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What Are the Different Types of Annuities?

Retirement Planning
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Father high-fives his son while mother watches after parents discuss their annuity options.

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. However, keep in mind that while each variety of annuity operates somewhat differently and offers certain benefits, their basic functions are the same. 

The terminology surrounding these long-term investments may be confusing at first. Financial professionals can help you make sense of everything, but here's a basic overview of the available annuity options and their timelines to help you get started.

Understanding the Basics of Annuities

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. Alternatively, you may 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 may be a death benefit allowing for any remaining payments to be paid to a beneficiary. There also might be optional features (riders) available to you, such as an enhanced death benefit or long-term care. These provisions typically have added fees and costs.

Immediate vs. Deferred Annuities

Depending on when they pay out, annuities fall into two main categories: immediate and deferred. Immediate annuities can offer you a stream of income right away. Deferred annuities, on the other hand, allow you to receive regular income payments later in life – typically during your retirement years. When you can afford to wait for a while to receive your payout, a deferred annuity may be a good choice for you. 

How Immediate Annuities Work

Immediate annuities can provide a regular stream of guaranteed payments 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. To begin payments from an immediate annuity, you pay a nonrefundable lump sum of money to an insurance company and then receive payments based on the terms of the contract or specific product.

With immediate annuities, there are different types of payment options. For instance, a life payout offers a payment for your lifetime (and for your spouse's lifetime, if the insurance company offers a product with this option). Period certain annuities are just as their name implies — a payout for a set amount of years (e.g., 10 or 20 years). Keep in mind that payments received are typically fixed, which can cause inflation risk. In addition, 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 access to the money than with other annuity types, as these cannot be surrendered.

How Deferred Annuities Work

Deferred annuities allow you to defer — that is, put off or delay — receiving a regular income or a lump sum of cash until some future date, often until retirement. Unlike an immediate annuity, a deferred annuity has two phases: an accumulation (or potential growth) phase and a payout (or income) phase. During the accumulation phase, you may be able to contribute payments to the deferred annuity on a regular basis. These annuity premiums, which are then invested by the insurer, can grow tax-deferred. The growth of your deferred annuity depends on how it accumulates interest, which is determined by the type of annuity you select: fixed, variable or fixed indexed. Once you decide to begin receiving income from a deferred annuity, the payout phase starts. Deferred annuities can be set up to provide a steady stream of retirement income for the rest of your life and sometimes for the rest of your spouse’s life, too.

You will not have to pay ordinary income tax on the funds in a deferred annuity until you begin making withdrawals. However, if you start making withdrawals from a deferred annuity before you reach age 59 ½, you are subject to a 10% tax penalty from the IRS. In addition, you may have to pay surrender fees (penalty charges) if you make early withdrawals or decide to cancel the deferred annuity contract.

Annuity Interest Types

While the terms immediate and deferred explain when an annuity pays out,  annuities are distinguished further by the way in which their interest is earned. Fixed, variable and fixed indexed annuities all accumulate interest in different ways. However, all three of these annuity types typically offer withdrawals, systematic withdrawals and/or can be set up with a guaranteed stream of income.

Fixed Annuities

Perhaps the easiest to understand, fixed annuities help you grow your money because they offer a fixed interest rate (guaranteed rate of return) over a set period of years. They typically have a minimum guaranteed interest rate, and your earnings are typically not taxed every year (although you will need to pay taxes when money in the annuity is taken out of the annuity). Interest earned is compounded and can be left in the annuity to continue to grow or can be withdrawn after the contract is annuitized (or possibly during the contract, depending on the insurance company).

Once the fixed 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. If you want to withdraw funds or transfer funds to another account, you can typically do so periodically, but 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.

Variable Annuities

Annuities are long-term investments designed for retirement purposes. If you'd like to grow your funds — and you're comfortable with the ups and downs of markets — variable annuities allow you to allocate your money among a variety of investment options called sub-accounts. Like a fixed annuity, any earnings in the variable annuity are tax-deferred, and you could eventually convert the annuity into a stream of guaranteed payments for life. 

Because they're invested in portfolios or investment options linked to the market, variable annuities have the potential to yield greater appreciation of earnings than fixed annuities. Depending on the performance of the annuity's subaccount options, you might receive a higher payout as a result of that market exposure; that’s 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. Like all other types of annuities, payouts can be structured in the form of systematic withdrawals for a variable annuity. 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. With variable annuities, it is possible to lose money, so it's critical to evaluate your risk tolerance and study your variable annuity's prospectus before investing.

Fixed Indexed Annuities

Fixed indexed annuities (once known as equity indexed annuities) credit interest based on the performance of a particular stock market index (e.g., the S&P 500, the Dow Jones Industrial Average or the NASDAQ) — though they don't actually participate in the stock market. With a fixed indexed annuity, you are allowed to participate in positive changes in an index to a limited degree; interest rates are based in part on positive changes in indexes. The minimum these will typically credit is 0 percent, since the principal is not directly exposed to the market. Your annuity cannot lose value due to declines in the index, but you may still have fees or other expenses. Plus, they may also pay a minimum guaranteed interest rate, regardless of what happens in the index.

Payouts for fixed indexed annuities can be structured as guaranteed periodic payments just like other kinds of annuities, and interest depends on the terms of your contract and the index to which the money is tied. You may not receive all of the potential stock market index returns, however. Surrender charges and early-withdrawal fees may apply.

Significant Annuity Milestones

So, what can you expect when you purchase an annuity? Some of the timelines below can help you understand how your annuity works.

Important Dates to Know

The following dates may be important when you purchase an annuity, depending on the type of annuity:

  • Issue date: All annuities have an issue date, which is when the insurance company issues your contract by processing your application and premium payment. Insurers typically begin paying any guaranteed interest rate on your account starting on the issue date.
  • Sweep date: Only fixed indexed annuities have a sweep date, which marks the day when you first start to participate in the index allocation's performance. The sweep date varies by insurer, but typically insurers will allocate the funds between one and 22 days after the initial investment.
  • Crediting period: With fixed indexed annuities, the crediting period begins on the sweep date and typically lasts from one to three years, depending on what you choose. At the end of the crediting period, the insurer calculates how much interest you'll receive from an index you have selected, and you receive any earnings you qualify for at the end of the crediting period.

Timelines for Withdrawals

  • Surrender period: Annuities are typically long-term investments. As such, insurance companies set early withdrawal charges to help them manage risk and discourage you from cashing out shortly after investing. You can typically take 10 percent of your account value with no withdrawal charge annually, but withdrawals above that amount may cause additional charges. Over time, the withdrawal charges decrease and fall off, allowing you to cash out or transfer the entire account.
  • First payment: If you purchase an immediate annuity (or if you convert an annuity into an income stream), you typically receive your first payment as early as one month after the issue date. However, verify the details with your insurance company. You may also be able to select a date in the future or opt for less-frequent payments (quarterly, for example).

Choosing the Right Annuity for You

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.

With an understanding of how annuities work, you'll be better equipped to choose the right annuity for your needs — and you'll have a better understanding of what you can likely expect along the way. Even though 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 your different annuity options with a qualified financial representative.

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