Annuities: Learn The Different Types And How They Work

Shawn Plummer

CEO, The Annuity Expert

When most people think about retirement, the first thing that comes to mind is pensions. However, annuities have become a smart retirement option over the last few decades. Annuities are contracts between an individual and an insurance company in which the individual pays a premium in exchange for a series of payments from the insurance company. This comprehensive guide will discuss what annuities are, how they work, and the available types. We will also explore the benefits of annuities and who typically buys them. Finally, we will look at some of the criticisms of annuities and compare them to other fixed-income products.

What Are Annuities?

An annuity is an insurance contract in which you make a lump sum or series of payments to an insurer, who then provides periodic payments to you immediately or at some point in the future.

Key Takeaways

  • An annuity is a financial product typically used by retirees that offers a guaranteed income stream.
  • Annuities can determine your future annuity payments.
  • An annuity can offer peace of mind by protecting your original investment, providing the potential for guaranteed income later in life, and allowing you to leave money to loved ones. Some annuities may also give tax breaks or help pay for long-term care expenses.
  • The first stage of an annuity is known as the accumulation phase. This is when investors put money into the product, either all at once or gradually over time.
  • After the annuitization period, the annuitant will begin receiving annuity payments for a set amount of time or until they pass away.
  • Annuities can be structured in different ways, giving investors more flexibility.
  • Immediate and deferred annuities are the two categories these products can fall under, and they are structured as fixed and variable annuities.
What Are Annuities? The Definition

How An Annuity Works

An annuity is an investment that pays you back over a long period – often for the rest of your life. The guaranteed income payments are designed to help you cover costs and protect yourself from the risk of not having enough money later. With annuitization, your initial investment (what you contribute) is turned into regular payments that last for as long as you need them. Annuities are issued by life insurance companies and can help make sure you don’t run out of funds during retirement.

An annuity contract is a document that you sign that legally binds you and the insurance company. This means that the responsibility for whether or not your savings will last through retirement shifts from you to the life insurance company. You pay premiums as outlined in return for this service.

Annuities Explained

  • Free-Look Period: A free-look period is a mandatory window that allows insurance policy buyers to cancel their contracts without being charged.
  • Riders: Annuity riders are extra features you can select to personalize your contract. You must understand all of the details and fees associated with each rider before making a selection.
  • Beneficiaries: You can add a death benefit rider to your contract to ensure that, after you die, your beneficiary will receive at least some of the money from the original value of the contract.
  • Fees and Commissions: Fees and commissions on annuities fluctuate depending on the type of annuity.
  • Taxation: The IRS offers more lenient taxation for annuities than other investments. If you purchased your annuity with money you already paid taxes on, then only its earnings will be taxed upon withdrawal.
  • Surrender Periods: Annuities have a set period, called a surrender period, during which the annuitant cannot cash in the contract without being charged a surrender charge. With penalty-free withdrawals, though, there is still some liquidity for regular withdrawals during the surrender period.

How Are Annuity Rates Set?

Interest rates fluctuate based on the type of annuity. For example, the issuing insurance company sets a fixed rate. This guaranteed rate usually applies for 2-20 years.

Annuity contracts are more complex when it comes to setting interest rates. Take, for instance, a fixed-indexed annuity that has both a rate based on growth in an equity market index–like the S&P 500 or Nasdaq–and a fixed rate.

How Are Annuities Taxed?

Many finance professionals recommend annuities to their clients for the potential of tax-deferred growth. You purchase the annuity, and your investment grows without being taxed for the length of the contract. The taxes aren’t owed until you receive income payments at the annuity’s maturity.

The amount of money from your annuity that is taxed depends on your contract type. If you own a qualified annuity, you’ll owe ordinary income tax on all the withdrawals. Meanwhile, only earnings are taxed for those with non-qualified annuities when they withdraw money.

How Does An Annuity Work?

The 4 Types of Annuities

There are four types of annuities that you can choose from, depending on when you want to start receiving payments and how you would like your retirement plan invested. The four types are immediate, deferred, variable, and fixed annuities.

Immediate Annuities

With an immediate annuity, you can begin receiving payments within a year of purchasing it. Single premium immediate annuities are usually funded by a retirement account, such as a 401(k) or IRA, and are ideal for those ready to retire but still want guaranteed monthly income.

Deferred Annuities

With a deferred annuity, you don’t receive payments until some point in the future. This is usually when you retire. As a result, your investment grows without being taxed during this period.

Variable Annuities

A variable annuity provides periodic payments that rely on the sub-account’s performance, similar to how mutual fund companies operate. Therefore, your payments will differ in size based on how well (or poorly) the sub-accounts are doing at any given time.

Fixed Annuities

Fixed annuities offer the least risk and the most predictability of all the different types of annuities. With a fixed annuity, you’ll enjoy a guaranteed interest rate that won’t fluctuate beyond the terms of your contract.

Example Of An Annuity

The lottery payout is an example of an immediate annuity in which an individual receives a guaranteed income stream for a pre-determined period (typically 30 years).

What Are The Benefits Of An Annuity

  • Tax-deferred growth: You won’t have to pay taxes on your earnings until you start making withdrawals or receiving regular payments. Be aware that if you withdraw before age 59½, you may be taxed an extra 10%.
  • Unlimited contributions: Regardless of your income or how you make it, you can put as much money as you want into an annuity after taxes.
  • Choice of investment options: While fixed annuities provide a prespecified return rate over a set duration, variable annuities fluctuate according to trends in the stock market.
  • No mandatory withdrawals: You are not required to take minimum distributions from your annuity after age 72 if it is a Roth IRA or not part of an IRA or a qualified retirement plan.
  • Death benefit: Most payouts come with insurance that promises to give your beneficiaries money if you die before withdrawals start. Usually, this money does not have to go through probate court.
  • Lifetime income benefits: When you retire and begin to receive annuity payments, you will have a few options concerning how to structure those payments. For example, you can continue benefits for beneficiaries even after your death.

Annuity Drawbacks

Annuities have some drawbacks. For example, you have to sign a long-term contract, you could lose control over your investment, you might not earn interest, and there can be high fees. There are also fewer options for cashing out your annuity, and you can’t withdraw any money until you’re 59.5 years old without penalty from the IRS. Annuities can also be complex and expensive.

Who Buys Annuities?

  • People wanting help managing their retirement income typically buy annuities. Remember that the lump sum invested in annuity contracts can’t be easily accessed without paying penalty fees, so it’s not ideal if you anticipate needing liquidity or are still young. However, you don’t have to worry about longevity risk – your income stream will last as long as you do.
  • The average annuity buyer is 60 years old, and most start to purchase them at 50. We see that these individuals usually have the most earnings and assets for retirement built up by this age. Annuities are typically bought to plan how much income will be available during retirement.

Why Do People Buy Annuities?

Is an annuity a good investment for retirement planning? Annuities provide security, long-term growth, and retirement income, which you can manage to fit your personal preferences regarding risk and amount of income. They also insure against the possibility that you will live longer than the money saved for retirement lasts.

The purpose of an annuity contract is to help individuals manage their income during retirement.

Annuities offer:

  • Recurring payments for the rest of your life or until the death of another specified person. Inflation adjustments are available too.
  • If you pass away before receiving any payments, the death benefits will go to the person you named as your beneficiary.
  • With tax-deferred growth, you don’t owe taxes on your annuity income and investment gains until you take the money out.

Other reasons to buy an annuity include the following:

  • Long-term security
  • Tax-deferred growth
  • Principal protection
  • Probate-free estate distribution
  • Inflation adjustments
  • Death benefits for heirs
  • Financial assistance for long-term care costs

Overall, annuities give you a chance to have stability, growth in the long run, and income. You can control how much money you want to receive as income and how risky you want the investment to be.

Annuities also let you save your money without being taxed on it until later when you’re ready to retire and need that saved-up cash. In some ways, they act as insurance against outliving your retirement funds entirely.

Who Should Not Buy Annuities?

Although an annuity could create another source of income during retirement, there are certain conditions where it would be unwise to purchase one. For example, you may want to avoid buying an annuity if:

  • If you have saved enough money for retirement and are confident that Social Security benefits will cover any additional income gaps, then an annuity might not be necessary. In this case, it would be better to use the money to purchase long-term care insurance or pay off outstanding debts before retiring.
  • If buying an annuity would force you to spend all your retirement savings on the premium, it may not be worth it. Insufficient liquid savings puts you at risk of borrowing money for unplanned expenses.
  • If you want to buy an annuity but doing so would put off other savings goals for retirement, think about whether the trade-off is worth it.
  • Individuals with a shorter life expectancy will not benefit as much from annuities. Annuities provide lifetime income, so the longer you expect to live, the more helpful they are. If you’re seriously ill and do not anticipate living very long, purchasing life insurance for your loved ones instead would be better.
  • Don’t enter into an annuity contract lightly- these are complex products you must understand fully before signing. Talk with a financial professional (like us!) if you’re considering buying an annuity to make the best decision for your particular situation.

What Kinds Of Annuities Are There?

  1. Multi-year guaranteed annuity (MYGA): A MYGA, or multi-year guaranteed annuity, is a fixed annuity typically spanning two to 10 years. Its main benefits are the deferral of taxes and a guaranteed return on investment, making it ideal for those nearing retirement.
  2. Fixed-index annuity: With a fixed-index annuity, your earnings are linked to a market index, like the S&P 500 or Nasdaq. These annuities also safeguard your principal if the index declines, making them more secure than investing directly into an index fund.
  3. Long-Term Care Annuities: A long-term care annuity pays tax-free for a nursing home, assisted living, and home health care costs.
BenefitVariableFixed IndexFixedImmediate
Principal ProtectionNoYesYesYes
Access To PrincipalYesYesYesNo
Control Over MoneyYesYesYesNo
Tax-Deferred GrowthYesYesYesNo
Guaranteed GrowthNoYesYesNo
Guaranteed IncomeYesYesYesYes
Inflation ProtectionYesYesNoYes
Death BenefitYesYesYesYes/No
LTC HelpYesYesYesNo

Annuities vs. Other Fixed Income Products

Annuities have similarities and differences compared to fixed-income products, such as life insurance, certificates of deposit (CDs), and bonds.

Annuities vs. Life Insurance

When an individual dies, life insurance pays for their loved ones. In contrast, annuities take payments from the policyholder upfront and provide a lifelong income stream until death. In addition, qualified annuities use pre-tax dollars, whereas life insurance and non-qualified annuities require post-tax funds.

The key distinction is that annuities ensure a lifelong income for the annuitant, with the choice to pass on earnings to an heir after death. At the same time, a life insurance policy provides a death benefit once the policyholder passes away.

A death benefit from an annuity is considered taxable income, while life insurance proceeds are generally tax-free.

Annuity contracts and permanent life insurance policies are tax-deferred insurance products. Some life insurance policies can grow over time, similar to annuities. When a contract matures, the income is often distributed as a series of payments or lump sum on a set schedule. Life insurance benefits are usually given in one lump sum payment to the policy’s beneficiary upon the policyholder’s death.

Both products require an up-front payment, which we will refer to as a premium. Your life expectancy is the main factor in annuity premiums being calculated, while your mortality rate solely affects insurance policy premiums.

Annuities vs. CDs

CDs and annuities are widely considered safe investments, as they are both guaranteed by different institutions. In addition, both products offer a set rate of return over a specific period while favoring protecting the investment principal over aggressive growth.

There are some notable differences between the two products.

  • CDs are short-term investments that banks offer, while annuities are long-term products that insurance companies offer.
  • The taxes on an annuity contract don’t start until you take out the payments (tax-deferred basis). CD interest is taxed every year.
  • When compared to CDs, annuities are much more customizable. For example, you get to choose the terms of your contract and whether or not you want add-ons like a death benefit rider.
  • CD interest rates will generally be lower than an annuity because CD terms are shorter.

The primary distinction between a CD and an annuity is how and when the returns are dispersed. With an annuity, you typically receive a regular income either over time or as a lump sum, while with a CD, you only get paid out in one lump sum upon maturity.

Annuities vs. Bonds

The main similarity between bonds and annuities is that both are bought with a lump-sum payment and have a set maturity date. However, a key difference between the two is that you can haggle over the details of a contract before signing, whereas the terms of a bond indenture cannot be changed.

Annuities typically have outperformed bonds in the long term and are less likely to lose value over time. When interest rates increase, bond values usually decrease. Another advantage of annuities is that they grow tax-deferred, whereas earnings from bonds are taxable.

When determining whether bonds or annuities are the better investment for you, consider both the risks and benefits of each option and compare them to your financial goals.

  • An annuity provides an income stream for a certain period, for life, or in a lump sum.
  • A bond is when an investor loans money and receives periodic interest payments for a set amount; afterward, the initial investment returns to the investor.
  • Typically, bonds and annuities strive to offer higher yields depending on the period.
Annuities Explained: Insurance Policies And Investment Contracts For Retirement

How Do I Buy An Annuity?

  1. Determine your current and future financial needs, and ask for help from an expert.
  2. Your choice of annuity product depends on your goals — income or growth, for example — and a comparative evaluation of the contract terms. Some annuities come with an illustration to give investors full transparency. Annuity providers also give a prospectus to investors considering variable annuities. Like illustrations, the purpose of the prospectus is to help investors make informed decisions.
  3. Choose your provider carefully: Check financial rating agencies like Moody’s and Standard & Poor’s for recent ratings on annuity providers to confirm the claims-paying ability. The government does not back annuities, so select a reputable and stable carrier.
  4. Submit An Application: Having all the necessary information in your application can help ensure that you get the quoted interest rate. If any part of your application is missing or incorrect, it could slow down processing time and lead to the insurance company not honoring the initial quoted rate.
  5. Decide how you will pay: You can use cash, funds from a retirement account, or a transfer from another brokerage. Keep in mind that each payment option may have different tax implications.
  6. Use The free-look period: Be sure to take advantage of the free-look period that most insurance companies offer. This allows buyers a window of 10 to 30 days from the contract start date to back out and receive a refund if they’re unhappy with their purchase.

Understanding Fees

  • Feature Charges. Be aware of special fees that may apply when you select specific features, such as a guaranteed minimum income benefit or long-term care insurance.
  • IRS Penalties. The Internal Revenue Service may charge you a 10% tax penalty in addition to taxes on the income if you remove money from an annuity before age 59 ½.
  • Commissions. Commissions are a portion of the cost given to the agent and paid by the insurance company, not the owner.
  • Investment fees. Variable annuities can charge fees above and beyond what other annuities require, such as mortality and expense risk charges and administrative fees.
  • Management fees. Management fees are a portion of the cost given to the financial advisor and paid by the annuity owner.
  • Surrender charges. A surrender charge is a fee levied upon cancellation of their annuity during the “surrender period.”

What Is An Annuity Fund?

When you purchase an annuity from an insurance company, you make a lump sum payment (the premium). This money is then deposited into the annuity fund. Therefore, the interest the annuity gains affect how much payout you will receive as the holder.

Annuities in 2023

Given the economic state in 2022, annuities are more appealing to consumers who want to get the most out of their retirement savings. In 2022, sales reached an all-time high since 2002–something experts attribute to the fallout from COVID-19.

By the end of 2022, inflation will have increased to the point where it could potentially cause problems for retirees living off of their savings. In addition, if your retirement savings are invested in low-interest vehicles like bonds or CDs, you may be at an even higher risk, as they offer little protection against inflation.

Annuities offer a unique solution to the problem of inflation. With Annuities, growth rates are typically higher than more common alternatives, such as CDs or bonds.

An annuity can benefit individuals looking to fill the “retirement gap.” The retirement gap is when your savings and retirement income falls short of your retirement costs. Annuities offer a guaranteed lifetime income, which could help cover costs if an individual’s existing retirement account isn’t sufficient.

An inflation-indexed annuity is one type of investment that helps to protect your savings from the effects of inflation. This guaranteed income is tied to movements in the Consumer Price Index, which determines how much prices have increased (i.e., inflation). If you’re worried about inflation eroding your purchasing power, you can add a cost-of-living rider to your annuity policy. This feature will increase monthly payments, so they maintain their original value despite the increased cost of living.

Avoiding Fraud

Annuities can be complex and easily get lost in the mix. To make sure you’re making the best decision for yourself, follow these tips.

  • You should never feel pressured into buying an annuity- if you do, walk away. A good agent or broker will understand that you might need time to make a final decision and won’t push you for an answer immediately.
  • Be wary of anyone who tells you to replace your annuity with a new one. Instead, get answers to your questions to understand the rationale behind the decision. If you choose to replace your annuity, the agent is required by law to present you with a replacement notice that outlines both the benefits and drawbacks of replacing your policy.
  • When searching for an annuity, ensure you buy from an independent licensed agent or broker. This will guarantee you have a more extensive selection of products to choose from.
  • Be wary of “free” lunch or dinner seminars: More often than not, these events are hosted by people who know how to close a sale. They may try to book a meeting with you to pitch their product.

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Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.

The Annuity Expert is an online insurance agency servicing consumers across the United States. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you. 

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