What's an Annuity? Definition, Types & Tax Treatment

Updated

You save and save during your working years and then you retire. The money that you have saved during your working years needs to last for your entire retirement until you and all your dependents pass away. It’s hard enough to save every month and watch the market go up and down, but knowing how to withdraw money from those accounts in a sustainable way is even more challenging. 

So exactly how do you withdraw in a way that ensures you will not outlive your income stream?

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In an age when most people do not have pensions, annuities are essentially a way to secure a stream of income that will never run out. There are lots of different types of annuities and companies who sell them, so it isn’t as easy as saying, “Yes! Give me some income, how much does it cost?” This article attempts to demystify the subject and the options that are available to you. 

Let’s start with the basics. Annuities are a fixed, guaranteed stream of income for either your entire life, or a defined number of years. It is protected from market volatility and is often used in retirement as a guaranteed base level of income. 

How Do Annuities Work? 

Generally, an annuity works like this: You purchase an annuity from an insurance company, either in a lump sum or a series of payments. In return, the annuity will make payments to you at a future date or series of dates. 

For example, Jane might contribute $100 per month for 10 years to an annuity in exchange for a guaranteed monthly income through retirement, which would depend on her age and interest rates at the time. Because of the guarantees as well as the tax advantages, annuities are important tools in retirement when it is so important to know how much money you are getting every month.

What Are the Basic Types of Annuities?

There are a lot of different varieties of annuities. Depending on individual circumstances, many people turn to a financial planner or professional to help them navigate their choices.

Here, we will explain the basic different types: deferred annuities and income annuities

Deferred annuities or accumulation annuities

There are two basic types of deferred annuities: fixed and variable. Fixed annuities offer guaranteed rates of growth. Variable annuities are invested in a market instrument (like the S&P 500). 

Both of these annuities can be used to generate income, but they are most often positioned as a safer and tax-advantaged way to accumulate assets that will be used in retirement rather than for their income advantages. 

Fixed annuities 

These are “fixed” because they offer fixed interest rates, similar to those of a corporate bond (2–4%). During the deferral period, money in the contract is credited with a fixed rate of interest and grows at a steady pace.

A fixed annuity may be worth considering if you are looking for a conservative way to grow a portion of your assets towards retirement and don’t want market volatility or any loss. It may not be the best choice if you want greater growth potential (and don’t mind taking on the risk that goes with it) or if you need income that starts right away.

Variable annuities 

These types of annuities are “variable” because they offer variable returns that are based on an underlying investment product or index. Variable annuities (or VA) generally offer lots of investment options, ranging from conservative to risky. 

Not all, but some variable annuities offset the risk associated with their variable nature by offering guaranteed income riders. Riders are additional features for additional fees that provide a minimum level of income regardless of the market’s performance. 

Read the fine print. When considering a variable annuity, it’s essential to understand how the annuity works, including associated fees and expenses as well as the taxation and surrender charges. 

A surrender charge is an amount the insurance company would keep if you decided you wanted to get out of the annuity in the first couple of years. Just as important, you should have a clear sense of your financial goals and tolerance for risk. A financial professional can help you make an informed decision on whether a variable annuity is right for you.

Income annuities

Income annuities are designed for the sole purpose of providing a guaranteed stream of income, immediately or in the future. In exchange for a payment or series of payments, the insurance company provides a pension-like stream of future guaranteed income. 

Compared with the above, there's no accumulation component to the income annuity. You give your money to the insurance company, which agrees to pay you an income for the rest of your life or some specific period. You generally don't have the ability to reclaim the money you gave the insurance company in the event something changes in your circumstances. 

Immediate income annuities

An immediate income annuity is purchased with a single premium, also known as a purchase payment, and income payments begin within 12 months. Income can be guaranteed for as long as you live or for a specific period. 

Is this a good investment? Perhaps the simplest form of an annuity. An immediate income annuity may be worth considering if you are nearing or already in retirement, want the security of guaranteed, predictable income, and need that income to start right away. It's probably not right for you if you think you might need that money down the road and you have limited additional liquid assets.

Deferred income annuities 

A deferred income annuity generally permits multiple purchase payments over a period of time (similar to the example of Jane at the top of the article). On the annuity date you choose, all purchase payments are combined into a single, guaranteed income stream that will continue for as long as you live or a certain period. 

Is this a good investment? An immediate or deferred income annuity may be worth considering if you want the security of guaranteed, predictable income and have additional assets in the event you have unexpected expenses. 

Who is it not right for? Because income annuities guarantee a specific income amount, they offer very limited access to withdrawals apart from the scheduled amounts. If you think you might need that money down the road and don’t have very much additional money, a deferred or immediate income annuity is probably not the best choice for you. 

If you are considering a deferred income annuity, it’s essential to have a separate source of liquid assets (cash, mutual funds, stocks, bonds, etc.) set aside for emergencies. It’s also important to get the facts and speak with a financial professional.

How Are Annuities Taxed? 

Annuities within retirement accounts (IRA, Roth IRA)

Annuities do not provide any additional tax advantages when bought inside a retirement account. If you plan to buy an annuity using retirement account money, be sure that you are purchasing it for the other benefits besides the tax-deferred characteristics. 

Annuities outside of retirement accounts

Ultimately, the tax rules vary depending on the type of annuity and how you take out the money. Broadly speaking, if the annuity is purchased with money that is non-qualified (not in a retirement account) then the growth is tax-deferred, meaning that you don’t pay tax on any of the gains or increases until you take the money out. 

However, when you receive your money, only the growth is taxed. The first portion of every payout represents a return of your original investment (tax-free) and another portion is considered the gain which is taxed when you receive the distribution. 

Keep in mind, there are some potential penalties for early withdrawal. In exchange for the tax benefits of annuities, the IRS imposes some restrictions on when you can access the money. If you try to access the money in the annuity before you are 59 ½, you’ll pay a 10 percent penalty to the IRS. 

That’s similar to what you would pay if you tried to withdraw money from a retirement account before age 59 ½. Therefore, it’s important that the money invested in an annuity is for retirement purposes. 

Make the Best Decision for You

While we hope it’s been helpful, the information provided here is not written or intended as specific tax or legal advice. We encourage you to seek advice from your own tax or legal counsel to figure out what’s best for you.

Before purchasing a variable annuity, you should carefully consider the investment objectives, risks, charges, and expenses of the variable annuity. For this and other information, obtain a prospectus from your registered representative.

With any annuity, it’s important to get the facts before making your decision. Retirement is your reward for decades of hard work—and part of that work is making sure you’ll have enough money for the kind of retirement you want. If you're looking for an additional source of predictable income now or in the future, or for a product that's designed to help you accumulate assets on a tax-deferred basis, annuities may be an option worth exploring.

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