Get Informed
How Do Annuities Work?
Annuities are long-term contracts between an individual and an insurance company that can generate steady income during retirement.
The contract holder agrees to pay the insurer a lump sum of money or a series of payments that grow over time. In return, the insurer agrees to pay a certain amount of money at regular intervals for a specific period of time.
The duration of this period and the amount of money promised to the contract holder will vary depending on the type of annuity.
Annuity funds and their growth are taxed only upon withdrawal. They may incur an additional 10% federal penalty for withdrawals before age 59-1/2.
Annuities typically bypass the probate process with a properly named beneficiary.
All annuities involve fees and charges, including potential surrender penalties.
Annuities can be funded with after-tax funds or with pre-tax funds as part of a qualified retirement plan.
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Annuities are long-term contracts, which may not be appropriate depending on your anticipated length of retirement.
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There are limited liquidity options with annuities and many aren’t designed for significant growth, potentially earning low or no interest.
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Not all annuities offer inflation-adjusted income.
Understand the 4 Types of Annuities
Not all annuities are the same. Some annuities pay out right away, while others focus on growth and don’t pay out for years. To find the right annuity for you, it’s a good idea to become familiar with the four basic types of annuities, their benefits, and their restrictions.
Fixed Annuities
Single Premium Immediate Annuities
Variable Annuities
Fixed Index Annuities (FIAs)
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Fixed Annuities
A fixed annuity is a type of insurance contract that promises to pay the buyer a specific, guaranteed interest rate on their premium payments into the annuity. Sometimes these types of annuities are referred to as a Multi-Year Guaranteed Annuity (MYGA). Consumers can buy a fixed annuity with either a lump sum of money or a series of payments over time. The insurance company, in turn, guarantees that the annuity will earn a certain rate of interest. This interest rate is generally for a determined time period, after which a new interest rate will be declared by the company.
ADVANTAGES
- A fixed annuity can guarantee that you receive ongoing income payments starting in retirement and continuing for a set period or the rest of your life.
- The initial interest rate is guaranteed for a certain portion of the contract. Rates can increase or decrease after that time, depending on your contract details.
- Most fixed annuities also offer a standard death benefit. That’s money paid to your beneficiaries if you pass away before annuity payouts begin.
- The benefit of guaranteed interest comes with the drawback of limited upside. When the market performs well, your fixed annuity will not pay anything extra.
- If you want to withdraw money during the surrender period you typically will forfeit a percentage of your withdrawal to the insurer.
- A fixed-rate annuity may not keep up with inflation. The inflation rate may be higher than the guaranteed rate your annuity contract pays.
- The interest earnings from your annuity have the benefit of being tax-deferred but also have the drawback of being taxed as ordinary income when withdrawn.
Single Premium Immediate Annuities
A single premium immediate annuity (SPIA) is one of the more consumer-friendly and simple choices for retirees, particularly if they need immediate income. With an SPIA, the contract holder can convert their retirement savings, such as funds from a 401(k) or other savings vehicle, into an annuity contract, which provides a permanent stream of income. At the time of purchase, the contract holder can choose the frequency of payments, which can be monthly, quarterly, semi-annually, or annually, as well as any customized options. These options can vary between annuity contracts but typically include life only (income for the lifetime of one person), joint (income for one person and their spouse), and payments over a structured period of time (which can provide income to beneficiaries beyond your lifetime).
ADVANTAGES
- Guaranteed, immediate income, usually within one month of signing the contract.
- May allow you to defer taxes on part of your retirement savings.
- Customizable options to help you reach your goals.
- Are often illiquid, which means once your contract has issued its set and there is no cashing it in for a lump sum unless you purchase additional features which usually come at the cost of income you receive from the policy.
- If you have not selected a certain period for your payments or purchased additional riders, your heirs are unlikely to receive a death benefit.
- All or a portion of the income you withdraw will be taxable as ordinary income.
- This product is not designed for growth.
Variable Annuities
Variable annuities offer periodic payments in exchange for a lump sum of money or a series of payments that can grow tax-deferred until you begin withdrawing. After withdrawal, the funds will be subject to ordinary income taxes. Variable Annuities have two phases: accumulation and payout. During accumulation, you make payments and allocate them to investment options. Your investments will fluctuate based on performance. During payout, you can receive payments as a lump sum or monthly payments over a set or indefinite period.
ADVANTAGES
- Your money can grow tax-deferred.
- VAs include a death benefit and sometimes a “stepped-up” death benefit which will lock in your investment performance and prevent a decline in value later.
- They are exempt from probate, and many states protect them from creditors.
- Your money has the potential to grow based on changes in the stock and bond markets.
- The fees are typically higher than other annuities.
- Additional features come with extra charges.
- You may be charged a transfer fee if you move money between investment options.
- They can be quite complex and sometimes carry riders with them you don’t need (but will pay for anyway) if you don’t review them thoroughly.
- Your investment can experience principal loss and could be worth less than your investment. There are not principal guarantees unless you purchase additional guarantee features or options.
Fixed Indexed Annuities (FIAs)
Fixed-indexed annuities (FIAs) are fixed annuity products that offer an alternative way to calculate interest. An FIA tracks a selected stock market index, such as the S&P 500 or the Dow Jones Industrial Average, and can earn interest tied to the performance of the selected index, typically on each contract anniversary. FIAs also protect a portion of your principal, so if the market index goes down, the worst that can happen is that you have zero interest for that year. However, if the index is higher on the anniversary of your contract, you can receive a portion of the growth as indexed interest credits, subject to limits set by the company called caps, spreads, or participation rates.
ADVANTAGES
- Your principal is protected from market volatility.
- Some contracts offer customization riders like guaranteed income or single and joint life options (some of these additional options may carry annual fees with them).
- Your money can grow tax-deferred.
CONSIDERATIONS BEFORE PURCHASING
- Interest credits are not guaranteed and are dictated by the underlying performance of the indexes it's tied to, even if you’ve chosen to allocate to a fixed account which is subject to change year over year.
- In years in which the annuity doesn’t earn any interest, the cost of additional riders purchased will be deducted which can reduce your principal value.
- You could lose buying power after years of rising inflation.
- You’re locked into your annuity for a set number of years (the surrender charge period), which means you will incur penalties if you choose to withdraw more money.