Understanding Annuities

An annuity can seem like it’s some word thrown around with retirement and savings on financial ads during football season. Here’s a little help to understand annuities.

Annuities are essentially a savings account that you get from an insurance company. They are set up to ensure that you have money for retirement and can help you stretch money over a couple of decades.

Usually, annuities are bought through, or along with, a life insurance policy. Common knowledge around life insurance is that it helps you make sure your loved ones are taken care of financially if you were to pass earlier than hoped. Conversely, an annuity is a policy that helps ensure you are taken care of should you live longer than you’d thought you would.

Taxes on annuities are deferred until they are paid out. What’s good about this is that there is more money to gain interest from than an investment that can be taxed. It’s important to note that annuities are invested in heavily up front. Then payments are made to you periodically. The payments can be made to you until you pass.

If you live out your life expectancy, an annuity can be an appropriate investment. However, if you were to go too early, an annuity may not be the best investment.

Why an annuity may be right for you

An annuity is practically the definition of long-term investment and almost strictly for that purpose. Also, it guarantees a  steady income for life.

One thing that makes it a long-term investment is the steep penalties for withdrawing finds too early. A ten percent tax can be charged on funds taken out before you reach the age of 59.5. Although, depending on how much the annuity has accumulated, it may be somewhat worth it. Note that the 10% penalty will only be applied to the return on the investment. The thinking is the money you put in was already subjected to taxation.

An annuity can be used for a child’s higher education however, when it’s time for them to use it, they can use it for whatever they want—not just education.

Annuities Options

Single-Premium
The name says it all in this one. You buy the annuity up front in one single payment. Single premiums usually require a minimum of around ten thousand dollars.

Immediate
Immediate annuities trigger payments to you as soon as the annuity has fully vested. Usually from a single-premium annuity. Typically, these annuities as well as single-premium annuities are purchased when a retired individual gets their retirement funds in a lump sum. They then take these funds and purchase an annuity. In the annuity it collects interest and creates a steady and dependable income.

Flexible-Premium
Basically the same as a single premium but breaks the payment up into a series of payments.

Deferred
A deferred annuity doesn’t start payments until way down the road and may come in the form of a lump sum or may come in the form of the typical guaranteed payments that are made periodically.

Fixed
This is a low-risk annuity along the lines of a Money Market account or a CD. The interest yields around 3-5% and the rate is guaranteed for an agreed upon amount of time. The money you invest is usually invested by the insurance company in safer investments such as bonds. This usually looks more lucrative when rates are low but when rates go up in a higher risk investment, that’s money you’re missing out on.

Variable
Essentially, the opposite of the Fixed annuity. This is a higher-risk investment—more along the lines of a mutual fund, which usually carries a growth rate of 12%. Also different from the fixed annuity is the Variable has no guarantee of interest or principal. Variable annuities are still appropriate for long-term investment.

Annuities and Taxes

Whether or not your annuity is a qualified annuity will determine how your payouts are taxed.

An annuity is qualified when it used as a means to fund a retirement plan like a Roth IRA or a 401k. The money you invest is not subject to taxes when withdrawn. Also, in a qualified annuity, the tax on the earnings is deferred until payout.

A non-qualified annuity is purchased with funds after they have already been subjected to taxation. While the tax on the earnings is deferred, the owner of a non-qualified annuity must pay taxes on profit from the original investment.