Note: This is the second in a series on annuities. Please be aware that annuities can be complex investments with significant fees, penalties for premature withdrawals and other issues. This series describes annuities in the broadest terms. There are many different types of annuity products that are variations on the basics. Some of those may not fit the descriptions and details mentioned here.
Many people use annuities as a retirement savings vehicle. You can find annuities in 401(k) and 403(b) retirement savings plans offered through employers and you can use them in IRAs, although they are not appropriate because they already have a tax-deferred status.
In these situations, the annuity is said to be qualified, because it is in a qualified retirement account and money contributed, for the most part, is pre-tax dollars, which reduces your current income taxes.
Nonqualified annuities have a special benefit that makes them attractive to people who have maxed out their employer-sponsored retirement accounts or don't have access to such accounts.
Nonqualified annuities grow tax-deferred until you begin withdrawing money. You do not get to reduce current income taxes, as you would with a deduction for a qualified retirement account, but you don't pay any income taxes until you begin withdrawing money.
Annuities also have no limits on the amount you can put away each year, nor any income restrictions that limit or prevent contributions like qualified retirement accounts do. This makes them attractive to high-income people.
Types of Annuities
Annuities can be categorized by when they pay out the benefit and how that benefit is calculated and paid. In this section, we look at the main characterizations of annuities.
An immediate annuity begins paying out benefits within one year of its purchase. In most cases, immediate annuities are bought with a lump-sum payment and the owner selects a payout method or schedule. Shortly thereafter, the monthly checks begin to arrive.
The owner can choose any payout schedule that works for her, including the lifetime payout. Immediate annuities are often used to handle large sums of pension plan distributions or IRA rollovers.
IRA rollover is when you take money is a qualified retirement account a roll it into or out of an IRA. To avoid taxes and penalties, the rollover must go into another qualified plan.
An immediate annuity is often a fixed annuity (see below) in design. It pays a fixed interest rate and never varies the monthly income checks. This makes for easy planning, but it offers no protection from inflation or rising interest rates. One of the risks of investing in annuities is locking up your money at an interest rate that may be less than future rates.
Deferred annuities put off the payout phase until some later date. Usually the owner funds the annuity with periodic deposits to build up the balance.
The annuity earns interest at whatever rate was authorized in the contract. By deferring payment, the owner allows compounding to work, increasing the size of the eventual payout. People saving for retirement often use the deferred annuity to fund an alternative retirement savings plan.
Deferred annuities may have a lower initial deposit requirement than an immediate annuity. There is no practical limit on how much you can deposit in an annuity, although life insurance companies may have some restrictions.
Because your money grows tax-deferred until you withdraw it, withdrawals before age 591/2, may result in a 10 percent early withdrawal penalty.
Tax-deferred refers to investment vehicles that allow principal and interest to grow without paying taxes on the earnings until sometime in the future. Qualified retirement accounts allow tax-deferred growth. Annuities, whether qualified or not, also allow tax-deferred growth.
Fixed annuities pay out a fixed rate each month based on the value of the annuity account and the payout schedule you choose. The amount never changes, whether it's for five or ten years or the rest of your life, no matter how long that may be. With the death benefit, you are guaranteed at least the return of your principal during the accumulation phase.
Variable payouts are tied to variable annuities, which use a form of mutual funds for investing your principal. Your payout may change based on the performance of these accounts, which makes them more risky than the fixed annuities.
If you need to know for certain what income to expect from the annuity, variable annuities are probably not for you. On the other hand, they offer the possibility of much higher returns if the accounts and the stock market perform well.
The funds are called sub-accounts and they exist inside the annuity contract. You can choose which sub-accounts to invest your money in and make changes as circumstances warrant. This type of annuity typically has very high expenses and you are exposed to market risk.
Sub-accounts are another name for mutual funds. They reside in the separate account of a variable annuity. Variable annuity investors split their money among the various sub-accounts. The money manager frequently takes an existing mutual fund and clones it into a sub-account for the variable annuity.