What is an Annuity?
An annuity is an investment that pays a fixed amount to a designated beneficiary for a specified number of years or for life. A client contracts with an insurance company to attain retirement or other long-range goals by making a lump-sum payment or a series of payments. Then, beginning immediately or at some specified date, the insurance makes periodic payments back to the client.
Annuities typically offer tax-deferred growth of earnings and may include a death benefit that will pay beneficiaries a specified minimum amount (i.e., total purchase payments). While tax is deferred on earnings growth, when funds are withdrawn from the annuity, gains are taxed at ordinary income rates, and not capital gains rates. Money withdrawn early from an annuity may result in substantial surrender charges to the insurance company, as well as tax penalties.
Fixed Annuities
Fixed Annuities represent a safe and steady way for more conservative investors to grow assets at a fixed rate of interest with a tax deferral. With a fixed annuity, the insurance company agrees to pay no less than a specified rate of interest during the time that the client’s account is growing. The insurance company also agrees that the periodic payments will be a specified amount per dollar in the client’s account. These periodic payments may last for a definite period, such as 20 years, or an indefinite period, such as the lifetime of the client and his/her spouse. Fixed annuities are not securities and are not regulated by the Securities Exchange Commission (SEC).
Which Annuity is Right for Me?
To determine which type of annuity best suits your financial goals, consider the following:
When Should Payout Start?
Immediate Annuities |
Deferred Annuities |
|---|---|
| You begin to receive payments immediately upon investing. | You usually start receiving payments at retirement. |
| You can specify a certain payment period (e.g., 15 years) or lifetime or spouse’s lifetime or any combination. | Most deferred annuities allow for systematic withdrawal payments beginning 30 days after purchase. |
| You can choose between fixed payment and variable payment that represents market performance. | In most cases, you can withdraw up to 10% per year. |
| You can either invest a lump sum or make periodic fixed or variable payments. | |
| Annuity funds grow tax-deferred. |
What Level of Risk Can I Tolerate?
Fixed Annuities
Fixed Annuities are invested primarily in government securities and high-grade corporate bonds. They offer a guaranteed rate of return over a specified period, generally between one and fifteen years. You can choose between Guaranteed Return Annuities (GRA) and Market Value Adjustment Annuities (MVA). GRAs guarantee 100% of principal investment upon surrender. MVAs often pay better than GRAs because of the increased short-term risk of rising rates but do not guarantee principal investment upon surrender. Because your assets are part of the general accounts of the insurer and are subject to the claims-paying ability of the issuing company, it is critical to understand the financial strength of the issuing company before buying a fixed annuity.
What If I Need Instant Access?
Penalties for Early Withdrawal
Most annuities have a surrender charge or penalty for making early withdrawals beyond the free withdrawal amount. Usually, this surrender charge declines over a seven-year period. To offset potential surrender charges, bonus annuities offer buyers a bonus of 3% to 5% of their principal investment. However, most bonus annuities extend the surrender period from seven years to eight or nine years.
Penalty-Free Annuities
Although any withdrawal from an annuity may be subject to taxes and a 10% federal penalty if taken before age 59, “No-Surrender” annuities let the owner withdraw either interest earnings or up to 15% per year without a penalty. By making a 1035 Tax-Free Exchange to another annuity, you can avoid any taxes or penalties regardless of age.