An annuity is a retirement savings contract you buy from an insurance company. There are two broad categories of annuity, deferred and immediate. While there are some similarities between the two, there are also important differences.
With a deferred annuity, you can choose a single premium annuity which you buy with a lump-sum purchase, or build your annuity account by adding money regularly over a period of time. There are no federal limits restricting the amount you can add to a deferred annuity each year, as there are with IRAs or employer-sponsored retirement plans. However, the amounts you spend on annuity premiums aren’t tax deferred so they don’t reduce your current income tax the way contributions to traditional 401(k)s or other employer plan do.
During the accumulation phase, while the premiums are invested, you pay no taxes on earnings in the account. You get the benefit of tax-deferred compounding, at either a fixed or variable rate, depending on the annuity. If you choose to convert your accumulated assets to income when the accumulation period ends, the various ways you can collect are spelled out in the terms of your contract.The payouts may be in regular monthly installments over your lifetime. As an alternative, you may choose a fixed number of lump-sum payments or some other payment methods.
If you’re 59½ or older when payments begin, you owe income tax on the earnings portion of your payout at the same rate you pay on regular income. If you’re younger than 59½, you may have to pay an additional 10% of the income as an early withdrawal tax penalty.
You buy an immediate annuity with a single payment and begin the payout period right away, or within the first year. Often the purchase is made with a lump-sum distribution from a retirement plan, an insurance settlement, an inheritance, or the sale of your business.
The amount of each payment you receive is set by the terms of your contract if you choose a fixed annuity, but may move higher or lower if you have a variable annuity. Because an annuity provides income on a regular schedule, usually after you retire, these plans resemble employer-sponsored pensions in certain ways. You can also buy an immediate annuity to provide a lifetime stream of income for another person.
If you purchase the immediate annuity with assets on which you’ve paid income tax, you owe income tax on only the earnings portion of your payout at the same rate as you pay on your other regular income. But if you roll over tax-deferred assets from a qualified employer plan to buy the immediate annuity, each payout is taxable at your regular rate.
FIXED OR VARIABLE?
Both deferred and immediate annuities are available in two forms: those that pay a fixed rate of interest for the life of the annuity and those that pay a variable rate.
When you buy a fixed annuity contract, the insurance company that issues it guarantees earnings at a fixed rate of return during the build-up period and a guaranteed income for life if you annuitize, which means converting your annuity into a stream of regular income. The company invests your principal and takes responsibility for earning enough income to meet its obligations to you.
With a variable annuity, you decide how your money will be allocated among a specific menu of subaccounts, also known as annuity funds, offered by the issuer. Subaccounts are pooled investments, as mutual funds are, with varying investment objectives and strategies.
Variable annuities give you the chance to choose how your contribution is invested and potentially make more than you could with a fixed rate. However, the contract makes no payment promises, so you could also end up earning less if the markets are weak or you choose poorly performing investments.
You can choose installment payments that are made on a regular monthly schedule for as long as you live or for a set period of time, such as 10 or 20 years. Or, you can use the balance that has accumulated in your deferred annuity to buy another annuity or for any purpose you choose. You may lose money if your contract imposes a penalty for lump-sum withdrawal.
The most common installment payout options for both deferred and immediate annuities are:
- Single life, which pays you income each month as long as you live. When you die, the payments stop.
- Life, or period certain, which covers your lifetime or a set number of years, whichever is longer. Your beneficiary gets the balance if you die before the term is up.
- Joint and survivor, also known as joint and several, which makes payments for your lifetime and the lifetime of your joint annuitant, often but not always your spouse. There is also a period certain option with a joint and several payout.
CHECKLIST FOR ANNUITY INVESTORS
- Consider deferred annuities only if you’re investing for the long term, as assets need time to accumulate. Withdrawals before age 59½ face a 10% tax penalty in addition to income tax.
- Investigate the reputation of the company offering the annuity to be sure it’s financially sound. Remember that receiving guaranteed income payments depends on the claims-paying ability of the issuer.
- Compare surrender periods. Most annuities have surrender charges in the first seven years, so avoid annuities with lifetime surrender charges.
- Look beyond the initial rate if you’re buying a fixed-rate annuity. Approach unusually high rates with caution.
- Look for maximum flexibility on getting your money out. You can avoid annuities that don’t offer a lump sum or give you a lower interest rate or charge a fee if you take one.
- Research the fees and annuity charges. There are alternatives to paying 2% or more annually.
- Compare costs. Some annuities cost more than others offering a similar income stream.
WEIGHING THE ISSUES
Immediate annuities provide the security of a regular income for people who are uncomfortable managing their investments. But they have some potential drawbacks:
- If you choose a single life annuity and die within a few years, the company keeps the balance of your money and your heirs get nothing.
- Your annuity income from a fixed-rate contract may not keep pace with inflation.
- You may not be able to withdraw a lump sum in an emergency.
- Collecting income from the annuity assumes that the issuing company will be able to meet its financial obligations to you.
LOOKING AT THE BOTTOM LINE
Annuities are popular retirement planning products, but they also have critics who argue that other investments give you more for your money. It pays to look at both sides:
- Tax-deferred compounding
- No federal government caps on contributions
- Guaranteed income stream with fixed-rate contract subject to claims-paying ability of issuer
- Expanding number of investment choices in variable-rate plans, many with lower fees and more income choices
- Some variable annuity contracts have high fees and other expenses
- Some annuities impose stiff surrender charges
- Payouts on variable-rate plans may be less than anticipated if investments don’t perform as expected
- Taxes on earnings due at regular income-tax rates, not the long-term capital gains rate