The Secret to Annuities? What the Heck Are They?

Posted on October 26th, 2021
annuities

If you’re hoping to diversify your retirement portfolio and have more peace of mind throughout retirement, you may consider purchasing an annuity. But, to make sure that this is the right financial more, let’s break down what the heck annuities are and how they work.

What is an annuity?

“The word annuity is derived from the Latin, annus, or year, and the Latin, annuitus,” explains Daniel Cotter, the Attorney on record for Due. “The reason for this is because annuities are investments that entitle the holder to equal annual payments.”

“Annuities are contracts that a financial institution (primarily insurance companies) issues to the individual or group,” he adds.

A lump-sum payment or periodic payments are used to fund the annuity contract, which is how annuities obtain their value. Then, at some point in the future, the annuity pays the individual a fixed amount for the rest of their life.

How exactly do annuities work?

A person who buys an annuity will receive an income stream for the rest of their life. In most cases, this is after the annuity was purchased with a one-time payment. However, for many retirees, annuities appeal as Social Security and investment savings won’t be enough to cover their expenses.

With a traditional annuity, this income is provided through a process of accumulation and annuitization. That’s not the case with immediate annuities. These types actually begin providing payment immediately upon purchase – without a need for accumulation.

Deferred annuities are purchased by paying a premium to the insurance company. Based on your contract, the initial investment will grow tax-deferred over the accumulation phase, typically ranging from 10 to 30 years. Upon entering the annuitization phase, you will receive regular payouts, based on your contract terms.

You’re protected from market fluctuations since the insurance company assumes all the risk of a down market in annuities. What’s more, this provides longevity risk meaning that you won’t outlive your money.

To offset this risk, insurance companies charge various fees. These can include services like investment management, contract riders, and other administrative activities. In addition, a surrender charge may also apply during the surrender period of most annuity contracts.

Additionally, indexed annuities generally have caps, spreads, and participation rates that reduce returns.

Why would I want to buy an annuity?

It’s common for people to purchase annuities to help them manage their retirement income. They offer the following benefits:

  • Periodic payments over a specified period of time. Whether you decide to do this is up to you, your spouse, or someone else.
  • Benefits upon death. You name a beneficiary when you name your payments, and that person receives a specific payment when you die.
  • Tax-deferred growth. As long as you don’t withdraw the money, you won’t pay taxes on your annuity income or investment gains.

Are there different types of annuities?

When it comes to annuities, there are two basic options;

  • Immediate. Here a lump-sum payment is converted into guaranteed recurring payments that can be distributed within one month after its purchase.
  • Deferred. This is just a long-term investment. Annuity providers invest money for you based on the strategy and type you select. This is either in a lump sum or as a series of payments. Afterward, you receive payments based on the interest accumulated. Over the next few years, deferred annuities are expected to grow at the highest rates, according to LIMRA.

From there, annuities come in three main varieties: Fixed, variable, and indexed,” writes Daniel Kurt for Investopedia.

The risk level and potential payout of each type differs. For example, a guaranteed payout is available with fixed annuities. “This type of annuity comes in two different styles—fixed immediate annuities, which pay a fixed rate right now, and fixed deferred annuities, which pay you later,” Kurt explains. “The downside of this predictability is a relatively modest annual return, generally slightly higher than a certificate of deposit (CD) from a bank.”

A variable annuity provides the potential for a higher return, but it also carries a more significant risk. This is because your retirement payments are based on the performance of investments in your personal “sub-account.” Here, you pick mutual funds from a menu.

When it comes to risk and reward, index annuities fall somewhere in the middle. Although you are guaranteed a minimum return, a portion is tied to the performance of a market index, such as the S&P 500, he states.

What is a qualified annuity?

A qualified annuity is funded by pre-tax dollars,” states Deanna Ritchie in a previous Due article. “Contributions to a qualified annuity are dependent on your income. Therefore, you must also follow the required minimum distribution rules that are also applied to traditional 401(k)s and IRAs. This means that you must begin taking minimum distributions starting at the age of 70 ½.”

What is a non-qualified annuity?

“With non-qualified annuities, you’re using after-tax dollars to fund the annuity,” adds Albert Costill in yet another Due piece. “That means you’ve already paid taxes on the money that you used to purchase it with.”

“Additionally, there are no required minimum distributions,” he says. “So, in a way, this is similar to how a Roth individual retirement account works. Unlike a Roth IRA, however, earnings that are withdrawn from non-qualified annuities are taxable at your regular tax rate.”

“And, the IRS doesn’t impose limitations on how much you can contribute to a non-qualified annuity annually. Just be aware that the insurance company that sold you the annuity may set an annual cap on contributions.”

What are the benefits of annuities?

A significant advantage of an annuity is that annuities offer tax-deferred growth. And, contrary to 401(k)s and IRAs, annuities have no contribution limits.

Additionally, annuities provide an income stream that can provide a predictable source of retirement income. Also, annuities eliminate any worry that you may outlive your savings, which is key in a post-pension age.

Are there disadvantages of annuities?

That’s not to say that annuities are flawless. Depending on the type of annuity you own, they can be expensive, complex, and only provide conservative returns.

In addition, there is “opportunity cost.” Potential customers often cite this as a significant disadvantage. For instance, if you’re able to absorb market losses, like a younger investor, this may prevent you from pursuing a more aggressive investment strategy.

How are annuities taxed?

You don’t pay taxes on annuity earnings until you withdraw them or turn them into a stream of payments, called annuitization. As a result, you may get a tax benefit, especially if you wait until you’re in a lower tax bracket (such as during retirement) before you begin to withdraw or convert the annuity to a stream of payments.

Remember that any earnings from your contract will be subject to tax if you make a withdrawal. Additionally, if you annuitize the contract, you may receive income. Each payment you receive from your annuity contract will be partially taxable and partly a return of your investment after you have annuitized.

Depending on your situation, if you withdraw from your annuity contract before age 59 ½, you may also face tax penalties. Therefore, an independent tax, legal, or financial professional should be consulted before you make any decisions regarding an early withdrawal.

What is an annuity rider?

An annuity can be enhanced with optional benefits similar to the way you can add a rider to your home insurance policy to protect your most valuable possessions. Some standard riders include:

  • With an income rider, you can receive guaranteed income for a certain period of time. This is a standard option for retirees who don’t want to run out of money in their golden years.
  • By acquiring a death benefit rider, you ensure that your beneficiary will receive your annuity balance, not the insurer, if you die.
  • An insurance rider for nursing homes helps pay for expensive long-term care, whether it be at home or in a nursing home.
  • When diagnosed with a terminal illness that reduces your life expectancy, a terminal illness rider lets you access some or all of your annuity balance without paying early withdrawal fees or surrender penalties.

In addition to protecting your finances, adding an annuity rider increases your income but at a cost.

What are the fees associated with purchasing an annuity?

While annuity fees and schedules will vary from company to company, the most common costs are;

  • Administrative annual fees. You’re typically charged these fees either as a percentage or on a flat-rate basis of your annuity’s value to maintain the contract. Generally, rates won’t exceed 0.30% of the contract value if the former applies. In contrast, flat-fee providers charge between $50 and $100.
  • Mortality and expense risk charge. This annual charge equals a certain percentage of the value of your account, generally about 1.25%. By charging this fee, the insurer is being compensated for assuming the risk of the annuity contract. In some cases, the annuity seller is paid a commission from the profit made from this charge.
  • Penalties. Depending on your age, you may have to pay a 10% tax penalty to the Internal Revenue Service if you withdraw annuity money before 59 12.
  • Fees and charges for other features. Special features, such as long-term care insurance and guaranteed minimum income benefits, usually include additional fees. In addition, other fees, such as initial sales loads, may be applied if transferring your account between investment options.

Are annuities insured?

It’s no secret that annuities are insurance products that insurance companies often sell. Despite this, annuities themselves are not insured. But that doesn’t mean that they’re not safe. Owners are protected if their insurance companies default on payments by state guaranty associations.

Can you tap an annuity early?

Even when you don’t own it within a retirement account, a deferred annuity functions somewhat like one. But, again, as long as you do not make withdrawals before age 59 ½, your investments grow tax-free. As such, if you want to fully enjoy your annuity benefits, you will have to wait until 59 ½.

Taxes and penalties typically apply when annuities are withdrawn early. An additional penalty may also apply to early withdrawals from annuities, called a surrender charge. These generally last six to eight years after purchasing the annuity.

How can I buy and sell an annuity?

As well as insurance companies, brokers, banks, and mutual fund companies sell annuities. Before committing to an annuity, always read and understand the contract. There should be no ambiguity about fees. Ideally, the best time to purchase an annuity is after you’ve maxed out your other retirement contributions.

If you decide to sell your annuity, you can either sell the entire annuity, a partial buyout, or a specific portion. In addition, selling an annuity can provide you with a liquid asset to address a financial emergency.

What happens to an annuity when you die?

“The short answer is that it depends on the type of annuity you own,” notes Rebecca Lake. “However, it also depends on the payout options’ structure and the death benefit terms.”

An annuity is an insurance contract you purchase. Annuity premium payments are made during the initial accumulation phase. Then, the annuity makes payments back to you during the distribution phase. With an immediate annuity, payments begin almost instantly. With a deferred annuity, they start at a later date,” Lake adds.

“Regardless of whether you have an immediate or deferred annuity, the goal may be the same: to provide an income stream,” Lake continues. Death benefit provisions may be included in your annuity contract, which details what happens to your annuity after your death. “Specifically, you can name a beneficiary that you’d like to receive any remaining annuity payments. In that sense, an annuity is similar to life insurance, in that you can provide a death benefit for a named beneficiary.”

If allowed, anyone can be named a beneficiary. And, you can even designate multiple beneficiaries, like if you have multiple children. How your beneficiary inherits an annuity depends on the payout type, which is often;

  • Single life or life only annuity. This type of annuity pays you for your entire life. There are no survivorship benefits, however.
  • Life annuity with period certain. Typically, annuities are paid over a minimum of 10, 15, or 20 years. Any remaining payments are paid to your beneficiary if you pass away during that time.
  • Joint and survivor annuity. During your lifetime, you and your spouse both receive annuity payments. If you and your spouse both pass away, your beneficiary can continue to receive payments.
Albert Costill

Albert Costill

Albert Costill graduated from Rowan University with a History degree. He has been a senior finance writer for Due since 2015. His financial advice has been featured in Money Magazine, Fool, The Street, Forbes, CNBC and MarketWatch. He loves to give personal finance advice to millennials.

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