An annuity can be used for long-term growth, retirement income, and tax advantages. To decide if one fits your goals, it helps to understand how annuities work, the different types of annuities and the potential benefits of annuities.
What Is an Annuity?
An annuity is a contract between you and an insurance company. You make a lump sum payment or a series of payments to the insurer. In return, the insurer can provide payments to you over a set period.
Some annuities begin payments right away. Others include an accumulation phase, where payments start later. The money you receive can be a lump sum or a series of payments, depending on your contract.
How Do Annuities Work?
An annuity can provide tax-deferred growth, income payments, or both. Growth is not always guaranteed and depends on the type of annuity.
Accumulation Phase
During this phase, your money can earn interest and grow in value. Some annuities allow flexible contributions, while others have limits based on the contract.
Immediate annuities do not have an accumulation phase. You fund them with a lump sum and begin receiving payments soon after. Deferred annuities include a longer accumulation period, with payments starting at a later date.
Depending on the annuity, your money may grow at a fixed interest rate or be allocated among investment options based on your goals and risk tolerance.
Payout Phase
During this phase, you receive payments from the annuity. These can be a lump sum or regular payments, often monthly. You can choose to receive payments for a set number of years or for the rest of your life. Converting your annuity into income payments is called annuitization.
How Are Annuities Categorized?
Immediate Annuities
Immediate annuities are funded with a lump sum, and payments begin soon after. You can choose to receive income for a set period or for life.
Deferred Annuities
Deferred annuities include an accumulation phase where your money can grow tax-deferred. Payments begin at a later date.
What Are the Main Types of Annuities?
Fixed Annuity
A fixed annuity provides growth based on a minimum interest rate set by the insurer. The rate may change over time, but it will not fall below the minimum stated in the contract.
Variable Annuity
A variable annuity allows you to invest in different options called sub-accounts. These range from conservative to more aggressive choices. Returns can be higher, but there is also a risk of losing money, including your original funds.
What Are the Benefits of Annuities?
Tax-Deferred Growth
Annuities do not have annual contribution limits. Your money grows tax-deferred, meaning you do not pay taxes on earnings until you withdraw them. This allows earnings to compound over time, which may lead to greater growth compared to taxable accounts.
Guaranteed Rates
With some annuities, there is a guaranteed interest rate. This could help ensure that your money is growing at a minimum rate over the life of your annuity contract.
Guaranteed Income
During the payout phase, you can choose a lump sum or regular payments. Payments can last for a set period or for your lifetime. This can provide steady income in retirement and help reduce the risk of running out of money.
What Are the Potential Risks?
Surrender Charges & Early-Withdrawal Fees
If you withdraw money earlier than expected, you may pay surrender charges or early withdrawal fees. Withdrawals before age 59½ may also be subject to a 10% federal tax penalty, in addition to regular income taxes.
Possibility of Higher Taxes
Tax deferral can be helpful, but it may not suit everyone. If you are in a higher income tax bracket later, you could pay more in taxes compared to capital gains rates in a taxable account. A tax professional can help you review your situation.
Premature Death
With some annuities, you may receive less than expected if you pass away early. However, you can name a beneficiary to receive any remaining value or payments, depending on your contract.
How Are Annuities Taxed?
For planning purposes, it's important to understand how annuities are taxed. Annuities are tax-deferred, so you do not pay taxes on interest or gains until you receive income payments from your annuity. The taxes owed at the time of withdrawal will depend on whether you have a qualified annuity or a nonqualified annuity.
Qualified Annuity Taxation
If you funded your annuity with a pretax dollars, it's considered a qualified annuity, which means the entire amount withdrawn is taxable. For example, if you buy an annuity with a qualified retirement plan, such as a traditional individual retirement account (IRA) or 401(k), the payments you receive are taxed as ordinary income because no taxes have been previously paid.
Nonqualified Annuity Taxation
If you funded your annuity with after-tax dollars, it's a nonqualified annuity. Only the earnings are taxed when you take a withdrawal from a nonqualified annuity. With some annuities, such as immediate annuities, the IRS treats part of each annuity payment as a "return of premium," so that money isn't taxed. The rest of the money is considered earnings, so it is taxed.
How Do Annuities Work When You Die?
If you own an annuity, you may be able to name a beneficiary to receive the funds in your annuity when you die. Similar to setting up a life insurance policy, the details of the payout to your beneficiaries is specified in your annuity contract with the insurer. The amount of money or number of payments left and the way they are distributed after you die will depend upon the type of annuity and how your contract is set up.
Final Thoughts
If used correctly, annuities can be helpful financial tools that offer many potential benefits. However, before buying an annuity, you'll likely want to carefully consider the potential advantages and risks, as well as your personal needs and goals. For more information, you may want to talk to a financial representative about your financial situation.
