Table of Contents
Table of Contents
Annuities have unique features that can help you accomplish what other investment vehicles can't accommodate. Whether you're looking for lifetime income guarantees, additional tax deferral or other strategies, an annuity might be an appropriate tool for the job.
To learn more, get familiar with the types of annuities available — from a basic flexible premium deferred annuity to more complicated options — along with some of the most popular features. Once you understand the tax aspects, payout options and terminology, you can be more confident when evaluating how these contracts might work with your situation.
- There are various types of annuities, including immediate, deferred, single premium, and multiple premium annuities. These options cater to different objectives, such as replacing income after retirement, growing your investment over time, or converting a lump sum into a stream of guaranteed payments.
- Annuities can be categorized based on risk and how they generate earnings. Fixed annuities offer a guaranteed minimum interest rate, while variable annuities provide more direct access to markets with the potential for higher growth and increased risk.
- Annuities offer features not available from other investment vehicles, such as establishing a guaranteed income stream for life, tax-deferred growth, and the ability to choose your risk level.
- Annuities can provide tax benefits, such as tax-deferred growth and no mandatory withdrawal age for non-qualified annuities. However, taxes apply to earnings (not the principal) during the payout period.
- Annuities offer flexibility when accessing funds through annuitizing (converting the annuity into regular payments) or making withdrawals. Being aware of tax implications, penalties, and surrender charges associated with accessing your annuity funds is essential.
What Is an Annuity?
An annuity is a contract between you and an insurance company. With an annuity, you can invest money in a tax-deferred account, and you get to choose whether you want to be aggressive (pursuing growth) or conservative in your contract. And when you're ready to take income, you can even convert your assets into a stream of guaranteed payments.
You don't necessarily have to take income, though. You might benefit from simply adding money to an annuity and only taking distributions when needed. There are tax implications and other factors to be aware of, though, and we'll cover many of those details here.
What Are the Different Types of Annuities?
Annuities come in a variety of flavors designed for different objectives.
An immediate annuity begins making payments shortly after you fund your account. You can effectively replace your income from work after retirement, and you have several choices on how the payout is structured.
When establishing the contract, you can choose to set up income that lasts for a certain number of years or for the rest of your life (whichever is longer). Depending on your needs, you might design an income stream that pays a specific amount, or you can choose a lump sum of available money to put into an annuity.
A deferred annuity starts with an accumulation phase. You contribute money, and the annuity grows tax-deferred. Then, during the payout period — which is delayed from when the annuity is first opened — you receive a regular stream of income or a lump sum.
With a flexible premium deferred annuity, you aren't required to convert your contract into a stream of payments. Instead, you can take distributions as needed — the choice is yours. That said, it's critical to be mindful of the potential for taxes, penalties and surrender charges whenever you take money out of an annuity.
Single & Multiple Premium Annuities
With a single premium annuity, you pay a single lump sum at the start, and that sum gets invested for growth. With a multiple premium annuity, however, you can spread out your premium payments over time.
A multiple premium annuity might make sense when you're still earning income and adding to your annuity over time. Meanwhile, a single premium annuity could be appropriate when you receive a bonus or inheritance. Single premium immediate annuities may also be an option for when you retire and want to convert a workplace savings plan into a stream of guaranteed payments.
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Are There Other Annuity Categories?
Annuities are also categorized by risk and how they generate earnings. Two additional components to consider with annuities are whether they're fixed or 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 wouldn't go below the guaranteed minimum interest rate. Fixed annuities can be good if you want to minimize risk and want a guaranteed payout.
It may also be possible to get some exposure to the upside in investment markets without taking any downside risk. Fixed indexed annuities can potentially provide more growth than standard fixed annuities when the market goes well, but your returns ultimately depend on multiple factors.
A variable annuity provides more direct access to the markets. These annuities enable you to choose one or more investment options, called subaccounts, to pursue long-term growth. There's a greater possibility for growth, as you can invest in stocks, bonds and mutual funds within the subaccounts.
So, you may want to have both the appetite and the tolerance for those risks if you use a variable annuity. In most cases, you can choose from moderate to aggressive growth options — or a combination of strategies — to take an amount of risk you're comfortable with.
What Are the Benefits of Annuities?
Annuities have unique features that aren't available from other vehicles. For example, you can establish a stream of income payments that continues for as long as you live — regardless of how long you live. The insurance company guarantees that you won't run out of income when you set up lifetime payments, and you can also guarantee income for a spouse.
You can also put a substantial amount of money into a tax-deferred account. That's meaningfully different from tax-deferred retirement accounts, which generally have annual contribution limits.
In addition, you can dial in a level of risk that you're comfortable with, choosing to protect your principal from market losses or to pursue long-term growth while accepting the risk of potential losses. Consider working with a financial professional to weigh the different advantages and see how annuities could complement your individual situation.
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Do Annuities Have Possible Tax Advantages?
Because they're insurance contracts, annuities can potentially provide unique tax advantages. The money you contribute to an annuity grows tax-deferred whether the money is in a retirement account or not. Also, annuities have compound growth, meaning all money in the account continues to earn interest — even interest on interest already paid. That sum of money can grow faster when it's tax-deferred because there's more money inside of the contract to grow.
Non-qualified annuities have other tax advantages. For example, there's no mandate for you to withdraw money from your annuity at a certain age, so the money can continue to grow tax-deferred. You eventually pay taxes on earnings (not the principal) during the payout period, but you can decide the amount and timing of the payments you take for tax purposes.
How Do Annuity Payouts Work?
Annuities may offer some flexibility when it's time to use your money. One option is to "annuitize" your contract, which means you convert the annuity to a stream of regular payments. This could be for a specific time period — like 10 years — or it could be paid out over your lifetime (or whichever period ends up being longer). Some annuities can also continue paying out money to a surviving beneficiary.
Another way to get money from an annuity is through withdrawals. These are lump-sum payments made at your discretion.
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What Is the Annuity Structure?
The payouts and recipients of the income are part of an 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 someone receives the subsequent income once the annuitant dies (known as an annuitant beneficiary).
Ultimately, you can design an annuity strategy that provides resources for whoever you want. That can be you, a loved one or a combination of recipients.
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 to know. If there are any annuity terms you don't understand, consider reaching out to a financial professional.
You purchase an immediate annuity from an insurance company, and you begin receiving income payments from your annuity immediately. That might be as soon as one month or within the next year, depending on your contract. Immediate annuities might make sense when you're ready to stop working or you just need a regular series of payments.
Deferred annuities allow you to keep your money in an annuity contract without taking systematic payments. 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. Deferred annuities might make sense when you're in the accumulation phase of life — building up assets for future use.
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 as a result of gains and losses in financial markets. The earnings you receive from your variable annuity depend on how those investments perform, and it's possible to lose money if the investments decrease in value. You can often choose investments within the contract and build your own portfolio.
An indexed annuity typically offers a guarantee on your investment along with potential exposure to a 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 contract.
With a single premium annuity, you only make one premium payment into the contract. For example, when you retire, you might purchase an immediate annuity by paying a lump sum and beginning income right away.
With flexible premium contracts, you can add money 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 could 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 professional to determine which riders might make sense for you.
A joint annuitant is a second person who can receive income payments from an annuity. For example, if a married couple establishes a stream of lifetime income payments, the couple might want the payments to last for as long as either spouse is alive.
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. Annuitizing is generally an irrevocable decision, which allows the insurance company to offer the highest income payment available given your age, assets and any other features associated with your contract.
If you're concerned about dying shortly after annuitizing, you can select a period certain. During that time frame, 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 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 during which you must pay a surrender charge if you withdraw too much from an annuity contract. Not all annuities have surrender periods, and they may be four years, 10 years or another term.
The beneficiary receives assets in your annuity after your death. By designating a beneficiary, you might make the process of transferring assets faster and easier for survivors.
Understanding the different types of annuities — as well as their 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 can help you make the best choice.
Consider reaching out to a financial professional if you could benefit from personalized insights and customized guidance based on your individual situation and needs.