Whether you’ve done retirement research on your own or spoken with your advisor, chances are you’ve heard of annuities. They’re offered by life insurance companies to help protect and grow your money and provide guaranteed income in retirement. While most annuities share the same general idea—you put money in, your money grows, you get your money back—they are not all the same, and their features vary by product and insurance company.
Today’s annuities can be broken out into two basic categories—immediate and deferred. There is a range of features and benefits within these types, but here are the basics so you can get a sense of how they work.
With a deferred annuity, your purchase payment is held for a certain number of years (generally a minimum of 3, 5 or 7 years) while it accumulates interest (the “accumulation phase”). In most cases, if you keep your money in for the designated period, you are guaranteed at least some amount of growth each year. The interest you earn is tax-deferred (not taxed until you take your money out), so your money can grow with compounding over time. This means the principal earns interest, the interest earns interest, and money you would have paid in taxes earns interest.
FIAs help you enjoy the upside potential of the market—and might earn more interest than regular fixed annuities—without putting your money at risk.
After the designated time is up, you enter the “payout” phase, which means you can take out your accumulated money in a lump sum, keep it in the annuity and continue earning interest, or you can begin receiving withdrawals from your annuity for a certain number of years or your lifetime. Your money is taxed at your ordinary rate at the time withdrawals are taken.
Withdrawals can generally be taken at any time, but there are charges for taking your money out during the accumulation phase, and there may be tax penalties for withdrawals taken before age 59½.
Types of deferred annuities:
- Fixed annuities: The most basic type of annuity pays a guaranteed, minimum fixed rate of interest for a certain number of years. So, as long as you keep your money in for the duration of the contract, your principal and any interest it accrues are guaranteed.
- Fixed indexed annuities (FIAs): These annuities provide opportunities to earn interest based on the performance of one or more market indexes. Depending on the index you choose, there’s usually a cap (upper limit) on the amount of interest you can earn in a given period, or a margin (deduction) which is subtracted from the index’s performance to determine the amount of interest you can earn in a given period. If the index goes down, you may not earn any interest for that term, but you won’t lose money either. FIAs help you enjoy the upside potential of the market—and might earn more interest than regular fixed annuities—without putting your money at risk.
- Variable annuities (VAs): Like FIAs, variable annuities are designed to help you invest on a tax-deferred basis and meet long-term financial goals, such as retirement funding. Unlike FIAs, you can choose among available sub-accounts. Each sub-account invests in a corresponding portfolio, and you can make or lose money depending upon market conditions. The investment performance of the sub-account(s) you select affects the value of your contract, and therefore affects the amount of the payments available at the time of annuitization and your death benefit. VAs offer the most growth potential for your money, but also carry the most risk.
As their name implies, immediate annuities (also called income annuities) are designed to turn a portion of your money into immediate, guaranteed income in retirement. Unlike deferred annuities, there is no designated waiting period while your annuity value builds. You put a portion of your money in, and you get regular payments for either a designated number of years or the rest of your life. However, many immediate annuities are irrevocable, and if you die prematurely, the annuity payments may end (unless the product provided certain payout options).
Immediate annuities can help supplement other income sources, such as pensions or Social Security, or even provide income if you choose to delay taking Social Security in order to maximize your future payments.
Today’s income annuities are more flexible than their predecessors, but you should still take time to understand what will happen to your future payments if you take additional money out or if you die earlier than expected.
The value of an annuity
This is a high-level view of annuity options, and products and features will vary by provider. While there are costs associated with the guarantees provided by annuities, they could be a valuable source of supplemental income in retirement.
Make sure you fully understand the pros and cons of any annuity before making a decision. When it comes to your future income, it’s important to know exactly what you’re buying. Talk to your financial professional or insurance producer to find out if an annuity is right for you.