An annuity is a type of financial product that lets you make an investment and then pays money at some future point in time. Annuity payments may be received monthly, quarterly, annually, or all at once. Payments from the annuity are based on the size of the annuity and the payment period. Many people favor annuities because earnings grow tax-deferred and there’s no annual contribution limit. However, annuities are known for their high fees, so if you’re considering the investment, weigh your options carefully.
Types of Annuities
There are two basic types of annuities: immediate and deferred. An immediate annuity pays out a benefit very soon after the initial investment is made. Someone who’s already in retirement might favor this option. A deferred annuity allows you to accumulate money in the annuity over time and then pays out at some future date. A deferred annuity can be converted to an immediate annuity at a later date.
Annuities can be further categorized as fixed and variable. The fixed annuity pays out a fixed amount each period until the annuity ends. Fixed annuities have a guaranteed earnings rate and the financial institution chooses how the annuity is invested. While a variable annuity may have a fixed minimum payout amount, payout is tied to the market performance of the investment. With a variable annuity, the investor has control over which funds the annuity is invested in.
You make post-tax contributions to an annuity, but theinvestment earnings aren’t taxed until you withdraw themmoney. At withdrawal, only earnings are taxed and at the tax bracket you fall into at the time of withdrawal. Keep in mind, your tax bracket could be higher or lower than what it is right now.
Other types of retirement plans have maximum investment amounts, but the annuity doesn’t have an annual limit on the amount you can contribute.
Annuity Payout Options
Annuities have four basic payment types that dictate how you receive your annuity payments and what happens to your payments if you die while there’s still money left in the annuity.
- Income for guaranteed period: You receive payments for a guaranteed period of time and if you pass away before that time expires, your beneficiary receives the payments for the rest of the period.
- Lifetime payments: You receive payments during your lifetime, but there is no survivor benefit. Your heirs do not receive any remaining payments.
- Income for life with guaranteed period certain or Period certain: You receive payments for the greater of your lifetime or the period certain, which is specified in the annuity contract. For example, if the period certain is 10 years and you pass away after 7 years, your beneficiary receives payments for the remaining 3 years. But, if you pass away after 15 years, the period certain has passed and your beneficiaries receive no payments.
- Joint and Survivor: Payments are guaranteed for the greater of your lifetime or the lifetime of your joint annuitant.
The fees can be one of the biggest drawbacks of an annuity and some of the fees aren’t always clear. This is more common when investing in variable annuities, rather the fixed annuity counterpart. Insurance brokers receive a commission from the sale of annuity products. Ten percent commission is not unusual, but it can be higher or lower. The good news is that you don’t have to pay an upfront commission with annuities, as the underlying insurance company compensates your agent directly.
Your annuity will typically have a surrender fee that you’ll pay for withdrawing your money soon after the annuity is purchased. Surrender fees are around 7% and often decrease as your annuity ages. It’s common for surrender fees to be eliminated once the annuity is five to seven years old. Note that if you withdraw money from your annuity before age 59 ½, you’ll be assessed a 10% early withdrawal penalty and have to include the earnings in your tax (which you have to do anyway).
Finally, there are annual fees which vary from one annuity to another and are very common with variable annuities.
Despite the fees, annuities are a great retirement option for many people, especially those who’ve already maxed out their 401(k) and stretch IRA options. Before you put money in an annuity make sure you shop around for the best deals. Be aware that you risk losing your money if the financial institution company goes out of business before you’re ready to withdraw your money. Always invest with reputable companies with a solid history.