Annuities can produce an income stream you can’t outlive, but annuities are among the most commonly misunderstood and misused financial products. 10 Things You Need To Know About Annuities will put you on the right track to ask the right questions.
It’s important to be an educated consumer when you shop for an annuity, so let’s look at what annuities are, how they work, and whether they make sense for you.
What is an annuity?
An annuity is a contract between you and an insurance company. People purchased annuities for specific goals, such as principal protection, lifetime income, legacy planning or long-term care costs. Annuities are not investments, they’re contracts just like Life Insurance.
Annuities have been around for centuries, in Ancient Rome, people would make a single payment in return for annual lifetime payments. Even back then, retirement planning was a concern.
Annuities became popular in the U.S. during the Great Depression when people began to worry about the stock market endangering their retirement. Today, with pension plans becoming less common many retirees are looking toward annuities as an option to replace income streams.
Annuities can be complicated and you should speak to a licensed agent before making any decisions yourself. Some people love annuities some fear them because they don’t understand them.
I always ask my clients who ask me about annuities if they receive social security? If you get a social security check every month, you are receiving annuities payments.
Social Security is the most basic example of an annuity. You made small payments into the system through your life and when you retire Social Security will give you a monthly stream of income for the rest of your life.
How does an annuity work?
An annuity works by transferring risk from the owner, called the annuitant, to the insurance company. Like other types of insurance, you pay the company premiums to bear this risk. Premiums can be a single lump sum or a series of payments, depending on the type of annuity you select. The time during which you make payment is called the accumulation phase of the contract.
You don’t pay annuity premiums indefinitely. Eventually, you stop paying the annuity and the annuity starts paying you. When this happens, your contract is said to enter the payout phase.
Annuities can be structured to give you payments for a fixed number of years or your heirs. You can also elect to receive payments for your lifetime or until you and your spouse have passed away, or a combination of both lifetime income with a guaranteed “period certain” payout.
A “life with period certain annuity” pays you income for life, but if you die during a specified time frame (the period certain years), the annuity will pay your beneficiary the remainder of your payments for the contractual period you chose at the time of application.
As with Social Security, annuity lifetime income is based on the recipient’s life expectancy, with smaller payments received over longer periods. So the younger you are when you start receiving income, the longer your life expectancy is, or the longer the period certain term is, the smaller your payments will be.
Payments can be monthly, quarterly, annual, or even a lump sum. They can start immediately or they can be postponed for years, even decades.
You make a single lump-sum payment to the insurance company, and it begins paying you an income. Your first payment can be in 30 days, 90 days or 1 year for example. The period is based on how often you elect to receive income payments.
With a deferred annuity, you begin receiving payments for years or decades in the future. In the meantime, your premiums grow tax-deferred inside the annuity. They’re often used to supplement individual retirement accounts and employer-sponsored retirement plan contributions because most annuities have no IRS contribution limits.
Some rules do apply to certain deferred annuities in regard to contribution limits. Please contact each annuities provider to make sure you keep to the rules.
Fixed annuities pay a guaranteed minimum rate of return and provide a fixed series of payments under conditions determined when you buy the annuity.
During the accumulation phase, the insurance company invests the premiums in high-quality, fixed-income investments like bonds. Because your rate of return is guaranteed, the insurance company bears all of the investment risks with fixed annuities.
It works much like a certificate of deposit by guaranteeing a rate over a fixed period. However, unlike CD interest, the interest isn’t taxed annually but rather allowed to grow tax-deferred until withdrawal.
Early Withdrawal Penalties
Annuities have surrender charges if you withdraw your money early. Surrender periods vary from two years to 10 or more, and the corresponding charges typically decline with time. For example, a deferred annuity with a 10-year surrender period would charge 10 percent on money that is withdrawn the first year, 9 percent the second year, 8 percent the third year and so on.
However, “nearly all companies give you access to at least the interest, with many allowing you access after 12 months to either 10 percent of your original premium deposited or 10 percent of your account value.
Bear in mind that as with IRAs and 401(k)s, earnings withdrawn before age 59½ may be subject to a 10 percent federal tax penalty. Likewise, annuity income is taxed as ordinary income the year it’s received.
Always consult with your tax professional before making decisions on the tax ramifications of annuities or any retirement account.
Not all annuities guarantee a fixed rate of return. With a variable annuity, your premiums are invested in a variety of subaccounts, similar to mutual funds. Each subaccount has an investment objective and charges a management fee in addition to the insurance company’s fees.
The annuity’s rate of return is based on the performance of these subaccounts. The insurance company does not guarantee variable annuity rates, so the annuitant bears all of the investment risks.
Fixed indexed annuity or formerly known as the equity-indexed annuity is a blend of secured returns with the potential stock market upside of variable annuities. Indexed annuities have a minimum guaranteed rate of return with gains tied to an underlying index like the Standard & Poor’s 500.
In exchange for downside protection, indexed annuities limit your upside. The annuity may set a participation rate that grants you only 80 percent of the gains. Or it may impose a maximum rate of interest. For instance, if your cap was 8 percent and the index gained 10 percent or even 15 percent you would still receive only the 8 percent.
You can attach additional benefits or protections to your annuity contract through contract riders. Riders can be used to enhance an annuity’s income, legacy or long-term care provisions.
They fall into two categories: living riders, which provide benefits while the annuitant is alive, and death benefit riders, which protect beneficiary benefits. For example, an income rider attached to a deferred annuity enables you to turn on your lifetime income stream whenever you want instead of the age you specified when you signed the contract.
The insurance company doesn’t keep your premiums if you die early
Many people like riders because they think riders keep more money out of the insurance company’s hands. It’s a common argument against single-life annuities, which pay income only for the annuitant’s life, that if you die early, the insurance company keeps your money, but this isn’t the case.
The insurance company pools your money with that of other customers. Deposits made by those who die earlier than expected contribute to the gains of the overall ‘pool’, thereby providing a higher yield or credit to those purchasers who receive income payments for longer than their life expectancies.