Learn more about the advantages of annuities and how they can provide guaranteed income for the rest of your life
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What Is an Annuity?
Annuities are an Insurance product designed to provide lifetime income for consumers that is guaranteed.
All annuity contracts are legally binding agreements between you and an insurance company that issue the contract. The contract ensures that you don’t outlive your retirement savings by transferring the risk of insolvency to the insurance company. In exchange, you pay either a single premium with a guaranteed income set to start a date in the future or a monthly fee collected by the insurance company as outlined in the annuity contract.
How Do Annuities Work?
Annuities often take a lump-sum premium and turn it into a stream of income that a person can’t outlive. Most people require more income than is provided by social security and their pensions. As such, annuities provide additional income that is guaranteed for the natural life of the person being insured.
Annuities can provide an income far into the future by accumulating more value as the funds are invested for a longer period of time and have the chance to build value through management by the annuity company, or can provide immediate income starting within 30 days of purchase of the annuity.
When you purchase a deferred annuity, you pay a premium to the insurance company for a set amount of time. This typically includes an initial investment that will grow tax deferred throughout the “Accumulation phase”. The “Accumulation Phase” can last 10-30 years. Once the annuitization or “Distribution” phase begins, based on the terms of the annuity, you will start receiving regular payments.
Annuities transfer all the risk of a bad stock market to the insurance company. This means as the annuity owner, you are protected from market volatility. Annuities also protect you from outliving your retirement savings as the income is guaranteed to last your entire life and keep up with inflation to protect your purchasing power.
In order to offset the risk of down markets, the insurance companies charge fees for managing the investments, contract riders and other administrative services. In addition, most annuity contracts include surrender periods where the contract holder can’t withdraw money without being charged a fee.
In addition, insurance companies impose caps, spreads and participation rates on indexed annuities which can reduce your return.
Annuity Terms Explained
You may not be aware of some of the terms used when annuities are being discussed. Here are a few terms that you may not be aware of:
Insurance companies are often required to offer a “Free-Look” period that allows a customer to cancel their annuity contract without incurring a surrender charge.
Riders are addendums to the annuity contract that allow the customization of basic annuity terms and conditions. It’s important that you understand the riders you select and are aware of their additional costs.
You can add a death benefit rider to your contract to ensure that your beneficiary receives a portion of the contract value. This is vital if you are married and want your spouse to receive income after your death.
Fees and Commissions
The fees and commissions for annuities vary by the type of annuity. Fixed annuities generally have the lowest fees.
One of the most attractive features of annuities is their favorable tax treatment from the IRS. If your annuity was purchased with money that you’ve already paid taxes on, then only your earnings will be taxed when the money is withdrawn.
ANNUITY TYPES: IMMEDIATE OR DEFERRED
Annuities come in two basic configurations: immediate or deferred.
The option you select will depend on your financial goals. If you want to begin receiving annuity payments right away, you will want to choose an immediate annuity.
Alternately, if you would like to set your payments to begin at some point in the future, you will purchase a deferred annuity and specify the start date in your contract.
INCOME NOW (IMMEDIATE)
Immediate income annuities require a single lump sum payment that offer guaranteed monthly payouts that grow with inflation for the rest of your life. Immediate annuities can supplement your retirement savings as well.
INCOME LATER (DEFERRED)
Deferred income annuities provide guaranteed lifetime income that begins on a date in the future that you specify. This can provide more income later in life because your money has a longer time to accumulate and grow. Your investments are also managed by the insurance company so they perform better than they would if you managed them yourself. You also only pay taxes on the earned interest your funds accumulate when they are paid out in the future.
TYPES OF ANNUITY INCOME
There are many types of annuities that exist to fit the different needs of all individuals. Your personal goals and objectives will help your financial planner find the annuity that is right for you. Below are a list of the types of annuities that are available and their objectives.
GUARANTEED INCOME ANNUITIES
Guaranteed income annuities earn a guaranteed rate of interest for a fixed period of time. The rate of interest may be guaranteed for a set period of tie or could fluctuate from anniversary to anniversary. They are also backed by the insurance company that issues it.
GROWTH POTENTIAL ANNUITIES
These annuities earn interest based on a market index such as the S&P 500. They don’t participate directly in the stock market which preserves the premium. These also offer a guaranteed minimum rate of return.
FLEXIBLE INCOME ANNUITIES
A Flexible Income Annuity earns interest through investments that you select within the annuity. It does not guarantee a return but offers much more growth potential.
REASONS TO PURCHASE AN ANNUITY
There are many reasons why people choose to purchase an annuity. As you build a nest egg, you may be worried that your retirement income needs will deplete your cash savings before you die. This could leave you with a lack of income when you are unable to earn money through employment because of age or bad health. An annuity can take a lump sum amount and ensure that you never outlive your savings.
An annuity also offers long term security, tax deferred growth, principal protection, probate-free estate distribution, inflation adjustments and death benefits for heirs.
“Income Annuities” are often well suited for people who are retiring within a year and want the security of long term guaranteed income. Single premium immediate annuities (SPIA’s) begin paying out within one year of purchase. This means there is no accumulation period for your investment to grow.
SPIA’s are great for those close to retirement with a large lump sum to invest in long term income. However, they are also a great option for younger people who receive a large lump sum inheritance or windfall and want to protect their money from poor financial management.
On the other hand, deferred annuities are generally not recommended for people with short term financial needs or younger people with more aggressive investment goals.
The key benefit of an annuity is that it allows investors the ability to save money without paying taxes on the interest until a much later date. Annuities have no limits on the initial contribution unlike 401 (k)s and IRA’s. This allows you to take more of your pre-tax income and defer it until much later where you can earn more interest on your savings and only pay taxes on it as you take the money out as income decades into the future.
Another benefit is that you can create a predictable income stream to fund retirement. With an annuity, you don’t have to worry about outliving your savings. This is a major advantage in the post-pension age.
Your decision for investing in an annuity should align with your lifestyle, aversion to future risk, tax advantages and financial situation. You should talk in depth with a financial planner who listens to your goals, needs and creates a comprehensive plan for your retirement.