The Basics Of Annuities: What They Are, How They Work

An annuity is a type of investment that is based on a contract between an investor and an insurance company. Annuities are designed to provide investors with a steady stream of income and work in two phases. The first phase is the accumulation phase. The accumulation phase is simply the phase in which the investor pays the insurance company for the annuity.

A one time lump sum payment can be made, but since many investors do not have enough cash up front they will opt to fund the annuity over time with payments. The money that is paid into the annuity will either be invested in the insurance company's general or separate account depending upon the goal of the investor.

The second phase of an annuity is the payout phase. This is the time in which the investor starts to receive payments from the insurer. The way the annuity will pay out depends upon how it is set up. For example, some annuities pay out for the remainder of your life expectancy, while other annuities will pay out for a specified amount of time such as 10 years.

If you buy a fixed annuity, the money that you invest into the annuity goes into the insurer's general investment account. This is an investment account that the insurance company uses to grow the annuity and is often composed of lower risk investments.

Fixed annuities have their name because the insurer guarantees that you will receive a minimum rate of return. The insurance company is obligated to pay out the annuity that you choose regardless of the underlying performance of the investment.

Due to this, the risk of fixed annuities is assumed by the insurer as they are obligated to provide you with fixed periodic payments during the payout phase of the annuity. With that being said, fixed annuities may not keep place with inflation over time so there is a trade off for their stability.  

Variable annuities differ from fixed annuities in that the money that you use to buy the annuity goes into the insurer's separate investment account. This account differs from the general investment account in that the rate of return you will earn is not fixed but instead variable.

This means that you are not guaranteed to receive a minimum return on your dollars. Within the separate account, there are sub accounts. You can choose to invest your dollars in one or multiple of these sub accounts depending on your risk tolerance and investment objectives.

Since your dollars can fluctuate due to the performance of your chosen investments, the risk of investing in a variable annuity is assumed by you and not the insurer. This means that the dollar value you receive during the payout phase of a variable annuity well, varies.

The way an annuity pays out to you as the investor will depend on how the contract pays out. There may be an immediate payout method in which the annuity starts to pay out right away, but most annuities are deferred income annuities which means they will not pay out until a future date. Below are some other common ways annuities pay out.

The straight life annuity payout option simply means that the investor would receive payments for as long as they live. This option does not allow a beneficiary to be designated which means that once the annuitant (investor) dies payments cease even if there was only a single payment before death.

Similar to the straight life payout option, a life annuity with period certain option means that the investor would receive period payments for life. However, if the investor dies prior to the end of a certain period, the payments will then be made to a beneficiary until the end of the period certain.

For example, say you bought a 15 year period certain life annuity. If you were to pass away 7 years into the payout phase, your beneficiary would receive 8 more years of payments (the remaining period certain). If you were to pass away after 15 years into the payout phase, the insurance company would not be obligated to pay your beneficiary as the period certain had been satisfied.

Under this payout option, payments from the annuity are made to two or more persons. If one person dies, the other continues to receive payments from the annuity. However, once the last survivor of the contract dies, the payments cease and the insurer is not obligated to continue payments.  

Under this payout option, the investor will receive periodic payments for their life. However, if the annuitant dies before they have received an equal amount of money back from the annuity that they put into it, the remaining amount will be paid to a designated beneficiary in payments or a lump sum.

The vast majority of annuities are non-qualified. This means that the investor who bought the annuity paid for the annuity with after tax dollars. Once these after tax dollars are placed into the annuity, the money grows on a tax deferred basis.

This means that you won't be taxed during the year you receive a return on your dollars. Once you reach the payout phase of the annuity, the earnings of a non-qualified annuity will be taxed. The basis (contributions you made) will not be taxed since you have already paid taxes on those dollars.

This can make non-qualified annuity taxes a bit complex to figure out as you have to calculate the ratio of basis to earnings that you have. Also keep in mind that in general you cannot start receiving payments from an annuity until you are 59 and a half years old.

Otherwise, you may be subject to applicable income taxes and an IRS early withdrawal penalty. Qualified annuities on the other hand allow you to make contributions into the annuity with pre-tax dollars which will then grow tax deferred.

For example, you may be able to purchase an annuity through your 401k if your plan allows it or through a Traditional IRA. 401k contributions are tax deductible and Traditional IRA contributions may be tax deductible depending on a variety of factors.

Once you start receiving payments from a qualified annuity, you will be subject to taxes on both the basis and earnings as you have not yet paid taxes on either. Keep in mind that this is just a general review of annuity taxation. Taxes can be complex so if you are considering an annuity always consult a professional tax advisor for accurate tax information.  

The primary selling point in regards to annuities is that they can provide a stable income in retirement. Many retirees' biggest fear is that their money will not last their life expectancy. An annuity may be a potential solution to reduce this fear especially if it is a fixed annuity. Annuities can be used to supplement other income that a retiree has.

As previously stated, annuities grow on a tax deferred basis. Depending on your individual circumstances it may make sense to wait to pay taxes on your investments until you retire. Keep in mind that this can also work against you so speak with a tax professional to see if tax deferral makes sense for you.

Almost all retirement accounts impose a limit to the amount of money you can contribute to them on an annual basis. However, annuities do not impose contribution limits. This means that you are able to contribute as much as you would like which can be beneficial if you have lots of income to invest.

Fixed annuities allow you to earn a guaranteed rate of return which is rare in the investment world. Keep in mind that these returns are often lower than what you would earn elsewhere, but it may be a way to add more stability to your portfolio as a whole.

Depending on how the annuity is set up, some of the money may go to your beneficiaries. Annuities may provide a way for you to leave your loved ones some money after you pass away. They may not be the best way to leave money to your heirs, but it is an option.

Some annuities will charge fees while others do not. Fees can eat away at your returns so it is important to review the fee structure before purchasing an annuity. Annuities may charge a variety of fees. First is a commission that goes to the individual who sold you the annuity.

Second, are administrative fees that go towards the insurer for maintaining the annuity. Thirdly, is a mortality charge that an insurer may charge to cover losses if you pass away before they anticipated. Finally, is a surrender charge.

This fee may be charged if you try to access your money during what is called a surrender period. The surrender period is simply the time in which you are not allowed to access funds in the annuity if you want to avoid paying the surrender charge.

In general, annuities are considered an illiquid investment meaning that you do not have easy access to the money inside of the annuity. If you try to take an early withdrawal you may be subject to income taxes, an early withdrawal penalty, and a surrender charge.

If you invest in a variable annuity, the value of that annuity will fluctuate in accordance with the performance of the underlying investments. For some investors, this may defeat the purpose of investing in an annuity as they are only looking for stable returns in their retirement.

Although fixed annuities provide a stable minimum guaranteed rate of return, this rate of return may not be sufficient to keep up with inflation. If you are planning on living another 30 years and a fixed annuity is a large portion of your retirement income, you can run into inflationary risk meaning your dollars have lost too much value to support your needs.

The bottom line is that annuities are a contract between yourself and an insurance company. Annuities work in two phases- the accumulation phase and the payout phase. During the accumulation phase, you pay the insurer for the annuity and the insurer then pays out the annuity during the payout phase.

The way an annuity pays out will depend on how the annuity is set up. Like all investments, annuities have their advantages and disadvantages. It is important to weigh both before investing in an annuity. You can always work with a financial professional if you need help deciding if annuities are a suitable investment solution for your individual needs and goals.