What is an Annuity? 5 Things You Need to Know About Annuities

Annuities can offer income for life.
Annuities can offer income for life.

An annuity is an insurance product that you can purchase from a financial institution—usually an insurance company—that is designed to accept, grow and eventually pay out funds over a period of time.

Because annuities can provide you with a steady source of income, they are commonly used as retirement planning tools by individuals who want to take a proactive approach to securing income during their non-working years.

“There’s a variety of ways to use annuities to meet different goals,” says Spencer Hall, managing partner at Retirement Planning Services, a financial planning firm based in Knoxville, Tennessee. “One of those goals might be having an income stream that’s secured for life.”

But annuities come in different structures with different payout plans you may choose from to better suit your particular financial needs—and trying to navigate these products can often create their fair share of complication and confusion.

To help you on your way, here are five things you should know when it comes to annuities:

1. You can choose how much money to invest

There are different ways you can fund annuities.

Depending on the type of annuity you choose, you can put a one-time lump sum payment, also known as a premium, into your account. This fully funds your annuity contract, allowing you to elect how you want to receive payment distribution from your investment.

Something to note: you may also be free to add additional funds to the annuity even if you fund it fully with a lump sum payment at first.

If you don’t feel comfortable depositing a large quantity of cash upfront, you can also choose an annuity product that allows you to fund your contract by making fixed premium payments. This funding method requires the contract owner to make equal payments of a specific dollar amount at regular intervals over a certain period of time until the annuity is fully funded.

Most insurance companies also offer a third way to help you fund your annuity: flexible premiums. Under this type of arrangement, you are permitted to make premium payments whenever and however often you choose as long as you meet a certain minimum amount.

The accumulation phase is always the first stage of any annuity. It begins right after you’ve made the initial payment and lasts until the payout phase, when you decide it’s time to start accessing funds.

When you choose to receive payouts is entirely up to you (depending on the annuity type), and there are two ways to go about this.

2. You can choose the timing of payouts

The payment methods of annuities can be broken down into two different types: immediate and deferred annuities.

An immediate annuity is when you make a lump sum payment and then begin to receive payments a short time later. Under this product, you can elect to receive payments however you so choose, be it monthly, quarterly or even yearly for life or for a specific number of years.

Your payment amount is based on factors such as the amount you’ve invested into the annuity, your age and life expectancy.

With the deferred payment method, you can contribute either a lump sum or monthly installments and your account grows on a tax-deferred basis. You can use deferred annuities if you want to build up money for retirement without accessing it right away.

3. There are different rate options

Like many financial products, annuities come in distinct rate types: variable and fixed.

With a variable annuity, you receive returns based on the performance of your account, which you can choose to invest in a variety of mutual funds and other sources, such as the stock market. When the market performs well, you reap the benefit of potentially higher payouts, however, your payments could decrease in a poor market.

“Variable annuities are for folks who want to see a bit higher rate of return,” says Hall. “If sub accounts do well, there is an opportunity for a stronger rate of return.”

For investors who want more stability and less risk, the alternative is using a fixed annuity. Under this type of product, you receive a set (or “fixed”) amount of money each month. While this eliminates the risk of fluctuating payouts, you miss out on earning more from your annuity in a bull market.

Investors generally use fixed annuities for the peace of mind in knowing that they will make the same interest rate on their money.

“Fixed annuities are going to give you a steady rate of return,” Hall says. “They’re typically for investors who want to have a portion of their money that’s not subject to ups and downs of the stock market.”

There is also a third type of annuity known as an indexed annuity. In these products, the seller gives an investment return based on changes in a particular index, such as the S&P 500. You can make a one-time payment or a series of payments into this annuity.

Regardless of how well the index performs, the insurance company from which you purchased the annuity will guarantee you a minimum return, though these minimums can vary from one insurance company to the next.

4. Taxes on your investments are deferred

When you purchase an annuity all earnings on your investment are tax deferred, meaning you don’t pay income taxes on interest, dividends or capital gains your account experiences until you withdraw funds.

“Tax deferral gives the owner of an annuity ultimate flexibility because they’re not paying tax year to year. They’re only paying tax when they withdraw resources from the annuity,” Hall says.

You will have to keep in mind that you will be taxed at regular income tax rates, which can be relatively high—up to 35%—depending on your income and assets.

Another tax implication to consider is the possibility of having to withdraw funds earlier than anticipated. In this event, if you withdraw from your annuity before you’ve reached 59 ½ years of age, you are subject to both regular income taxes as well as a tax penalty of at least 10%.

5. You can use annuities with other retirement assets

There are various types of annuities that can best suit your retirement situation depending on what it is you are looking for the annuity to accomplish.

For instance, annuities can be used as a supplement to your retirement portfolio if you have other assets like a 401(k) plan or an Individual Retirement Account (IRA).

“When pairing an annuity with an IRA, you might see clients put a portion of their resources into an IRA and the investment for the IRA might be an annuity,” says Hall.

Another strategy could be using an annuity with a living benefit rider to guarantee a lifetime income stream, however, these are optional add-ons that you can choose to purchase for extra cost.

“There are just so many different kinds of annuities out there and there’s also such a wide range of what the fees on those annuities are,” says Hall. “Most folks find that because there are so many different moving parts, getting input from a financial advisor is often times a very helpful step.”

Is an Annuity Right for You?

All retirement investment ideas can be confusing and annuities are particularly complicated.  There are so many different kinds.  To help you, there are many resources on our All About Annuities page that might help you.  Learn about the Pros and Cons of Annuities and Best Annuities or use the Lifetime Annuity Calculator.

In addition to educating yourself about these retirement investments, you might also consider working with a financial advisor who may be able to help you make a more informed decision.

NewRetirement Planner

Do it yourself retirement planning: easy, comprehensive, reliable

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Take financial wellness into your own hands and do it yourself retirement planning: easy, comprehensive, reliable.

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