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How Do Annuities Work? 

Retirement Planning
Woman zipping up coat on a run and thinking about how annuities work

An annuity can be used as a vehicle for long-term growth, for guaranteed retirement income and for tax benefits. To determine if one might fit into your financial road map, it's important to understand how an annuity works, 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 or a series of payments to the insurance company, and it can then be set up to make payments to you over a specified period of time. With some annuities, you can receive payments immediately, but others go through an accumulation phase and you can start payments at a later date. The money you receive from an annuity can be in the form of a single lump sum or a series of payments, depending on the annuity you purchase and the details within your contract.

How Do Annuities Work?

An annuity works as a tax-deferred contract for long-term growth, a guaranteed stream of income or both. However, growth is not always guaranteed, depending on the type of annuity you purchase. 

What Is the Accumulation Phase?

During this phase, the money in the annuity can earn interest to help build your account value. Some annuities may allow you to contribute as much as you want during the accumulation phase, but the length of accumulation varies depending on the type of annuity you purchase. For instance, with an immediate annuity there is no real accumulation phase because you fund the annuity with a single lump sum and immediately start to receive payments. On the other hand, deferred annuities have a longer accumulation phase and the payout period is delayed from when the annuity is first opened to a later date.

Depending on the type of annuity, the money you accumulate may grow at a fixed rate of interest, or you may choose to invest it among various sub-accounts that are appropriate for your financial goals and risk tolerance.

What Is the Payout Phase?

During this phase, you may receive a lump sum payment or a series of payments as a guaranteed stream of income. Payments are usually made on a monthly basis, and you can typically choose to receive the payments over a certain period of time or for your entire life. When you convert an annuity to a stream of income, it's called annuitization.

How Are Annuities Categorized?

Immediate Annuities

Immediate annuities are funded with a lump sum and payments, begin soon after you make your initial payment. You can choose to receive a stream of income for as long as you like, such as a certain amount of years or for your entire life.

Deferred Annuities

Deferred annuities start with an accumulation phase and have the potential to earn interest tax-deferred. The payout period is delayed so that income payments can start at a later date.

What Are the Main Types of Annuities?

Fixed Annuity

When you buy a fixed annuity, the insurer guarantees growth based on a minimum interest rate for the life of the contract. While the interest may increase or decrease periodically, it will always have at least the minimum interest rate.

Variable Annuity

With a variable annuity, you can potentially grow your money by allocating it among a variety of investment options, which are called sub-accounts. These investment options can range in objective from conservative to aggressive, and while they can have the potential for higher returns, they also come with the risk of losing both the principal and your earnings.

What Are the Benefits of Annuities?

Tax-Deferred Growth

Annuities have no annual contribution limit and the money you contribute grows tax-deferred. Annuities have compound growth, so you earn interest on interest. Deferring taxes could help enable faster growth than non-tax-deferred accounts because there's more money in the account to compound year after year.

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 to take a lump sum or to set up guaranteed payments for a specific length of time or for the rest of your life. This could be helpful if you're retired and are looking for more stability and predictability with your income. Guaranteed income may help you avoid outliving your money.

What Are the Potential Risks?

Surrender Charges & Early-Withdrawal Fees

If you need to make withdrawals from your annuity sooner than you expected, you may have to pay surrender charges or early-withdrawal fees. Withdrawals taken before age 59 1/2 are subject to an additional 10% early withdrawal tax penalty on top of the normal taxes that are required to be paid.

Possibility of Higher Taxes

While deferring taxes is a potential benefit of annuities, this could be a disadvantage for individuals who earn a high income because their income tax bracket may be higher than the capital gains rates that would be owed on withdrawals from a taxable brokerage account. Consider speaking with a tax professional for more information.

Premature Death

With certain annuities, you may only receive a small amount of your investment if you die prematurely. However, you are able to set up a beneficiary to receive the balance of the annuity or any remaining payments, depending on the type of annuity you purchase.

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.

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.

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