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Annuities 101

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What is an annuity?

In its most general sense, an annuity is an agreement for one person or organization to pay another a stream or series of payments. Usually the term "annuity" relates to a contract between you and a life insurance company, but a charity or a trust can take the place of the insurance company.

There are many categories of annuities. They can be classified by:
  • Nature of the underlying investment – fixed or variable
  • Primary purpose – accumulation or pay-out (deferred or immediate)
  • Nature of pay-out commitment – fixed period, fixed amount, or lifetime
  • Tax status – qualified or non-qualified
  • Premium payment arrangement – single premium or flexible premium
An annuity can be classified in several of these categories at once. For example, you might buy a non-qualified single premium deferred variable annuity.

In general, annuities have the following attractive features:
  • Tax deferral on investment earnings: Many investments are taxed year by year, but the investment earnings (capital gains and investment income) in annuities aren't taxable until you withdraw money. This tax deferral is also true of 401(k)s and IRAs; however, unlike these products, there are no limits on the amount you can put into an annuity. Moreover, the minimum withdrawal requirements for annuities are much more liberal than they are for 401(k)s and IRAs.
  • Protection from creditors: If you own an immediate annuity (that is, you are receiving money from an insurance company), generally the most that creditors can access is the payments as they're made, since the money you gave the insurance company now belongs to the company. Some state statutes and court decisions also protect some or all of the payments from those annuities. Plus your money in tax-favored retirement plans, such as IRAs and 401(k)s, are generally protected, whether invested in an annuity or not.
  • An array of investment options, including “floors”: Many annuity companies offer a variety of investment options. You can invest in a fixed annuity which would credit a specified interest rate, similar to a bank Certificate of Deposit (CD). If you buy a variable annuity, your money can be invested in stock or bond (or other) mutual funds. In recent years, annuity companies have created various types of “floors” that limit the extent of investment decline from an increasing reference point. For example, the annuity may offer a feature that guarantees your investment will never fall below its value on its most recent policy anniversary.
  • Tax-free transfers among investment options: In contrast to mutual funds and other investments made with "after-tax money," with annuities there are no tax consequences if you change how your funds are invested. This can be particularly valuable if you are using a strategy called "rebalancing," which is recommended by many financial advisors. Under rebalancing, you shift your investments periodically to return them to the proportions that you determine represent the risk/return combination most appropriate for your situation.
  • Lifetime income: A lifetime immediate annuity converts an investment into a stream of payments that last as long as you do. In concept, the payments come from three “pockets”: Your investment, investment earnings and money from a pool of people in your group who do not live as long as actuarial tables forecast. It's the pooling that's unique to annuities, and it’s what enables annuity companies to be able to guarantee you a lifetime income.
  • Benefits to your heirs: There is a common misconception about annuities that goes like this: if you start an immediate lifetime annuity and die soon after that, the insurance company keeps all of your investment in the annuity. That can happen, but it doesn't have to. To prevent it, buy a "guaranteed period" with the immediate annuity. A guaranteed period commits the insurance company to continue payments after you die to one or more beneficiaries you designate; the payments continue until the end of the stated guaranteed period—usually 10 or 20 years (measured from when you started receiving the annuity payments). Moreover, annuity benefits that pass to beneficiaries don't go through probate and aren't governed by your will.

How Are Annuities Different From Insurance?

Both annuities and life insurance should be considered in your long-term financial plan. While both include death benefits, you buy life insurance in the event you die too soon and an annuity in case you live too long. In other words, life insurance provides economic protection to your loved ones if you die before your financial obligations to them are met, while annuities guard against outliving your assets.

How Much Should I Invest?

Unlike a 401(k) or an IRA, there are no limits on the amount that you can invest in an annuity. Whether you're considering a deferred or immediate annuity, the amount of money you should consider putting into an annuity depends on:
  • Your immediate actual and potential financial needs
  • Your long-term financial goals
  • Your current savings/investment portfolio
  • The range of alternatives available to you
Of these, the most important is your immediate actual and potential financial needs. If you're buying a deferred annuity and you have a sudden need for cash, you can usually withdraw a small amount without penalty. However, you will likely pay a penalty if you make a large withdrawal within a few years after you have purchased the annuity. If you're buying an immediate annuity, you usually can't get any more than the regular payments, no matter how badly you need cash. However, if you have other sources of cash that are sufficient for any emergency or unforeseen needs, then the immediate needs criterion is satisfied and the other criteria become more important.

What Are Deferred and Immediate Annuities?

Deferred Annuity

This type of annuity is good for long-term retirement planning for the following reasons:
  • Payments on income taxes are deferred until you withdraw the money.
  • Unlike a 401(k) or an IRA, there are no limits on your annual annuity contributions.
  • There is a death benefit. If you die before collecting on the annuity, your heirs get the amount you contributed, plus investment earnings, minus whatever cash withdrawals you made.
Immediate Annuity

This allows you to convert a lump sum of money into an annuity so that you can immediately receive income. Payments generally start about a month after you purchase the annuity. This type of annuity offers financial security in the form of income payments for the rest of your life. In other words, you cannot outlive it.

Immediate annuities allow you to:
  • Supplement your current income. If you are nearing retirement, you may consider transferring another savings or investment account into an immediate annuity. You can also move the proceeds from a deferred annuity into an immediate annuity.
  • Pay taxes only on the portion of your immediate annuity payments that is considered earnings. You are not taxed on the portion that is principal. The principal is the initial deposit made with funds that have already been taxed.
Like deferred annuities, immediate annuities can be fixed or variable. Fixed immediate annuity income payments are pegged to the amount you contribute, your age and the interest rate at the time of purchase. Those payments to you will not go up or down. Variable immediate annuity payments vary with the investments you chose.

How Will I Receive Annuity Payments?

An important decision in purchasing an annuity is deciding how you want to be paid. You can select annuity payouts for a set period of time or continue for your lifetime. With some options, a beneficiary can be designated to receive payments upon your death. You have several choices including:

Straight life
You will get income for your entire life—even after all the money you put into the annuity has been used up. However, if you die before the money in your account has been used up, nobody, not even your dependents, will collect payouts. The straight life annuity might be right for you if you need to maximize the amount of income you receive and either don't have dependents or are not planning to use the annuity for the purposes of estate planning.

Joint and survivor
This type of annuity pays you as long as you live. After your death, it will pay the joint annuitant for the rest of his or her life. You can choose the benefit your survivor will get upon your death, but this option reduces the payout amount you get.

Refund annuity
This payout option is gaining in popularity. It provides income for life. If, however, you die before you receive an amount equal to all of the premiums you paid, your beneficiary gets the portion you had not yet collected.

What Are Surrender Fees?

If you take money out of an annuity, there may be a penalty called a surrender fee or a withdrawal charge. This fee is higher if you withdraw funds within the first years of an annuity contract. The penalty, however, drops gradually each year. Since immediate annuities are purchased to provide income, they usually can't be "surrendered" and will therefore not be subjected to a fee.

A typical surrender fee schedule could be:
  • 7 percent if you withdraw funds in the first year
  • 6 percent in the second year
  • 5 percent in the third year
  • 4 percent in the fourth year
  • 3 percent in the fifth year
  • 2 percent in the sixth year
  • 1 percent in the seventh year
  • Zero in the eighth year and beyond
The purpose of the fee is to allow the insurer enough time to recover its expenses, largely commissions, in setting up the annuity contract. It also serves to discourage annuity buyers from using deferred annuities as short-term investments for quick cash.

Some contracts may permit you to pull out a portion of the funds annually, usually up to 10 percent without a surrender charge. If this option is important to you, ask your insurance agent or company representative about this before deciding to invest your money in a specific annuity. Also, ask if there may be any other fees or charges.

Souce of this Material: Insurance Information Institute