An annuity is an insurance contract under which one party (the insured) agrees to pay a lump sum to the other party (the insurer). An annuity is a contract between you and a life insurance company in which you pay a sum of money (either immediately or over a period of years), in return for a series of payments over a specified period of time. Generally the sum is allowed to grow tax-deferred and is then distributed through a stream of payments. Annuities may be either immediate or deferred. Today, annuities come in many varied types and sizes and, while they are still often utilized to provide a stream of income over one’s retirement years.
There are four parties to every annuity contract:
The insurance company providing the annuity contract.
The person or entity that owns the annuity. Typically, this is the individual who made the purchase.
The person whose life is the “measuring life” of the annuity contract.
The persons to benefit from the annuity following the death of the annuitant.
Often, the purchaser will name him or herself as the owner and annuitant, with a spouse, child, charity, or other heir as the beneficiary.
In addition to their tax-deferred status, annuities have no annual contribution limit (unlike IRAs and qualified plans), nor are they subjected to many of the various fees that mutual funds charge. Thus, annuities work nicely in conjunction with retirement plans for those who have maximized their contributions.
Most annuities also have a guaranteed death benefit, helping to ensure the safety of principal placed in the annuity. This feature is often appealing to clients who seek a high degree of security in their investments, especially those who have seen their investment values drop in the stock market. Annuities have flexible distribution options, allowing payment in a lump sum, for a period of years, over a lifetime, or over joint lifetimes. Annuities help to avoid what can be a lengthy and costly probate process and should be considered as part of your estate planning solution.
A retirement annuity is simply any annuity that is used to provide for retirement. Retirement annuities can be of any type and are typically used as the backbone of a retirement income plan, or to supplement other sources of retirement income such as a pension or social security benefits.
An immediate annuity is an insurance policy that, in exchange for the payment an initial lump sum of money, makes a series of payments to you that begin, as the name suggests, immediately. These payments may be structured in a number of ways: they may periodically increase or they may stay the same over the life of the annuity. The stream of payments may continue for a fixed term of years or until the end of an annuitant’s life.
One of the primary benefits of an immediate annuity is that it serves as a vehicle for distributing savings with a tax deferred growth factor. As a result, one common use for an immediate annuity is to provide a retirement income. In the U.S., the tax treatment of an immediate annuity is that every payment is a combination of a return of principal (which is not taxed) and income (which is only taxed at normal rates).
A deferred annuity will take either a lump sum or periodic payments and hold the money for a period of time, known as the accumulation period, before distributing any payments to the annuitant. When you begin to receive payments, the annuity is now annuitized. When a deferred annuity is annuitized, it works like an immediate annuity from that point on, but with a lower cost basis, which means that more of the payment is taxed. During the accumulation period, however, the annuitant is not taxed for the growth in the account’s value (which is known as tax-deferred growth).
There are two phases to a deferred annuity. The period between the time that the annuitant makes the initial payment and the time that the stream of payments start is called the accumulation phase. The period after the stream of payments starts is the annuitization phase.
There are several types of deferred annuities. A fixed deferred annuity is a deferred annuity that grows by interest rate earnings alone. A deferred annuity that is not guaranteed to stay above the initial amount invested is a variable annuity. A variable annuity allows the annuitant to make allocations to stock or bond funds and involves a higher degree of risk than a fixed annuity.
An equity indexed annuity (EIA) is an annuity that has features of both fixed and variable deferred annuities. EIAs involve more limited risk than variable annuities, because they feature protection of principle unless cancelled (or surrenderd) early in the policy’s term (during the policy’s stated “surrender” period). EIAs also involve more limited reward than variable annuities, as they typically involve a cap on the amount of growth the account can experience, regardless of how quickly the market grows.
Deferred annuities are advantageous in that all capital gains and income are tax-deferred until withdrawn. However, when withdrawn or inherited, the interest and/or gains are treated as ordinary income and are taxed accordingl
There are several factors you may want to consider when you are exploring the possibility of buying an annuity. One of these factors is the current interest rate paid by the annuity. Some companies will pay what’s called a “first year bump,” which is an additional amount during the first year in which the annuity is held.
Another factor to consider is a guaranteed interest rate. This is an interest rate floor beneath which the annuity is guaranteed not to fall.
Third, you’ll want to pay attention to the surrender charges and the surrender period of any annuity you consider. Most annuities will charge a penalty if you withdrawal your money soon after placing it into the annuity.
Along these lines, you may want to ask about penalty-free withdrawals. Does the company allow a portion of the annuity’s principal to be paid out each year without subjecting you to a surrender charges? An annuity with penalty-free withdrawals may be advantageous to investors because many investors prefer (or need) investments with a high degree of what’s called “liquidity,” meaning that they can access their money readily, easily and with minimal cost.
While annuities are historically very safe investments, you should carefully consider the company from which you are purchasing the annuity. You can find this information by referring to services such as Moody’s, A.M. Best, or Standard & Poor’s.
Contact a Peak Trust Financial Advisor today to discuss if an Annuity is right for you.