The Basics of Annuities

An annuity is considered an agreement between one organization or person and another to make a set of payments. This term is commonly used when referring to a contract between an individual and a life insurance company. However, charities and trusts may also replace insurance companies and make annuity payments. While the term may seem simple, there are several different aspects by which annuities are classified, which include the following:

  • Primary Purpose – This consists of an accumulation or a payout. The payout may be either immediate or deferred.
  • Nature Of Underlying Investment – This type of annuity may be variable or fixed.
  • Tax Status – These annuities are either qualified or non-qualified.
  • Nature Of Pay-Out Commitment – These annuities offer a fixed amount, fixed period or lifetime payout.
  • Premium Payment Arrangement – This type of annuity can have either a flexible or single premium.

Some annuities can be classified in more than one of these categories at once. For example, a person could purchase a non-qualified single premium annuity that is also classified as a deferred variable annuity. To learn the brief definitions of these annuities and combinations, contact an agent.

Features of Annuities

There are several beneficial features of annuities. There are tax deferrals on investment earnings. Investments are taxed one year at a time. However, the investment earnings, which consist of investment income and capital gain, are not taxable until the holder of the annuity withdraws money. This tax deferral is also a feature of IRAs and 401(k) plans. However, annuities differ from these products in the respect that there are no limits placed on the amount individuals may contribute to their annuities.

In addition to this, the minimum withdrawal requirements are more generous than those for IRAs or 401(k) plans. Those who have annuities also enjoy protection from creditors. Owners of immediate annuities won’t see creditors access anything more than regular payments as they’re made. This is because any money previously given to the insurance company belongs to them. However, there are some states that have statutes in place to protect all or some of the payments from annuities.

There are also several investment options for annuities. Owners can invest their money in a fixed annuity. A specific interest rate would be credited for this investment. The idea is similar to a bank CD. Individuals who buy variable annuities may invest their money in bonds, mutual funds or stocks. There have been floors, which are limits, placed on annuities by the companies issuing them. These floors are in place to limit the extent of the decline of investments from an increasing reference point.

Annuities have the benefit of tax-free transfers for investment options. If owners of annuities change how their funds are invested, there are no tax consequences. This is a great advantage for those who are using the re-balancing strategy. Many financial advisers recommend re-balancing. Owners who use re-balancing are able to periodically shift their investments in order to help them return to the proportions that are best for their needs.

Lifetime income is another feature of annuities. Lifetime immediate annuities convert investments into a series of payments that last as long as the individuals who own the annuities do. To illustrate where payments come from, it’s best to visualize them coming from three different pockets. One of the pockets is a pool of people in the same group who don’t live as long as expected. The second pocket is an individual investment, and the third pocket is investment earnings. Pooling is what is unique to annuities. It is also what makes it possible for companies to guarantee a lifetime income.

Heir benefits are another feature to consider. Although there is a misconception that insurance companies keep annuities after death, this isn’t always true. To prevent this from happening, it’s best to purchase a guaranteed period when buying the annuity. This period requires the insurance company to continue payments after death to one or more named beneficiaries. These payments will continue for a specific length of time, which is usually between 10 and 20 years. Talk to an agent to learn more about annuity features and the in-depth details of each feature.

* Liquidated earnings are subject to ordinary income tax, may be subject to surrender charges and, if taken prior to age 59 1⁄2, may be subject to a 10% federal income tax penalty. Guarantees and payment of lifetime income are contingent on the claims paying ability of the issuing insurance company.