An annuity is a contract between you and an insurance company, whereby you give the insurer your premium dollars, and in return the insurer guarantees* you certain benefits. While annuities are not life insurance policies, they are typically issued by life insurance companies and are considered insurance products.
An annuity can be a part of your total retirement strategy, in that you can purchase one with a lump sum or regular premium payments over time. Annuity assets grow tax-deferred, and interest is compounded. When you begin making withdrawals** or receiving payouts, you will only pay taxes on the interest earned if you paid for the annuity with after-tax dollars. There is no IRS limit as to how much premium you can put into annuities.
If you have determined that an annuity might fit within your financial strategies, you will then need to determine which one(s) might be most appropriate for your situation. The large number of annuity products on the market today can make selecting the most suitable annuity a challenge. But in fact, there are only a handful of different types of annuities. When selecting an annuity, you will be presented with essentially three choices:
Immediate or deferred payout – In an immediate annuity, the annuity owner begins to receive payments immediately after purchasing the annuity (or sometimes can wait for up to 12 months). The immediate annuity is for those who need income from their annuity right away. In a deferred annuity, the annuity-owner receives payments starting at some later date, often upon retirement.
Fixed or variable interest – Fixed annuities pay a fixed rate of interest for a fixed period of time, typically over 1-10 years. After that point, the interest rate may change, depending on the insurance company’s financial experience during that time, but the interest rate will never be below zero. Variable annuities enable you to invest in a selection of sub-accounts, such as securities portfolios, fixed interest accounts, and money market securities. These sub-accounts are tied to market performance, and often have a corresponding managed investment portfolio after which they are modeled. Variable annuities do have the potential to fall below the market and may lose some of the principal.
Liquidity options: Most annuities allow you to withdraw either your interest earnings or up to 15% per year without a penalty (although any withdrawal from an annuity may be subject to taxes and a 10% federal penalty if taken prior to 59 1/2 years of age). Most annuities have a surrender charge — a penalty for making an early withdrawal above the free withdrawal amount. Typically this surrender charge decreases over a period typically from the first to 15 years of the contract. Some annuities with surrender charges reward the owner by offering a bonus: the insurance company adds on an average 3% to 5% to the amount of your principal. Bonus annuities typically have slightly longer surrender periods, and some charge a slightly higher fee than they charge for a standard annuity. For retirees and pre-retirees who may need spur-of-the-moment access to their money, there are also annuities without any surrender charges — these annuities do not offer bonuses, and may also charge a slightly higher fee than the standard annuity, in exchange for 100% access to your money.
While there are many advantages to annuities, they are not right for everyone. Click here to see if an annuity is right for you.
* Annuity guarantees rely on the financial strength and claims-paying interest of the issuing insurance company.
** Withdrawals are subject to income tax and prior to age 59 1/2 a 10% federal penalty tax may apply.
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