indexed Annuities are essentially a fixed annuity with a variable rate of interest that is added to your account value if the underlying market index, such as the S&P 500, has positive growth. Typically, they offer you a guaranteed minimum income benefit, with the potential for principal and monthly payment amount growth, based on the market-based index's performance.
One of the drawbacks of an indexed annuity is that it never keeps pace with a robust market because of specific caps built into the contract. This is a trade-off for having the guaranteed minimum income benefit. For this reason, indexed annuities appeal mainly to retirees and pre-retirees that want to conservatively participate in stock and bond market appreciation with principal downside protection.
Immediate annuities pay regular income payments to an annuitant upon making a lump-sum payment to the insurance company. These income payments are made until death or for a specified period, typically beginning one to twelve months after receipt of the investment by the insurer.
An immediate annuity will typically pay you a larger amount than other annuities because they include both principal and interest, which offers favorable tax treatment. Immediate annuities are popular among those needing a higher than average income stream and are comfortable sacrificing principal in exchange for a higher income for the remainder of their life.
Deferred annuities provide delayed payments until a future date, which is greater than one year. With a deferred annuity, you'll begin receiving payments years or decades in the future while your premiums grow tax-deferred inside the annuity. Deferred annuities often are utilized to supplement individual retirement accounts and employer-sponsored retirement plans because IRS contribution limits do not pertain to most annuities.
Annuities are tax-deferred, meaning you don't pay taxes on your money until you withdraw it, not while it's in the annuity. Similar to a 401(k) or IRA, you'll only pay taxes on the money when you withdraw it.
With a "qualified annuity," your annuity is funded with pre-tax dollars, and all of your withdrawals are then taxed at your ordinary-income rate. However, if you funded your annuity with after-tax dollars, your annuity is then considered a "non-qualified annuity." Accordingly, you won't be taxed on the portion of your withdrawal that represents a return of the original principal you provided to the insurance company.
For non-qualified annuities, insurers use something called the "exclusion ratio" to determine how much of your withdrawal is principal and how much is interest. The ratio is designed to spread the principal amount paid to you out over your expected life expectancy. This determines what portion of your annuity payment is taxable.
Annuities aren't right for everyone. If you aren't worried about outliving your income, an annuity might not be for you.
But, if you are looking for the security of an income stream that you won’t outlive, or you want to provide financially for your spouse or heirs, you may find an annuity beneficial.
Putting all of your eggs in one basket is rarely a good idea financially. It's important to have enough money outside of your annuity to cover unanticipated expenses and a portion of your living expenses.
It's advisable to consult a financial advisor when deciding whether-or-not to buy an annuity. They'll help you understand what you're getting, particularly the insurance charges and fees, as well as the contract itself. They can help you shop multiple insurance companies, as well as help you find the best guarantees for your situation.
Jack Wolstenholm is the head of content at Breeze.
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