The Annuities Guide for Beginners
Learning more about annuities can help you understand what options are available to you. Below are the answers to questions that many consumers, similar to yourself, have asked our licensed annuity experts.
To start, an annuity is a legal document between you and your insurance provider. This document or contract helps you generate additional earnings and take advantage of tax deferments. Tax deferral benefits you because it can help you accumulate wealth for various long-term goals, including retirement.
In this context, the term annuity refers to your annual payments. Investors are familiar with annuities, making them a common choice for people of every level. This is because they receive a steady cash flow to for retirement income.
Any income that you receive from your annuity can be dispersed at a regular interval every month, quarter, annually, or even as a lump sum payment. The size of these payments depends on a variety of factors, including the length of the period you receive them.
An annuity consists of an accumulation phase and a payout phase. This means that once you purchase an annuity, your insurance company will pay you a specified income for an agreed-upon time frame. This can be immediate, which is an immediate annuity, or after the accumulation period has been reached, which is a deferred annuity.
Before you decide to buy an annuity, you should research and then consult a professional on whether purchasing an annuity is the best investment strategy for your current financial situation.
When it comes to managing an annuity, there are typically four parties involved: the owner, the annuitant, the beneficiary, and the insurance carrier.
The owner is the person who controls the annuity and holds the rights to the cash. The owner is also responsible for selecting the beneficiary, assigning the policy, and making withdrawals. In most cases, the owner is also the annuitant.
The most important thing to note when it comes to the structure of an annuity is that the owner receives the tax benefit for the annuity during the accumulation phase. The owner doesn’t pay annual taxes on the earned interest of the tax deferral. However, the owner may be responsible for paying taxes on withdrawals that are made during this phase. Instead, the owner typically receives payments during the income phase.
The annuitant is the individual whose life determines the measure of the annuity. In many cases, this is also the owner. So, when the owner dies, the beneficiary receives the benefits.
There are two annuity types to choose from: immediate and deferred.
An immediate annuity begins with your payments right away. You also get to choose if you want your income guaranteed for a set amount of time or how long you live. The insurance company considers the amount of each payment according to how much the purchase cost was and your life expectancy.
A deferred annuity is broken into two phases: accumulation and payout.
The accumulation phase is when the money grows. During this phase, earnings grow tax-deferred until they’re withdrawn. You choose when to receive payments, which dictates when you pay taxes.
The payout phase is when you begin to receive scheduled payments. This is typical during retirement. Depending on your needs, you can take out partial withdrawals, surrender the annuity, or receive money through a steady flow of income. This flow is called annuitization, which is the same as purchasing an immediate annuity.
All three of these options provide different ways that you can generate value and differ in how much risk is involved in each plan.
Fixed: With this plan, your insurance carrier guarantees an interest for a fixed timeframe. However, when this period ends, the carrier will offer you a new interest rate with a new timeframe. Additionally, most fixed annuities come with a fixed interest rate that lasts for the entire lifetime of the contract. This means that, regardless of the current market conditions, you will never receive less than the guaranteed percentage rate of the contract when it was signed. This type of annuity is ideal for individuals who want to know how much they’re earning.
Fixed indexed: The fixed index annuity comes with a higher performance risk than that of the traditional fixed annuity. On the other hand, it comes with the potential for a higher return if the market conditions sway in your favor.
True to its name, the fixed index annuity comes with an interest rate that is determined partially by an investment-based index. This means that the interest earnings are cemented into the account value, preventing it from being able to participate in potential future markdown returns all while the interest is being credited. Since the annuity is associated with an index, the offer to earn credit interest from a rising financial market can provide security similar to that of the traditional fixed annuity.
It may come with a lower performance risk than a variable annuity, but that also means that it comes with a lower earning potential than the riskiest alternative.
Variable: Now, with a variable annuity, you have a lot more control over the money in the investment. You can allocate your funds to a variety of investment options, all with different objectives. With this investment, your returns are connected to the performance of the investments in sub-accounts. Since this type of investment relies on securities, the principal amount and earnings will always fluctuate with the performance of those other investments.
Variable annuities differ from fixed annuities because the policy owner is subject to possible risk and loss of principal from the original contract. This type of investment is more complex and can only be sold by brokers who have experience with them.
- Earning potential: A fixed index annuity can help you get higher interest rates on your earnings than a fixed annuity that comes with a minimum interest credit rate. You also don’t have to worry about downward market risk; your down payment is always protected, no matter how much the market fluctuates.
- Less stress: It can help you save money by guaranteeing you money for life. Your retirement fund will be right there with you no matter how long you’re here.
- Cover the gaps: Social Security, IRAs, and pensions don’t always have you covered. A fixed index annuity can supplement the gaps in your retirement fund.
Annuities make a good retirement investment because you have the guarantee of a monthly income that you might not otherwise receive, depending on your financial situation. You will receive this money each month for the rest of your life.
With a fixed annuity, you have a periodic flow of income. This can be purchased in a lump sum that immediately generates income. There are also a variety of payout options that are offered by your chosen insurance carrier. The structure of this investment is determined by the contract set with your insurance carrier. Typically, the longer you choose to receive the benefits, the lower your monthly payments will be. However, each company determines its payment schedule based on the individual’s expected survival rate and the carrier’s expected earnings. You’re purchasing the guarantee of a fixed income, but you also lose control of your capital.
The alternative of the variable annuity allows you the option of an investment that can potentially earn you a higher return and gives you more control over your investment. The options with this alternative provide you with more flexibility by allowing you to better tailor it to your financial needs. However, since variable annuities don’t come with any guarantees, you take on a higher risk of losing your principal and an increased chance of earning more than you could with a fixed annuity.
Despite the marked differences, you can take out money from both of these annuities as long as they haven’t been annuitized. Once an annuity has been annuitized, no withdrawals can be made, and the company pays out the income. That’s it. You essentially exchange the value for a fixed income as long as the contract lasts.
Although you’re unable to swap securities or an investment account for an annuity, there are several situations where you can exchange your funds for one or more annuities. These include:
- Rollover of assets or through a qualified employer plan.
- Exchange of any form or deferred annuity, whether in full or in part.
- Exchange of cash value of a life insurance policy.
- Rollover from current traditional or Roth IRA
The amount of your savings you should use will be determined by how much money you want to receive, for how long, and your risk tolerance. You should also take into consideration other forms of income and the disbursement of your retirement savings when calculating risk management. An annuity will become part of your retirement planning.
There are several ways you can purchase an annuity, but this is typically done with the funding you have saved for your retirement planning, in addition to any deferred annuities or lump sums you received. These lump sums can be the products of any life events such as an inheritance, selling properties, or funding from a life insurance policy. Your deposit can also come from any accounts that have generated a high-interest rate. The funds can also come directly out of retirement plans. However, these may offer limited annuity plans.
While you are considering where to get the money for your annuity, you should consider assets that you have that don’t require taxable gain. This typically includes stocks and mutual funds.
However, these are a few of the options in which gain is not taxable:
- Deferred annuities:This can include fixed and variable annuities. Even if they have appreciated since they were purchased, the annuity may be eligible to be exchanged with another income tax-free annuity. The taxes will still be paid, but they can be dispersed if you are in a lower tax bracket.
- Home downsizing gains: Even if the value of your home has gone up, some gains can be excluded from taxes.
- Inheritance: If you are receiving appreciated assets, these assets can receive a step-up in basis at death, so unreceived capital appreciation does not get taxed.
The options are the same, regardless of what annuity type you purchase. You can still choose to receive payments monthly, quarterly, semi-annually, or annually. You can also choose a specific time frame in which you would like to receive the payment. You can also choose to receive a guaranteed income for the rest of your life.
Some of your other options include:
- Advance: This means that your income will be paid out from the start date
- Arrears: This means that the income will be paid either in a month, a quarter, a half-year, or even a year after the start date.
- Chosen start date: This means that you can choose to be paid out on a certain date each month. For this plan to work, the first payment is required within one month of the start date. This option is only available if income is paid monthly.
Yes, there are! Under federal law, annuities are eligible for special tax treatment. Income tax on annuities is deferred, meaning you are not taxed on the interest your money earns while it remains under the contract of the annuity.
When you annuitize a deferred annuity or purchase an immediate annuity, a percentage of each payment is considered earnings, while another percentage is the tax-free return of your principal. Before you reach the mid-point of your 59th birthday, these earnings remain taxable as regular income if they are distributed or withdrawn.
Once enough payments have been made on the annuity, you can recover the entire principal, and any additional payments will be fully taxable. But, there are other ways to access the value that has accumulated. For instance, rather than annuitizing, you can make withdrawals. These distributions will represent the taxable earnings. Once the earnings are distributed, the return of the principal will remain.
If your annuity is associated with an IRA, 401(k), or a similar retirement plan, the entirety of the payment will be subject to taxes.
Annuity Associates is not authorized to provide tax advice, so it’s highly recommended you speak with your tax or legal advisor to discuss your situation regarding taxes.
One of the biggest advantages that come from purchasing annuities is the guaranteed income. This type of guaranteed income can only come from insurance company-issued annuities and beneficiary income payments.
Unlike other tax-deferred retirement accounts, your contributions have no annual limits. This makes saving additional money for retirement easier, which is especially helpful when you’re close to retiring but need a little push to catch up with your retirement fund goals.
The money is compounded each year without a tax bill, allowing you to use every penny you’ve saved to generate a larger investment as opposed to what you would lose with alternative taxable investments.
In addition, when you’re ready to cash out the payments, you can choose to have it paid out in a lump sum. But if you’re not interested in a lump sum, you also have the choice to receive guaranteed payments that will come through whenever you set the time frame for. This could be for the rest of your life or just the next few years.
The annuity you purchase is designed to cushion additional retirement income sources for you to live your best retirement life. Keeping in mind how much money you would like to have in your retirement savings, what your financial situation looks like at the time of purchase, and any plans to meet that goal will influence how well these benefits apply to you.
As with all things, there are some disadvantages. Below are two of the biggest advantages that come with this investment type.
- Surrender charges: There’s a high chance you’re going to be met with a restrictive surrender charge if you withdraw any money from your annuity within the first few years after purchasing it. Surrender charges are a type of sales charge that individuals are required to pay if they sell or withdraw any money that is kept in their annuity within about six to eight years after purchasing it. In addition, these charges will reduce the value and the return of your investment. These charges usually decline until they go down to nothing. It’s important to keep in mind that some surrender charges can be as high as 20% in the first year after purchase. You don’t want to pay that on your new investment. You should avoid making any withdrawals if possible.
- High annual fees: If you purchase a variable annuity, there is a chance you will have higher annual expenses. This insurance charge can start at 1.25%, with annual investment fees ranging from 0.5% to over 2%. From there, you can have an additional 0.06% for rider’s fees. Altogether, you could be paying as much as 3% just in annual fees on your investment. This could result in a huge hit to your retirement funds and, in some cases, cancel some of the benefits.
There are different fees and costs that come with every annuity contract. You want to make sure you understand everything before making the purchase, so don’t hesitate to ask any questions before making a decision. Most insurance carriers won’t charge an initial commission fee, but they will levy a large surrender charge if you wish to withdraw or transfer any money from your annuity to another company within the first few years.
Some companies allow one free withdrawal after the first year but apply a charge for any year thereafter. This free withdrawal is usually limited to a certain amount, which tends to be about 10% of the accumulated value. Keep in mind that withdrawals are subject to income tax if it’s taken out before the age of 59 ½. This penalty tax is about 10% as well.
When it comes to immediate annuities, surrender charges don’t apply. This is because once the contract is official, it can no longer be surrendered. On the other hand, variable annuities have higher expenses than the traditional fixed annuities due to sub-accounts having a 3% rate or higher.
Most experts report that you should have an annuity for a minimum of 15 years for the annuity to be a worthwhile investment in comparison to a mutual fund. This value is typically lower than that of fixed annuities, but it’s still an option worth considering. When it comes to immediate variable annuities, these higher expenses are the result of lower monthly checks that you will receive.
A majority of annuity contracts permit you to make a one-time withdrawal per year without being charged a withdrawal fee. This amount is typically limited to 10-15% of the current accumulated value of the investment. However, they comply with income tax laws for all withdrawals, including the free once-a-year withdrawal.
Another way that you can get money from your annuity is through what is called the systematic withdrawal plan. A systematic withdrawal plan is what allows you to receive a guaranteed flow of income every month, quarter, semi-annual, or annual basis.
The systematic withdrawal system differs from annuitization because it’s not a permanent decision. This system gives you the option to start or stop these payments whenever you desire. These payments give you flexibility without losing control of your money or the taxes that come with the transactions.
With systemic withdrawals, the earnings are taxed first, so your earnings have been exhausted, allowing the tax-free return on principal to remain.
No. Annuities are only sold by licensed insurance professionals. These experts are required to complete training and must represent the company with a valid insurance license in your state. They are compensated directly by the insurance carrier, meaning that 100% of your funds are working for you from the beginning. Get in touch with Annuity Associates to learn more. We’re here to guide you through the annuity buying process from top to bottom.
Figuring out which insurance company to go with depends on what you’re looking for. The market is competitive, with countless companies offering different types of annuity plans to the public. The same type of investment can have anywhere between 5-10% in purchase rates, depending on which company you’re looking at.
You’ll want to make sure you make the best choice for yourself and your finances because the wrong choice can have a major impact on your retirement income amount. You might not know you made the wrong choice until it’s too late to back out of a contract.
It’s important to keep in mind that the ranking of insurance companies depends on their objectives and market conditions at the time. These ratings will fluctuate along with these factors. Make sure that you’re reviewing a current ranking to ensure that it’s right before making a purchase.
There will also be different product features that you’ll want to pay attention to before settling on an option. Not only will you want to move forward with the company that has the best rates, but you’ll also want to select the product that has the best features that you want. Finding these ratings to help you narrow your search comes from recognized rating agencies.
There isn’t necessarily a right time or a wrong time to make this investment. However, there are a few situations where purchasing one will make the most sense. These situations include:
- When you’re saving for retirement: If you’re already putting the maximum into other retirement funds, then a fixed indexed annuity may be an ideal investment for you. This will add some more cushion to your retirement savings, especially since it’s tax-deferred.
- When you aren’t strapped for cash: If you’re comfortable in your current situation and don’t expect to need the money needed to invest, then a fixed annuity may be ideal for you. As long as you don’t need the money before you’re 59 ½, then the investment can shape up to be a great way to maximize your retirement funds.
- When your savings won’t cover you: Ideally, you won’t outlive every penny of your retirement fund. You want your fund to comfortably cover you for the rest of your life, so you’re free to enjoy retirement. Annuities provide the comfort of a steady income for life, even if you live to be over 100. In this day and age, living into the next century has become more common.
How the payments are handled after your death depends on the plan of the investment you purchased. The calculations, whether you named a beneficiary, and the payout you chose will impact the process. Payments can either stop or be passed over to a spouse.
Annuities are complicated, so you don’t see most of the work that goes on behind the scenes. You receive guarantees from your chosen insurance carrier, and then you receive fixed income payments or wait until your payout date arrives to enjoy all your savings.
Below are some of the ways it’s determined whether or not payments will continue and who will get them:
- Simple lifetime payout: With this plan, the payment ends when the annuitant dies. So, in this case, you and your heirs do not get your principal back when you pass away. However, this option provides the largest annual or monthly payments because you’re taking a significant risk.
- Lifetime payout with period certain: With this option, the payments will be made as long as the period certain, which can be your life or longer, is within bounds. In this case, your beneficiary will receive payments until this period has ended. This means they will most likely receive some of your principal. However, this is done in exchange for smaller payments that would otherwise come out of a lifetime investment.
- Joint (and survivor) lifetime payout: If one person on the annuity contract is still living, the insurance carrier will continue to make payments. While the payment may decrease after the first person dies (this isn’t always the case), the payments will continue to come in as always. However, once the second person dies, there will be no more payments, and a refund will not be given unless additional features are added to the investment contract.
- A lifetime with a refund: The “refund” option is to protect individuals against early death. If you die before the principal is earned back, the insurance carrier will pay the difference to your named beneficiaries. Again, this option is in exchange for smaller payments.
- Period certain only: You can also opt for this option that gives you payments for a set number of years, even if you’re still alive beyond the set period. You or, in some cases, your beneficiaries will get your money back because the payments aren’t based on your life expectancy.
Whatever option you choose, the insurance carrier is required to honor the terms of your contract.
Insurance company financial rankings may fluctuate based on company objectives and market conditions, therefore you should get current rankings whenever considering a new purchase. Since there may be little difference in product features, you generally want to select the company with the best rates. However, you still should pay attention to the insurance company ratings, which are assigned to insurance companies by recognized rating agencies.
If you decide you no longer want the annuity, you can return it and receive your money in full. This can be done within the allotted time frame allowed in your state for reviewing annuity contracts. This process refers to the “free look” or “right to return” period.
Traditional qualified annuity plans are regulated by federal tax codes, making them eligible for some tax credits and advantages. Non-qualified annuities come from places like savings accounts or from selling your home, which are considered after-tax money reserves. Both offer tax-deferred compounding and the option for a lifetime income.
If a joint and survivor annuity is purchased, a joint annuitant is the person named to continue receiving benefit payments upon the annuitant’s death. Depending on the type of annuity, the joint annuitant’s gender and age also are used to determine how long the benefits will be payable. After a purchase is made, the joint annuitant cannot be changed, whereas the beneficiary can be changed. A beneficiary is a person named to receive a lump sum death benefit or monthly payments after the annuitant and/or joint annuitant’s death, if applicable.
The accumulation phase is the period when the value of the investment is generated. This phase lasts until the payout or annuitization phase begins. Again, this is when you start receiving payments.
An annuity rider is the result of investors being drawn to annuities that come with guaranteed income with mutual aid investments. These attached benefits are the income riders. They are a diverse range of benefits that can also be purchased with fixed indexed annuities.
In comparison, life insurance policies protect individuals and families from financial loss if their primary breadwinner passes away unexpectedly, while life annuities are used to help fund people who are expected to live a long life. Life annuities guarantee you a fixed periodic income stream that you can’t outlive. As a result, if you choose to take income payments for the rest of your expected life, you will have a source of income the entire time.
However, if you don’t live as long as expected and therefore receive income that is less than what you paid in the beginning, the insurance carrier makes more money. If you surpass the life expectancy, then you can get back more than the initial cost of the annuity.
Unfortunately, neither deferred annuities nor variable immediate annuities are liquid. Variable deferred annuities come with penalties and surrender charges for early withdrawals. On the other hand, variable immediate annuities only allow fixed monthly payments to help you avoid this problem.
We know this is a lot of information to process. Annuity Associates is here to connect you to qualified insurance agents from across the country. These experts will help you find the right annuities for your retirement goals depending on your income needs. If you’d like to learn more about your options, get current rates, or get more information on how to purchase, contact one of our specialists for a free consultation.