Trying to decide whether an annuity could fit into your financial plan? Understanding the different available annuity options can be a helpful way to start. But it can also be helpful to keep in mind that while each variety of annuity operates somewhat differently, their basic functions are the same.
The Basics of Annuities Explained
An annuity is a contract between you and an insurance company. In exchange for the initial or ongoing premium payment, the insurance company commits to certain terms agreed upon in the contract.
The simplest of these agreements is the insurer's commitment to providing you with payments, which can be structured on a monthly, quarterly, semi-annual or annual basis. You can choose to forego payments and allow the annuity to grow tax-deferred, or leave a lump sum to a beneficiary.
Depending on the type of annuity, there might also be optional features available, such as a death benefit or long-term care. These provisions typically have added fees and costs.
4 Types of Annuities Explained
Here are the ins and outs when it comes to figuring out your annuity options.
1. Immediate Annuities
Immediate annuities offer a guaranteed payment that can be structured for the rest of your life. They might even refund any leftover payments that haven't been made in the event of premature death.
With immediate annuities, there are different types of payment options. For instance, a life payout offers a payment for your lifetime. Period certain annuities are just as their name implies — a payout for a set amount of years (e.g., 10 or 20 years). There's sometimes a refund option, a feature that will pay your beneficiaries any leftover that hasn't been paid from the initial premium.
Immediate annuities usually offer the highest payments compared to other annuities and can help address an immediate income need. However, there's always the chance they may not keep up with inflation, or that the annuity's beneficiary may not receive the remaining balance if the owner chooses the life payout option and then passes away prematurely. You would also have less control than with other annuity types, as these cannot be surrendered.
2. Fixed Annuities
Fixed annuities offer a fixed interest rate over a set period of years. Interest earned is compounded and can be deferred or withdrawn after the contract is annuitized (or possibly during the contract, depending on the insurance company).
Fixed annuities are a little more flexible for you, as you can choose to take a shorter- or longer-term contract. Once the annuity contract is initiated, the insurance company cannot modify its interest. However, the interest rates offered may not keep up with inflation, and you are committed to them for the set period regardless of economic fluctuations. Still, these can also offer a fairly regular rate of return for those who would prefer less uncertainty. It's important to note that you'll have to pay surrender charges if the annuity contract is terminated within the surrender charge period.You'll also have to pay a 10 percent early-withdrawal penalty if you're under age 59 1/2.
3. Variable Annuities
Variable annuities are long-term investments designed for retirement purposes. They have the potential to see the greatest appreciation of earnings because they're invested in portfolios or investment options linked to the market. Depending on the performance of the annuity's subaccount options, you might receive a higher payout as a result of that market exposure. That is because you're also risking the contributed balance, so there's also a chance of loss.
With a variable annuity, you receive all of the interest credited from the invested subaccount. Payouts can be structured similarly to an immediate annuity without annuitization (converting the annuity directly into a series of payouts). There are fees (e.g., mortality and expense, administrative, subaccounts and annual service charges), though, and you'll pay surrender charges if the contract is terminated within the surrender charge period. The same early-withdrawal penalties as a fixed annuity also apply.
4. Fixed Indexed Annuities
Fixed-indexed annuities (once known as equity-indexed annuities) credit interest based on the performance of a particular stock market index — though they don't actually participate in the stock market. The minimum these will typically credit is 0 percent, since the principal is not directly exposed to the market.
Payouts can be structured similarly to an immediate annuity without annuitization, and interest depends on the terms of your contract and the index in which the money is tied to. You may not receive all of the potential stock market index returns, however. Surrender charges and early-withdrawal fees may apply.
Annuities & Your Needs
Normally, annuities are positioned as a solution to a particular dilemma, such as helping to reduce Social Security taxation, helping to decrease Medicare Part B premiums and potentially staying in a lower tax bracket. For younger people, a benefit of annuities is that they offer a way to start preparing for retirement early on.
Although annuities can be a useful planning tool, you don't have to make them your only financial solution. In order to make an informed decision, consider evaluating the different annuity options with a qualified financial representative.