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When you think of life insurance, you probably think about how it can help protect your family if you were to pass away. But what about living longer than you expect? Will you outlive your savings?
Understanding "annuities 101" — the types, tax advantages, payouts and structure — can help you feel confident in preparing for your retirement needs. There may be many variables involved, but a good foundation of knowledge will help you make the best choice.
What Is an Annuity?
An annuity is a contract between you and an insurance company that allows you to contribute money in a tax-deferred account. In return, you can get regular payments as income — or you can withdraw those funds when you need them at a later date.
Many people choose annuities as a way to get guaranteed income in retirement that is tax-deferred. Let's examine the various types of annuities — and review the tax advantages, payouts and structure.
What Are the Different Types of Annuities?
There are two main types of annuities: immediate and deferred.
An immediate annuity starts paying income soon after the account is activated. In order to determine the payment amount, you must decide whether you want to receive the income over your lifetime or a certain number of years.
A deferred annuity starts with an accumulation phase. You contribute funds and the annuity grows tax-deferred. Then, during the payout period — which is delayed from when the annuity is first opened — you will receive a regular stream of income or a lump sum.
Single & Multiple Premium Annuities
There are also single- and multiple-premium annuities. With a single-premium annuity, you pay a single lump sum at the start, and that sum then grows. With a multiple-premium annuity, however, you can spread out your premium payments over time.
Are There Other Annuity Categories?
Annuities are also categorized by risk and how they generate earnings. So, here are two additional components to consider with annuities: fixed and variable.
Fixed annuities guarantee growth based on a minimum interest rate for the life of the annuity.
With that in mind, the insurance company may periodically increase or decrease the rate based on the market for a specified time period — though it would not go below the guaranteed minimum interest rate. Fixed annuities can be good for those who want to minimize risk and want a guaranteed payout.
A variable annuity, on the other hand, lets you choose one or more investment options, called subaccounts, to potentially grow your funds. There is a greater possibility for growth as you can invest in stocks, bonds and mutual funds within the subaccounts. This comes with an investment risk of loss of both the principal and earnings. Additionally, you can usually choose from moderate to aggressive growth options — or a combination of these.
What Are Possible Tax Advantages of Annuities?
One reason annuities are included as a possible financial option is to provide tax advantages. The money you contribute to the annuity grows tax-deferred. Also, annuities have compound growth, meaning all funds in the account continue to earn interest — even interest on interest already paid. That sum of money grows faster when it's tax-deferred because there's more money to grow. The taxes are then paid on earnings (not the principal) during the payout period.
There are other tax advantages to non-qualified annuities. There's no mandate for you to withdraw money from your annuity at a certain age — so the funds can continue to grow tax-deferred. You can also decide the amount and timing of the payments you take for tax purposes.
MORE: How Are Annuities Taxed?
How Do Annuity Payouts Work?
Now, annuities offer some flexibility for payout. Often an annuity is "annuitized," which means that the annuity is converted into regular payments. This could be for a specific time period — like 10 years — or it could be paid out over your lifetime. Some annuities can also continue paying out funds to a surviving beneficiary.
Another way to get funds from an annuity is via withdrawals. These are lump-sum payments made at your discretion.
Keep in mind, however, that pre-tax payments and annuity earnings are subject to income tax upon withdrawal, and withdrawing funds before the age of 59 1/2 generally incurs a 10 percent penalty tax from the Internal Revenue Service.
What Is the Annuity Structure?
The payouts and recipients of the income are part of something known as the annuity structure. First, the owner enters into a contract with the insurance company for the annuity. The owner can then choose to be the recipient of the income (known as the annuitant) or they can designate someone else to receive that income. The owner can also decide if there will be someone to receive the subsequent income once the annuitant dies (known as an annuitant beneficiary).
Annuities can be complicated or simple, depending on the products you choose and the goals you're working toward. Understanding common annuity terms can help you make educated decisions about your finances.
To help you sort through the differences, here's an annuity glossary with some of the essential terms you should know. If there are any annuity terms you don't understand, consider speaking with your financial representative.
Deferred annuities allow you to keep your money in an annuity contract. You can often let the money sit to potentially earn interest for many years until you're ready to start drawing income or taking withdrawals.
A fixed annuity is perhaps the easiest type of annuity to understand. You place money into the contract, and the insurance company pays you interest at a fixed, guaranteed rate.
Variable annuities fluctuate with value gains and losses in financial markets. The earnings you receive from your variable annuity will depend on how those investments perform, and it is possible to lose money if the investments decrease in value. You can often choose investments within the contract.
An indexed annuity typically offers a guarantee on your investment along with potential market index. For example, some contracts prevent you from losing money while providing growth potential through a market index such as the S&P 500. If the index performs well during specific periods, you might benefit from those gains to a limited degree and earn slightly more in your annuity.
With a single-premium annuity, you only make one premium payment into the contract. For example, when you purchase an immediate annuity, you pay a lump sum and begin taking income.
With flexible-premium contracts, you can add funds to your annuity multiple times. For example, you might establish monthly premium payments, or you might pay a lump sum at the end of every year (or whenever you choose). The more you put in, the more you'll potentially have later, depending on the gains or losses in your contract.
A rider is an optional feature that you can add to an annuity contract. Riders might provide growth guarantees, income guarantees, enhanced death benefits or other features. Not all annuities have riders, and those features typically come with additional costs, so consider speaking with a financial representative to determine which riders might make sense for you.
When you annuitize, you convert assets in your annuity contract into a stream of regular payments. This could be for a specific time period or it could be paid out over your lifetime.
If you're concerned about dying shortly after annuitizing, you can select a period certain. During that period, the insurance company pays you or your beneficiaries, regardless of when you die.
For example, you might choose a 10-year period certain. If you die in the year following annuitization, your beneficiaries continue to receive payments for nine more years.
During the payout phase, an annuity contract pays income monthly, annually or on any other schedule available in the contract. Payments might last for your lifetime or for a specified number of years.
With variable annuities, a subaccount is an investment option available in the contract. Those options may have different risk and return characteristics, allowing you to choose an investment strategy that fits your needs and goals.
A surrender charge is a fee that insurance companies charge to discourage you from taking withdrawals shortly after purchasing certain types of annuities. The amount you pay is typically a percentage of your withdrawal, and surrender charges often decline over time until they're completely eliminated.
The surrender period is a specified number of years, and if you withdraw too much from an annuity contract during this time period, you must pay a surrender charge. Not all annuities have surrender periods, and they may be four years, 10 years or another term.