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The days of generous company pensions are mostly a thing of the past. Now, people usually have to put money away for their own retirement planning, such as 401k and IRA plans. Another retirement account is annuities, which offer special features and tax benefits.
Annuities for retirement can be an important part of your financial plan, but they’re not for everyone. In this article, you’ll learn about annuities and how they work, so you can determine whether they work for you.
What is an annuity?
Annuities is a retirement planning option that provides an income stream during retirement.
They’re insurance contracts between the insurance company and the owner. The owner decides on the annuitant and beneficiaries. The insurance company determines how much and when income is paid based on the annuitant’s age and sex.
The insurance company guarantees to pay income for the life of the annuitant or a period of time. You decide whether you want annuities that are fixed or variable for your individual retirement.
The guaranteed lifetime income feature is what distinguishes annuities from other retirement savings products. At the owner’s death, the beneficiary receives proceeds not paid out by the insurance company.
Annuities are retirement products — and they receive special tax treatment.
The premiums deposited into an annuity grow tax deferred until the owner takes withdrawals or income. The IRS imposes a 10% penalty tax on withdrawals taken before age 59 1/2.
KEY TAKEAWAYS
- Annuities are an insurance contract to help you save for retirement and can provide a stream of income for the rest of your life.
- The beneficiary receives money not paid out by the insurance company at the annuity owner’s death.
- Money taken out of an annuity account before the age of 59 1/2 is subject to a 10% federal tax penalty.
How do annuities work?
Retirement annuities are purchased by making either a single lump sum or a series of payments. That’s called the accumulation phase of an annuity contract.
Deferred annuities accumulate money for one year or more before income is paid out to the owner. Immediate annuities mean you begin receiving payments within one year of the lump sum payment or start of payments.
Annuities can be tax qualified or non tax qualified. Tax qualified annuities are purchased within:
- An IRA
- 401 k plan
- 403 B plan
Contributions to tax qualified annuities are made with before tax dollars. Non qualified annuities are purchased individually with after tax dollars.
Retirement annuities are either deferred or immediate:
- Deferred annuities accumulate money for one year or more before the insurance company pays out deferred income.
- Immediate annuities begin to pay income within a year of purchase.
Annuity contracts offer four basic options to take income:
- Life only — The insurance company guarantees income to the owner for the life of the annuitant. The annuity payments cease at the death of the annuitant.
- Life and period certain — The insurance company pays an income to the owner for the life of the annuitant for at least the period certain. For instance, 10-year certain pays income for at least 10 years and 20-year certain for at least 20 years.
- Period certain — The insurance company pays income to the owner for a set period of time.
- Joint life and survivor — The insurance company pays income for the lives of two annuitants. The survivor receives either 100% of the income or a reduced percentage for the remainder of their life.
Annuities pay a death benefit to the beneficiary if the owner dies before the insurance company has paid the full amount of the income due. If the owner dies before the income begins, the beneficiary receives the full value of the account. If the owner dies while income is being paid, there’s no death benefit unless there is a period certain or a joint and survivor option.
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Types of annuities
There are four types, including indexed, fixed and variable. Which type of annuity is best for you? Let’s take a look.
Fixed annuities
Fixed annuities can be either immediate or deferred:
- Immediate fixed annuities pay a set income that doesn’t change.
- Fixed deferred annuities pay interest on the premiums deposited.
The rate of interest is guaranteed for one to 10 years depending on the policy.
Variable annuities
The premium deposits of variable annuities accumulate money in investments selected by the owner called subaccount funds.
Subaccounts are similar to mutual funds and offer a wide menu of investment options. Like mutual funds, subaccount funds aren’t guaranteed. Variable annuities can be immediate or deferred. Immediate variable annuities pay lifetime income that changes based on the performance of the subaccounts selected.
Variable annuities also offer optional benefits called riders. These riders enhance the death benefit and income options at an additional cost.
Fixed indexed annuities
A fixed indexed annuity has the same features as fixed annuities with one important difference. Fixed indexed annuities offer tax deferred growth based on the stock market without stock market risk. Index accounts credit a portion of the gains of a market index like the S&P 500 and none of the losses.
Principal is guaranteed. Fixed indexed annuities are only deferred. They also offer optional enhanced death benefits and income options.
Indexed linked annuities
Index linked annuities are similar to fixed indexed annuities. The difference is they offer a range of upside gains and downside protection. For example, an indexed linked option may be a 10% downside protection with a 7% upside cap on the gains.
Principal is not guaranteed.
Tax benefit of annuities
Non qualified annuities accumulate money on a tax deferred basis. Taxes aren’t paid on interest or gains until the money is withdrawn from the annuity. This feature is especially important for variable annuities because the owner can buy and sell subaccount funds without paying capital gains tax.
Non qualified annuity withdrawals are 100% taxable until all of the gains are exhausted. Withdrawals of principal aren’t taxable. Non qualified annuities are taxed at ordinary rates.
Annuity lifetime income options are taxed partly as gain and partly as principal. There is a 10% penalty tax if you withdraw money from a non qualified annuity before age 59 1/2.
There is no additional tax benefit to qualified retirement annuity plans. Qualified plan contributions are already pre-tax, and deposits accumulate tax deferred. All withdrawals and income from qualified annuities are 100% taxable at ordinary rates.
Who is the best candidate for buying an annuity?
Generally, annuities are often best for people over the age of 50 who want a retirement plan with guaranteed income. You should have enough liquid investments to cover any emergencies or unusual expenses.
An annuity shouldn’t be your only retirement investment. If you’re a senior, you should carefully review your retirement plan and talk to a personal finance professional before buying an annuity.
Here are some ways that annuities can be used in your financial plan.
Certificate of deposit alternative
Fixed multi-year guarantee annuities generally offer a higher guaranteed minimum interest rate than a similar term CD. Multi-year guaranteed annuities usually have a surrender charge for the same period as the interest rate guarantee.
The interest is tax deferred until money is withdrawn.
Supplemental retirement savings
If you’re contributing the maximum amount to your company-sponsored retirement plan or IRA, a deferred annuity may be a good option because of the favorable tax treatment. The account values of annuities grow tax deferred. You can reallocate your portfolio in a variable annuity and defer the tax on capital gains.
Portfolio management
Investors can rebalance the fixed income and equity subaccount fund allocations without triggering capital gains tax.
Downside protection features
For some investors, the downside protection features of indexed and variable annuities may be attractive. Variable and indexed annuities offer a variety of living benefit riders to protect retirement income from down markets. Death benefit riders can protect the value of the annuity for beneficiaries.
Guaranteed lifetime income
There are only three sources of a guaranteed lifetime income: pensions, social security, and annuities. If you’re concerned about potentially running out of money later in retirement, annuities can provide a foundation for income. You can use your IRA, 401k, or 403B to fund the annuity, as well as non qualified money.
Beneficiary protection
Proceeds from an annuity death benefit don’t go through probate. They pass directly to the beneficiary. Some annuities offer enhanced death benefit riders, which provide additional protection for the beneficiary. Enhanced death benefits can be an attractive option for investors who don’t qualify for life insurance.
Are there fees associated with an annuity?
All annuities have some form of fees and/or expenses. Make sure you know what they are before you invest your money. Let’s take a look at fees.
- Front load sales loads — Front load sales and commissions reduce your deposit; they can be 6% or more.
- Mortality and expense fees — Variable annuities charge a mortality and expense fee for providing a basic death benefit. The fee is a percentage of the account and can be 1% of the account value or more.
- Management fees — Variable annuity subaccount managers charge a fee for running the fund. The fee can be from .1% to 1.25% of the account value or more depending on the fund.
- Administrative fees — Administrative fees are fees for fund transfers, withdrawals, and other transactions
- Optional rider fees — The optional death benefit and income features of variable and indexed annuities provide valuable benefits, but they can be expensive. Optional rider fees can be 1% of the account value and more.
- Surrender charges — Most annuities have surrender charges from one to 10 years. The insurance company usually allows you to withdraw 10% of the account value penalty free.
Surrendering an annuity
You can surrender your annuity if you buy an annuity and then decide to cancel the contract. But most insurance companies charge you a surrender fee if you cancel within the first seven to eight years of owning it. The shorter amount of time you own the annuity, the more you’ll pay in surrender fees.
For example, if your annuity has a seven-year surrender period and you surrender it in the first year, you may pay a charge of 7% of the account value. If you surrender in the second year, you may pay 6%, and so on. (For more, read about getting out of your annuity.)
If you want to switch annuities, you can do so without paying taxes. Exchanging one contract for another is known as a 1035 exchange (named after Section 1035 of the federal tax code). In a 1035 exchange, you can exchange:
- A life insurance policy for another life insurance policy
- An annuity for another annuity
- A life insurance policy for an annuity without paying taxes
However, you can’t exchange an annuity for a life insurance policy without paying taxes on the gains in your contract value.
If you need to tap into your money before the surrender period, most annuities allow you to access 10% of the account value without paying a surrender penalty. After the surrender period, you can withdraw as much out of your annuity as you want.
However, if you take out that money before age 59½, it is subject to a 10% federal tax penalty.
Shopping for an annuity from an insurance company
If you’re looking to buy an annuity, review your retirement plan and ask yourselves these questions:
- How do you plan to create income?
- Do you want a base level of guaranteed lifetime income?
- Are you contributing the maximum to your retirement plans?
- Do you need a supplemental retirement plan?
- When do you need the money? If you need it sooner than 10 years, a deferred annuity may not be a good option.
- What type of investor are you?
- Can you take advantage of the investment and tax deferral features of a variable annuity? Do you want some protection from market volatility?
- Do you want the guarantees of a fixed annuity?
Consider the financial strength of the provider. Fixed annuity deposits are invested in the insurance company’s general account, subject to creditors’ claims. Each state provides some protection from the insolvency of an annuity provider through “guarantee associations” or “guarantee funds,” but there are limits to that protection.
Ask questions. Be sure you understand all of the fees and expenses. Some annuities have features and riders that can meet a future need. If you’re purchasing a rider, make sure you understand the provisions and the charges.
