Annuities are financial products that straddle the line between life insurance and retirement planning. Learn about the various types of annuities, how they work, and which ones are best for you and your family.
An annuity is a financial account used to save for and spend during retirement. Premiums deposited into an annuity grow on a tax-deferred basis. If they’re withdrawn before age 59 ½, there are usually tax penalties. A feature of annuities and what makes them insurance products is that you can elect to receive the value of your annuity in payments guaranteed for life - no matter how long you live.
There are two main types of annuities: deferred and immediate annuities. Deferred are the type you contribute to for a future, long-term goal, such as retirement. Once you reach that goal, you can make withdrawals or annuitize to access the money. With immediate annuities, you skip the saving part. Instead, you purchase an immediate annuity with a lump sum that is converted into guaranteed income for life or a designated number of years.
How annuities are taxed depends on when and how you access the money and whether the annuity is held in a retirement account (and what type). Unless the annuity is in a Roth-type account, withdrawals are generally taxed as income and may be assessed a 10% penalty tax if withdrawn prior to age 59 ½. If you annuitize, payments may be only partially taxable because a portion is seen as a return of principal. Qualified distributions from a Roth account are not taxed, while distributions from a non-Roth retirement account are taxed as income.
A fixed annuity is an annuity in which you receive an interest rate guaranteed by an insurance company. Unlike some other fixed interest accounts, earnings are tax-deferred until withdrawal. It can be either a deferred annuity that you contribute to for years before making withdrawals, or an immediate annuity, which is purchased with a lump sum and annuitized immediately. Fixed annuities are generally low-risk investments with limited upside potential.
If you have a deferred annuity, you can choose to make withdrawals from the account or annuitize. If you annuitize, you exchange some or all of the contract value for a stream of guaranteed payments. You can structure those payments in a few different ways. Common payout options are for life, for the longer-lived of you and a spouse, for a specific number of years, or for your life with a minimum number of years guaranteed. If you purchase an immediate annuity, you’ll choose one of the annuitization options.
You can invest in a range of market securities like mutual funds in a variable annuity (VA) and your gains are tax-deferred until you begin taking income from the annuity. But while your potential for gain is theoretically unlimited, you could lose the entire value of the annuity because market investments aren’t guaranteed. To mitigate this, many VAs offer withdrawal and income riders that allow you to receive payments from the annuity even if it loses some or all of its value.
A deferred annuity is a tax-deferred account you can use to save for retirement. You don't pay taxes until you withdraw money or annuitize and start receiving payments, and there's no annual contribution limit (unless the annuity is part of a qualified retirement plan). Like an IRA or a retirement plan through work, you’ll generally need to wait until 59 ½ to withdraw funds without penalty.
A single premium immediate annuity (SPIA) is a retirement product sold by life insurance companies to provide guaranteed lifetime income in exchange for a lump-sum payment. They're considered life insurance contracts because the amount they pay out is frequently tied to how long you live.
A surrender charge is a penalty payment you may have to pay to an insurance company for withdrawing funds within an annuity’s surrender period. Some annuities allow you to take money out whenever you want, or allow you to withdraw up to 10% during the surrender period. If you withdraw funds in excess of what’s allowed, you’ll pay surrender charges.
This type of annuity payout provides income for your lifetime or for a set period, whichever is longer. For example, you might opt for life with a 10-year term. If you live for 20 years after payments start, you receive income for that entire time. If you live for five years, your beneficiary would receive payments for the five remaining years of the 10-year period certain.
The name of this annuity rider can vary between companies, but it guarantees you can withdraw a certain percentage of funds for life, usually based on a “benefit base.” This amount may be determined by the highest contract value reached on any contract anniversary or by a set percentage credited annually to the benefit base. You can activate the GMWB rider without annuitizing the annuity.
The "free look" period gives purchasers of annuities a set time period to walk away from the transaction penalty-free, with no reason required. Each state sets the period.
This type of annuity payout is most often used by couples. Joint-life annuity payments are structured similarly to life-only. The difference is that payments will continue as long as either spouse lives.
This type of rider provides a guaranteed minimum level of lifetime income, and may also go by other names such as guaranteed minimum income benefit (GMIB). The income amount may be determined by the highest anniversary value your contract reaches before you exercise the benefit, or by an annual accumulation rate credited to the value of an “income base.” A GMIB requires that you annuitize the contract to receive the benefit, which means you give up access to the actual contract value in exchange for a guaranteed stream of income.
A rider is a benefit that you can add to some deferred annuity policies that solve for a specific need like income, legacy, or long-term care. Riders are typically chosen at the time of application and usually cannot be added to the policy after the annuity has been issued.
Indexed annuity returns are based on an index like the S&P 500. If the value of the index goes up, you receive a return based on that value but typically capped at a maximum amount. If the value of the index goes down, you would receive a guaranteed minimum interest rate, which could be zero.
Annuitization is the process of converting either a lump sum payment or an account value (like in a deferred annuity) to a stream of guaranteed income payments. These payments may be structured to last for life or a predetermined number of years. The decision to annuitize is typically irrevocable—it may be difficult or impossible to reverse the process.
Life-only annuity payments continue as long as you live and stop immediately upon your death. They provide a higher monthly income payment, but no refund to your heirs if you die prior to receiving all the principal back.
Period-certain annuity payouts are guaranteed for a specific term, such as 10 years. If you were to pass away during this time, payments would continue to your named beneficiary for the duration of the term you selected.
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