How do Annuities Work?
There are several options available when purchasing an annuity. Two main factors will determine the type of annuity to be purchased. The first is how the annuity is funded. Will the annuity be funded with a lump-sum or a series of payments. The second is how the money will be invested.
- Single Premium Annuities: An annuity that is funded through a single lump-sum premium payment.
- Flexible Premium Annuities: An annuity that is funded through a series of premium payments during a specific period of time.
- Immediate Annuities: With an immediate annuity, a single premium is paid and payments begin immediately at the end of each payment period, which is usually monthly or annually.
- Deferred Annuities: A deferred annuity is established by paying one or more premiums over a period of time. The premiums paid and interest credited to the premiums goes into a fund called an accumulation fund, which may provide a minimum guaranteed interest rate. Annuity payments begin at a set future date.
- Fixed Annuities: A fixed annuity provides fixed-dollar income payments backed by the guarantees in the contract. In this scenario, the investment cannot be lost once the income payments begin and the amount of the payments will not change. With fixed annuities, the company bears the investment risk.
- Equity-Indexed Annuities: Equity-indexed annuities, either immediate or deferred, earn interest or provide benefits that are linked to an external equity index, such as Standard and Poor's 500 Composite Stock Price Index. Equity-indexed annuities are not normally subject to loss of the principal investment, however the account growth is often limited to a percentage of the equity index, and may also contain caps on the maximum annual growth. When you purchase an equity-indexed annuity, you own an insurance contract not shares of any stock or index.
- Variable Annuities Variable annuity investments are securities, which tend to fluctuate with economic conditions. The value of a variable annuity depends upon the value of the underlying investment portfolios associated with the annuity. Variable annuities generally do not provide a maximum limit or minimum guarantee, which means the full investment, including the principal, could be lost. With a variable annuity the owner bears the investment risk.
The maturity date of an annuity is determined at the time of purchase; this date determines when payments begin. Once an annuity has reached its maturity date a settlement option is selected by the annuitant, which is the owner of the annuity, and payments can begin. The settlement option chosen will determine how payments are received. When the annuity pay-out period begins, the terms of the contract are generally fixed and cannot be changed, regardless of the option selected. There are four basic settlement options available.
- Lump sum distributions allow the contract owner to receive the balance of the account in a single payment.
- Fixed period options provide that the annuity’s accumulated value will be paid out over a specified period of time, such as 10 or 20 years.
- Fixed amount options provide payments for a specific dollar amount and will last until the account balance is exhausted.
- Life income options provide payments for the remainder of the annuitant’s life.
Under normal circumstances, withdrawals from an annuity cannot be made until age 59 ½. If a withdrawal is made prior to this age, tax penalties and surrender charges are applied. Tax penalties average 10 percent on the investment amount, plus the regular income tax rate on the investment's earnings. The surrender charge is applied by the insurance company that held the investment. Annuity payouts are taxed depending on the type of annuity.
- Qualified annuities are generally tax deductible, and taxes on interest are deferred until withdrawal. However, withdrawals from qualified annuities must generally start by age 70½, or the owner will be subject to certain penalties.
- Non-qualified annuities are funded with after-tax dollars. Taxes are applied to the interest earnings portions of the investment at time of withdrawal.
The purchase of an annuity is accompanied by a 21-day free look period for all consumers. The free look period begins when the contract is received by the purchaser. During this period, the contract can be returned and a full refund requested without penalties or fees. As with any insurance product, carefully review the terms and conditions of the annuity. If the contract uses language that is ambiguous or confusing, talk to the agent and/or company offering the product for an explanation and additional information, if necessary.