People today are living longer than ever before in history. But, while a long life may be nice, it can stretch out your retirement savings and income for a much longer period of time.
The biggest fear on the minds of many retirees today is outliving retirement income. So, how can you ensure that you will have income for as long as you need it – regardless of how long that may be? One way is by purchasing an annuity.
An annuity is technically defined as a type of contract that is between an individual and an insurance company. This contract can guarantee a stream of income to the person on whose life is based on this contract – otherwise known as the annuitant.
The income payment is in return for either a lump sum deposit or periodic deposits over time. The interest that occurs inside of an annuity is income tax deferred until it is either paid out or withdrawn.
How Does an Annuity Work?
Annuities can be structured in different ways, based on how they are funded, and in terms of how (and how long) they pay out an income stream.
An immediate annuity will begin to pay out income immediately, or very soon after, a lump sum is deposited. A deferred annuity will allow either one single deposit or numerous deposits over time. Then, at a point in the future, it will pay out income.
There are typically several different income options on annuities. These may include the payment of income for a set number of years. There is also usually a lifetime income option. By choosing to receive lifetime income, payments from the annuity will continue for the remainder of your life.
With some annuities, if the annuitant (income recipient) dies before receiving income, a named beneficiary will receive a death benefit.
What are the Different Types of Annuities
There are several different types of annuities. These include fixed, fixed indexed, and variable.
With a fixed annuity, a fixed amount of interest will be credited to the account each year. This rate is declared by the offering insurance company. While this rate is usually quite low, the funds inside the annuity are protected – regardless of what occurs in the market.
Fixed indexed annuities provide the opportunity for a higher rate of return than regular fixed annuities. That is because the return on a fixed indexed annuity is based on the performance of an underlying index, such as the S&P 500.
If the index performs well, the return will be credited to the annuity – typically up to a certain “cap.” However, if the index performs poorly in a given time frame, the principal is still protected, and the account is simply credited with a 0% for that period.
Many people like fixed indexed annuities. One reason for this is because they provide the ability for a nice return, while also keeping principal safe.
With variable annuities, the return is based on the performance of underlying equities. These typically include mutual funds. The annuity holder does not invest directly in these investments, though. Rather, the funds are held in the insurance company’s “sub-accounts.”
While a variable annuity can provide the opportunity for a high return, they are also subject to risk if the market goes down. Unlike a fixed indexed annuity, the principal is not protected in a variable annuity.
The Pros and Cons of Having an Annuity
As with most other financial vehicles, there can be pros and cons of owning an annuity.
With that in mind, annuities should always be considered as long term financial commitments.
There are also many advantages to owning an annuity. For instance, with a deferred annuity, the funds are allowed to grow tax-deferred. This means that no tax is due on the growth until the time the money is withdrawn.
Also, the income that is received from an annuity can last a lifetime. By choosing the lifetime option, an annuity holder can rest assured that his or her income will last as long as it is needed.
One key consideration is that there can be fees and charges involved on annuities. For instance, if an annuity holder withdraws more than 10% of the account value within the first several years of purchasing the annuity, they will usually be hit with a surrender charge.
In some instances, an annuity may be used as collateral for a loan. In this case, the monetary value of the annuity is considered. When considering the use of a qualified annuity as loan collateral, it is important to consult with a tax professional, as the value of the annuity may be treated as being distributed – which in turn, can lead to being taxed on the amount that is used. In addition, if you are under age 59 ½ when using an annuity’s value as loan collateral, you may also be subject to an additional IRS “early withdrawal” penalty of 10%.
With most deferred annuities, you are able to up to 10% of your annuity’s value each year without adverse tax consequences during the annuity’s “accumulation period”, until the annuity’s surrender period has ended. Annuities will typically have surrender charges if you withdraw more than 10% of the total account value within the first several years of owning the annuity.
In addition to the tax consequences that you may incur when you withdraw money from an annuity, you could also be subject to an additional “early withdrawal” penalty of 10% from the IRS if you withdrawal the money before 59 1/2.
If you are purchasing an immediate annuity, you are typically able to begin receiving an income stream right away (or at least within six months of purchasing the annuity).
There are several ways in which an annuity can be paid out. Annuity owners may withdraw the entire lump sum value of their account. If this is done within the surrender period, a surrender charge will generally apply on amounts that are withdrawn over and above 10% of the annuity’s value.
Once an annuity is converted over to its “income” phase, most will allow the choice of several different income options. These may include:
- Period Certain – With the period certain option, the annuitant will be guaranteed to receive a set amount of income for a certain period of time (such as 10 or 20 years). If the annuitant dies during this time period, the remainder of the annuity’s amount will be paid out as a death benefit to a named beneficiary.
- Lifetime Income – The lifetime income option will continue to pay out a certain amount of income for the rest of the annuitant’s life – regardless of how long that may be.
- Lifetime Income with Period Certain – With this option, income will be received for a certain period of time. If the annuitant dies during this time period, a named beneficiary will rec