go here An annuity is a contract between you as the “annuitant” and an insurance company. You basically pay money in the form of premiums to the insurance company, which then invests the money and charges you related fees. The invested funds grow on a tax deferred basis within the annuity until they are paid out to the annuitant or a beneficiary.
Annuities are essentially a form of retirement plan. You put money in and the insurance company invests it so that you can have an income stream, usually at some future date. However, there are different types of annuities and options which are available. In order to make the best decision for your own situation and preferences, it is worth getting to know some of the basics.
An annuity is typically referred to as “non-qualified” since contributions (or premiums) are not tax-deductible. As such, it is funded with “after-tax” dollars. Since you do not receive a tax deduction up front, only the earnings portion of the ultimate distributions is taxable. The original contributed amounts (premiums) represent “basis” in the annuity and are not taxable upon distribution.
However, although you do not get a tax deduction up front, the funds still grow on a tax-deferred basis. This means that you do not pay any tax on earnings within the annuity until distributions begin.
A traditional individual retirement account (IRA) account is considered “qualified” since contributions are generally tax deductible. When you ultimately take distributions out of such a plan, the entire amount is usually taxable since you received a tax deduction up front for the money you put in.
However, if you or your spouse are covered by a retirement plan at work, for example, and you make over a certain amount of income for the year, your IRA contributions may not be tax deductible. In such a case, you receive “basis” in the IRA, and similar to an annuity, a portion of your IRA distributions will be non-taxable.
When you purchase an annuity inside a traditional IRA account, it essentially becomes a “qualified” annuity. The reason is that you purchase it with the pre-tax dollars contributed to the IRA. This is generally not a recommended strategy since the annuity already grows on a tax deferred basis.
Plus, you should put lower cost investments inside the IRA, such as mutual funds, instead of a higher fee annuity. However, it may be worthwhile to consider buying an SPIA with some of your existing IRA assets. This way you can establish an income stream which the insurance company will guarantee for life. Doing so can give you some peace of mind if you are concerned that you may outlive your nest egg.
Unlike Annuities, IRAs Have Contribution Limits
Keep in mind though that with an IRA, the maximum that you can contribute is limited each year. In 2017, the limit is $5,500, or $6,500 if you are 50 or older. An annuity, on the other hand, has no such limits. This is one of its greatest benefits.
Annuities are therefore ideal for someone who has maxed out their qualified retirement plan contributions such as an employer 401k, a Simplified Employee Pension (SEP), or an IRA. If you purchase the annuity inside your IRA, you may be limited as to how much you can invest, unless you have existing funds in there already.
There Are Options When it Comes to Annuity Premium Payments
You can choose to pay your premium in different ways. A single premium annuity is one in which you pay any required premiums in one lump sum at the outset. Individuals usually select this option when they receive a lump sum of money. Examples may include an inheritance or a payout from an employer pension plan.
Alternatively, you can pay fixed premiums for a period of time on a regular basis such as monthly, quarterly, or annually. The advantage of such an option is that it requires you to save something on a regular basis. However, the lack of flexibility makes it a less common approach.
With a flexible premium option, you can pay as much as you want within certain limits set by the issuer of the annuity. This is the most preferred option since you may not know for sure if you will max out your other qualified retirement plans such as a SEP or IRA.
Also, you may not wish to contribute to any type of retirement plan or annuity. If money is tight in a particular year, you might wish to contribute as little as possible to such vehicles.
You Have Options As To When You Will Start Receiving Benefit Payouts
There are different types of annuities with regard to when the insurance company makes distributions or benefit payments. The two main categories are immediate and deferred.
With an immediate annuity, you start receiving your income within 12 months of entering into the contract. Immediate annuities require a lump sum premium. As such, they are usually called single premium immediate annuities (SPIA).
These annuities make up a relatively small portion of all annuities sold by insurance companies. They are typically purchased by individuals near age 59 1/2, since that is generally the minimum age by which you can receive benefit payouts without incurring a 10% tax penalty.
With an SPIA, you are essentially converting a lump sum of money into a lifetime monthly stream of income. The upside is that you can guarantee that your savings will last for your lifetime, and potentially during a surviving spouse’s lifetime.
The downside of the SPIA is that you tie up your money in the annuity, and therefore cannot use it for other purposes such as an emergency. Your limit for that money is the monthly benefit payout.
Deferred annuities are much more common than their SPIA counterparts. With a deferred annuity, your income stream does not start until at least one year has passed, and often much longer. You pay premiums during the “accumulation period”, which is the time from inception of the contract until benefit payments begin, which ushers in the “payout period.”
You can also purchase deferred annuities with one lump sum, but payouts will begin at a future time. Immediate annuities do not have an “accumulation period” since they make benefit payments from the outset.
How Will The Insurance Company Invest Your Annuity Premiums?
With a fixed annuity, your funds earn a fixed interest rate at specified intervals during the life of the annuity. The rates are based on what an insurance company earns from its investment portfolio mostly made up of lower risk fixed income securities such as bonds. Fixed annuities also have a stated minimum interest rate. So the money you invest (the principal) is guaranteed as long as the insurance company is financially stable.
A variable annuity, on the other hand, allows you to invest in different mutual funds offered by the company. Variable annuities provide more risk, but also potentially a higher reward. You have the potential to increase the value of your annuity and therefore your ultimate benefit payout more so than with a fixed annuity.
However, the opposite is also true. Although there is usually a minimum guaranteed payment, poor investment performance plus higher fees can leave you with a lower benefit payment than you would otherwise might have with a fixed annuity.
Your individual risk tolerance and financial goals will determine which option you choose. Variable annuity fees and expenses will be higher due to the more involved investment management aspect of the contract.
The fees may also be higher than if invested directly in mutual funds or ETFs. However, the only limit to the amount of money you can put to work with an annuity on a tax deferred basis is your available funds. This is what you get in exchange for the higher fees.
An indexed annuity is similar to a variable annuity. However, the earnings on the account are generally based on an index, such as the S&P 500, instead of a group of mutual funds, as is the case in a variable annuity.
Benefit Payout Options
You can structure the distributions or benefit payouts from your annuity in different ways. You may receive fixed annuity payments which do not change over time. Alternatively, you may have a cost of living adjustment (COLA) option with your annuity. This option will allow you to receive greater premiums as inflation increases over time. However, the initial payout amount may be lower with a COLA option, which may diminish its overall benefit.
Another option is a variable payout. In this case the payout can change over time based on the underlying investment performance of the funds in the annuity. So market conditions can affect your benefit amount if you choose this option.
Insurers usually make annuity benefit payments on a monthly basis. However, quarterly, annually, and lump sum are also options. Among some key factors affecting the amount of the benefit payment are:
- the amount of money you put in (premiums)
- the earnings over the accumulation period
- the projected life expectancy of the annuitant(s)
- the type of payout you select
For How Long Will Your Annuity Pay You?
The length of time you are to receive benefit payments will vary based on the terms in your annuity contract. If you have a period certain contract (guaranteed period), then you will receive benefits for a specified period such as 5, 10, 20, or 30 years.
Single Life, Joint Life, and Life With Period Certain Options
Alternatively, you may receive payments based on your life or a joint life. With a single life annuity (aka straight life), payments stop once you die. This type of annuity pays a higher monthly benefit. But the tradeoff is that if you die prematurely, you will forfeit some of your principal to the insurer. Your survivor beneficiaries will not receive anything.
As a result, these types of payouts are not very common. When they are selected, they are usually based on a joint life payout. With a joint life annuity contract, the insurer pays benefits until the second or joint annuitant (typically a spouse) dies. This way there is less of a chance of forfeiting principal to the insurance company.
You also have the option of purchasing a life annuity combined with a period certain. With this type of annuity, you receive benefit payments during your lifetime or a joint lifetime.
However, if you and any joint annuitant die during the guaranteed period, your beneficiaries will continue to receive payments for the remainder of the period certain. Due to the higher risk for the issuer, the monthly percentage payouts for such a policy are lower. And even more so the longer the term of the guaranteed period.
With a refund annuity, your beneficiaries receive any remaining amount left in the annuity after you die. It can be in installments (installment refund annuity) or in a lump sum (cash refund annuity). In exchange for the refund option, monthly payments during the annuitant’s life will be smaller.
If the annuitant dies before the annuity begins benefit payments, the named beneficiaries will receive the greater of the premiums paid or the amount in the account at that time.
Commissions and Fees
Annuity commissions and related expenses such as annual fees can also be very high. Although the insurance company pays a commission to the agent, you may be subject to surrender charges relative to the commission size if you withdraw money from the annuity or terminate it within the first few years. The longer the window of time that a surrender charge applies, the higher the commission for the sales agent. So this is an area worth close attention before you proceed with a purchase.
You may, however, be able to purchase a so called direct-sold annuity from investment companies such as Fidelity, Vanguard, and TIAA-CREF. Such direct purchases are not sold through an agent, so there is generally no commission (or “load”) and therefore no surrender charge either. Keep in mind though that annuities can be somewhat complex investment products, and many individuals may prefer the advice of a professional in exchange for a potential surrender charge.
When working with an agent, it is important to know that more complex products such as variable annuities have higher commission rates. So they may “push” these products more aggressively than a lower commission product such as an SPIA.
This does not mean that a variable annuity is not the right product for you. Neither does it imply that you should go with an SPIA. Only you and/or your agent can properly determine the right product for your situation after careful analysis of all factors. It just helps to know that there might be some bias towards the higher commission products.
Annuities can be a useful financial planning tool especially for those who seek tax deferred growth, and have maxed out their qualified retirement plan contributions. The lack of contribution limits allows you to invest more money on a tax deferred basis.
However, as with insurance policies, it is important to keep an eye on the financial stability of the insurer you invest with. You want to make sure your principal will be safe, and that the company will be able to pay your benefits when the time comes.
Some states provide some protection in this regard, but it is limited. It is probably also a good idea to diversify among issuers. Insurance company financial stability ratings are provided by companies such as A.M. Best and Standard & Poors.
You also want to keep an eye on any costs to make sure they are reasonable.