An annuity is a financial product purchased through an insurance company that provides the buyer a steady stream of income over a specific period of time, typically during retirement. You buy an annuity by giving an insurance company either a single lump sum or making payments over time. The insurance company then invests your money (called “premium” or “purchase payment”) in different ways depending on the type of annuity you select. You can buy an annuity that begins making payments back to you right away (an “immediate annuity”) or, if you prefer, annuities are available that delay making payments to you for an extended period — sometimes many years — giving your investment in the annuity an opportunity to grow. This is called a deferred annuity.
Types of annuities
There are two types of annuities: Immediate annuities and Deferred annuities.
Immediate annuities
Immediate annuities will begin paying a stream of income immediately upon issuance for either a set period of time or as long as the annuitant or annuitants are living. Immediate annuities are funded with a single lump-sum purchase.
Deferred annuities
Deferred annuities can grow tax-deferred for a period of time before paying out, and they can be funded with either a single lump-sum purchase or with a series of payments. Some employer retirement plans even offer annuity contracts as investment choices for participants. Deferred annuities can be divided into separate categories:
Fixed annuities pay a guaranteed rate of interest and can offer a variety of interest rate guaranteed periods and payout options.
Fixed indexed annuities calculate an interest crediting rate according to a formula that is based on the performance of an underlying financial benchmark, such as the S&P 500 Index.
Varible annuities don't come with a principal guarantee like fixed and indexed annuities. The money that is invested in them is allocated among a selection of mutual fund-like subaccounts, which may rise or fall according to market conditions. Many variable annuity contracts offer living and death benefit riders that provide different guarantees within the contract. They typically come with additional costs.
How do annuities work?
Regardless of the type of annuity you buy, the primary purpose is to create income for you, and there are different ways to do that. You can set up payments that last for your entire life, a specific period of time, or a combination of both.
For example, you may choose to receive monthly payments for 20 years.
In this scenario, the company will calculate the payment amount based on the current value of your annuity contract and begin making payments. Under this plan, you would be guaranteed to receive 240 monthly payments. If you were to die before all the payments were made, your beneficiary would receive the remainder, until all 240 payments were made.
Alternatively, you may want payments for your entire life, with a guarantee that payments will be received for a certain period of time, say 20 years.
In this example, if you were to die before the company made 240 monthly payments (20 years), your beneficiary would get the remaining payments, just like in the situation above. If you lived past the end of the 20-year guaranteed period, however, the insurance company would continue to make payments as long as you lived but your beneficiary would not be entitled to any payments after your death.
If you buy a deferred annuity, you can take withdrawals from the contract, even before your income payments begin. Each annuity has its own rules about how much you can withdraw from the contract without incurring a penalty — called a “surrender charge.” You may also completely surrender a deferred annuity. That means you tell the insurance company to cancel your contract and pay you the surrender value — the value of your contract less any fees and surrender charge the insurance company imposes.
Benefits of annuities
- Guaranteed income stream
- Tax-deferred growth
- Death benefits
Drawback of annuities
- Fees
- Surrender charges
- Market risk and/or caps on returns, depending on the type of annuity
Are annuities a good investment for retirement?
Annuities are commonly used for retirement planning. They allow you to convert a lump sum of money into guaranteed income for the rest of your life, or to invest over time and later convert the annuity contract's value into guaranteed income payments. And, any growth in your annuity value is generally not taxed until you take money out of the contract. This combination of tax deferral and the ability to establish guaranteed income can make an annuity an effective tool for retirement planning and other long term goals.
How to choose an annuity
When it comes to annuities, you have many options from which to choose from. The right annuity for you is the one that aligns your financial objectives and risk tolerance. Here are a few things you should consider when choosing an annuity:
- Assess your retirement needs and goals
- Understand the various types of annuities available, how they work, and their features, benefits, fees, and potential risks
- Assess your risk tolerance and investment preferences
- Research the financial strength and stability of the insurance company offering the annuity
- Seek professional advice from a qualified financial advisor or retirement planner
- Take the time to research and compare options, ask questions, and seek clarification on any terms or features you do not understand
Frequently asked questions
Can you lose money in an annuity?
Yes, it is possible to lose money in certain types of annuities, depending on the type of annuity and market conditions. It is important to carefully consider your risk tolerance and investment objectives when selecting an annuity.
Are annuities taxable?
Any growth within an annuity is generally tax-deferred, meaning, you don't pay taxes on those gains until they are withdrawn. Qualified annuities, those held in a qualified retirement plan, such as an IRA or 401(k), have similar tax treatment, only with the addition of tax deferral for contributions.* It is important to note, if you take withdrawals from an annuity before reaching age 59 ½, you may be subject to a 10% early withdrawal penalty on the taxable portion of the distribution, in addition to any applicable income taxes. It’s important to consult with a tax advisor or financial professional to understand the tax implications of annuities based on your individual circumstances.
Can you withdraw money from an annuity?
Yes, but there may be restrictions and consequences depending on the type of annuity you have. It is essential to review the terms and conditions of your annuity contract carefully to understand any withdrawal restrictions, fees, taxes, and penalties that may apply. Consider consulting with a financial professional to discuss your options and determine the best course of action based on your individual financial goals and circumstances.
*Annuity payments from a tax-qualified plan will be fully taxable as ordinary income. Purchasing an annuity in a tax-qualified plan does not provide any additional tax deferral benefits.
As you determine what annuity might be right for you, remember annuities are intended as vehicles for long-term retirement planning, which is why withdrawals reduce an annuity's remaining death benefit, contract value, cash surrender value and future earnings. Annuities also may be subject to income tax and, if taken prior to age 59½, an additional 10% IRS tax penalty may apply. Because Protective and its representatives do not offer legal or tax advice, it is important that you talk with your own legal and tax advisor about your specific situation.
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