When looking at annuities, it’s important understand what they involve. A good starting point is understanding their fundamentals. In this article, you will learn about various types of annuities, different uses for them in a financial plan, and questions to ask when considering them.
What is an Annuity?
An annuity is a contract between a policy owner and an insurance company. People pay premiums to the insurance carrier. Depending on the contract, premiums may be paid in a lump sum or as a series of payments over time. In exchange, the insurance carrier provides specific guarantees, which are stated in the contract.
These guarantees may apply to a number of contract components. They may encompass income payments, interest crediting, contract withdrawals, or death benefit protections.
A primary purpose of an annuity is to provide someone with a steady stream of income payments. Some people need to start receiving income right away, so they buy an immediate annuity. Most annuities, except for immediate annuities, allow your money to grow tax-deferred until you start making withdrawals.
Single and Deferred Annuity Contracts
Depending on your needs, you can start income payments now or at a future date. This difference is important for distinguishing between two primary categories of annuities: single annuities and deferred annuities.
- Immediate annuities are also known as “single premium immediate annuities,” or SPIAs for short. You make a premium payment, in most cases a single lump sum, and in exchange will receive income payments in the future. Generally speaking, income payments begin no later than 12 months after the premium payment.
- Deferred annuities begin income payments at a later point in time. This is generally a number of years after the premium payment. In deferred annuity contracts, there is a period before income payments start called the “accumulation period.” During this time, the premium you paid into the contract – less any applicable charges – is credited interest. This money grows tax-deferred as long as it stays in the contract.
When income payments begin is another period, which is called the “payout period” or the “distribution period.”
Immediate annuities don’t have an accumulation period. In the payout period, the insurance carrier will make payments to you or someone you choose. You may have a variety of annuity distribution options. Some choices are free withdrawals, lifetime income withdrawals, annuitization, or lump sum cash surrender.
What Different Types of Annuities are Available?
Generally speaking, there are five overall types of annuities:
- Immediate Annuities (SPIAs)
- Fixed Annuities
- Fixed Index Annuities (FIAs)
- Multi Year Guarantee Annuities (MYGAs)
- Variable Annuities
Here are some terms that help to identify specific features within the annuity: Flexible or single premium annuities.
This means having the ability to add money or not. Annuities are issued by insurance companies and all vary within the contract design.
There are a variety of annuities to help fit your individual needs. It’s important to understand that just like with any financial product, different types of annuities fit different needs. Before committing to any annuity contract, it’s also crucial that you understand its pros, its cons, its guarantees, and its other important details.
What is the Difference between a Single Premium or Flexible Premium?
You pay the insurance company only one payment for a single premium annuity. On the other hand, you can make a series of payments into a flexible premium annuity.
There are two kinds of flexible premium annuities. In a flexible premium contract, you pay as much premium as you want, whenever you want, within set limits. For a scheduled premium annuity, the contract spells out your payments and how often you must make them.
How are Fixed Annuities Different from Variable Annuities?
Fixed: During the accumulation period of a fixed deferred annuity, your money earns interest at rates set by the insurance company or in a way spelled out in the annuity contract. The company guarantees that it will pay no less than a minimum rate of interest. During the payout period, the amount of each income payment to you is generally set when the payments start and will not change. Note, this applies with annuitization income.
Variable: During the accumulation period of a variable annuity, the insurance company puts your premiums into a separate component. You decide how the company will invest those premiums, depending on how much risk you want to take. You may put your premium into stocks, bonds, or other accounts, with no guarantees, or into a fixed account, with a minimum guaranteed interest rate. During the payout period, the amount of each income payment to you may be fixed (set at the beginning) or variable (changing the value of the investments in the separate component).
How do I Know if a Fixed Deferred Annuity is Right for Me?
You should think about your goals for the money you put into the annuity, and how much risk you’re willing to take.
Ask yourself the following questions:
- How much retirement income will I need in addition to what I’ll get from Social Security and my pension?
- Will I need that additional income only for myself, or for myself and someone else?
- How long can I leave my money in the annuity?
- When will I need income payments?
- Does the annuity allow me to get money when I need it?
- Do I want a fixed annuity with a guaranteed interest rate and little or no risk of losing the principal?
- Do I want a variable annuity with the potential for higher earnings that aren’t guaranteed and the possibility of losing principal?
- How are interest rates set for my fixed deferred annuity?
- During the accumulation period, your money earns interest at rates that change. Usually, what these rates will be is up to the insurance company.
- For those wanting a steady rate, there are options. Some MYGAs (multi-year guarantee annuities) will not change for the suggested term of the contract.
What is a Current Interest Rate?
The current rate is the rate the company decides to credit to your contract at a particular time, which the company guarantees will not change for some period. The initial rate is an interest rate the insurance company may credit for a set period of time after you first buy your annuity.
Some contracts offer a higher initial rate, then the interest rate is lower later on. This is often called a bonus rate. The renewal rate is the rate credited by the company after the end of a specified time period.
Your contract will state how the insurance company will set the renewal rate. In some contracts, the renewal rate may be tied to an external reference or an external index.
What is a Minimum Guaranteed Rate?
The minimum guaranteed interest rate is the lowest rate your annuity will earn. Your contract will state this rate.
What Charges or Fees may be Taken from My Fixed Deferred Annuity?
Most annuities have charges related to the cost of selling or servicing it. These charges may be subtracted directly from the contract value. Ask your financial advisor or the insurance company to describe the charges that apply to your annuity, if any.
Some possible charges or fees are:
- Surrender charges (a penalty for withdrawing too much money or during the surrender period)
- Withdrawal charges (fees that may be incurred if more than the contract-permitted withdrawal amount of money is taken)
- Contract or transaction fee (a flat dollar amount that is charged annually or one time; a charge per premium payment or other transaction)
- Percentage of premium charge (a charge determined from each premium that is paid)
- Premium tax (a tax on premium payments levied in some states, in which the cost is passed onto the annuity buyer)
Some Fixed Deferred Annuity Income Payment Options
One of the most important benefits of deferred annuities is your ability to use the value built up during the accumulation period to give you a lump sum payment or to make income payments during the payout period.
Income payments are usually made monthly, but you may choose to receive them less often. The size of the income payments is based on the accumulated value in your annuity and the benefit rate in effect when payments start.
The company pays income for your lifetime, but doesn’t make any payments to anyone after you die. You might choose this option if you have no dependents, if you have taken care of them through other means, or if the dependents have enough income of their own. This payment option usually pays the highest income possible.
Life Annuity with Period Certain:
The company pays income for as long as you live and guarantees to make payments for a set number of years – called the period certain – even if you die. The period certain is usually 10 or 20 years. If you live longer than the period certain, you will still continue to receive payments until you die.
However, if you die during the period certain, your beneficiary gets regular payments for the rest of that period. If you die after the period certain, your beneficiary does not receive any payments from your annuity.
Joint and Survivor:
The company pays income as long as either you or your beneficiary lives. You may choose to decrease the amount of the payments after your death, or you may be able to choose to have payments continue for only a set length of time.
What is the Tax Treatment of Annuities?
Under current federal law, annuities receive special tax treatment. Income tax on annuities is deferred, which means you are not taxed on the interest your money earns while it stays in the annuity. Tax-deferred accumulation is not the same as tax-free accumulation.
An advantage of tax deferral is the tax bracket you are in when you receive annuity income payments may be lower than the one you are in during the accumulation period. You will also be earning interest on the amount you would have paid in taxes during the accumulation period. Most states’ tax laws on annuities follow the federal law.
Part of the payments you receive from an annuity will be considered as a repayment of the premium you have paid. You won’t have to pay taxes on that part.
Another part of the payments is considered interest you have earned. You must pay taxes on the part that is considered interest when you withdraw the money. You may also have to pay a 10% tax penalty if you withdraw the accumulation before 59.5.
The IRS tax code has rules for distributions upon the death of the contract holder.
What is an Annuity “Free Look” Period?
Many states have laws which specify a number of days to look at the annuity contract after you buy it. If you decide during then that you don’t want the annuity, you can return the contract. You can get all of your money back.
This is often referred to as a free look or right to return period. The free look period should be prominently stated in your contract. Be sure to use this feature, if available, and review your contract carefully.
Important Questions to Ask Before Buying an Annuity
- Is this a single premium or flexible premium contract?
- Is this a Fixed-Indexed Annuity?
- What is the initial interest rate and how long is it guaranteed?
- Does the initial rate include a bonus rate, and how much is the bonus?
- What is the guaranteed minimum interest rate?
- What renewal rate is the company crediting on annuity contracts of the same type that were issued last year?
- Are there withdrawals or surrender charges or penalties if I want to end my contract early and take out all of my money, and if so, how much are they?
- Can I get a partial withdrawal without paying surrender charges for reasons such as death, confinement in a nursing home or terminal illness?
- Is there a market value adjustment (MVA) provision in my annuity?
- What other charges, if any, may be deducted from my premium or contract value?
- If I pick a shorter or longer payout period or surrender the annuity, will the accumulated value or the way interest is credited change?
- Is there a death benefit? How is it set? Can it change?
- What income payment options can I choose? Once I choose one payment option, can it be changed?