Financial Definition of ANNUITY
How It Works
An annuity is similar to a life insurance product, but there are important differences between the two. Under the terms of a life insurance policy, the insurer will generally make a payment upon the death of the insured. Under the terms of an annuity, the company makes its payments during the lifetime of the individual. In addition, unless the annuity contract specifies a beneficiary, most annuity payments cease upon the death of the recipient. Annuity.
There are several ways categorize types of annuities:
Immediate Annuities are usually purchased at retirement age, with benefits that begin immediately (within one year of purchase).
Deferred Annuities offer benefit payments that begin at some future date. Interest usually accrues on a tax-deferred basis in the interim.
Qualified Annuities are annuities that an investor funds with either pre-tax dollars or tax-deductible contributions.
Non-Qualified Annuities are those contracts funded with after-tax dollars.
A Fixed Annuity is a personal retirement account in which the earnings are based on a fixed rate set by the insurance company. Fixed annuities are susceptible to inflation risk due to the fact that there is no adjustment provided for runaway inflation.
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A Variable Annuity is a personal retirement account in which the investment grows tax-deferred until the investor is ready to withdraw the assets. Another important feature of the variable annuity is the family protection, or death benefit, that often comes along with such contracts. This guarantees that, should the investor die during the accumulation phase of the variable annuity, the account owner's beneficiary will receive at least the amount of the investor's contributions minus withdrawals or the current market value of the account.
How It Works
There are two phases in the life of a deferred annuity: the savings or accumulation phase, and the income or annuitization phase. During the accumulation phase, the investor will deposit money into the account either periodically or all in one lump-sum. When the annuity reaches the contractually agreed-upon date, the investor will begin receiving several payments over a period of time or in one lump-sum.
It is important to note that earnings on a deferred annuity are only taxed when they're withdrawn. However, if an investor withdraws money before the contractually agreed-upon date, he or she may have to pay considerable surrender fees. Annuity owners younger than 59.5 years old may also have to pay a 10% penalty tax, even if the surrender period has expired.
Another important feature of deferred annuities is the family protection, or death benefit, which guarantees that, should the owner die during the accumulation phase, the beneficiary will receive at least the amount of the owner's investments minus withdrawals, or the current market value of the account.
Often, the beneficiary cannot take advantage of a "step-up" in basis on an annuity, meaning that he or she becomes responsible for paying income taxes on all the gains in the account since it was opened.
Why It Matters
Investors purchase deferred annuities for many reasons, the most common being the tax deferral of earnings, the lack of restrictions on the amount of the annual investment (unlike an IRA or 401(k)), and the guarantee of a lifelong annual income. Control over the investment decisions and the ability to switch between investments is also attractive to some investors.
Despite these advantages, wise investors must consider some important drawbacks to annuities. For one, annuity investors pay taxes on gains at their ordinary income tax rate (rather than the lower long-term capital gains tax rate) when they make withdrawals.
Fees are also major source of controversy for annuities. There are often front-end loads, state taxes, annual fees based on a percentage of the account value, early withdrawal penalties, etc., and they may offset much or all of an annuity's tax advantages. Variable annuities are particularly controversial because fees charged by their underlying mutual funds also burden them.
This is why less-than-stellar returns can turn into serious setbacks for some annuity investors. And even though investors can trade within their annuities and defer the taxes on the realized gains, most investors do not trade frequently enough to make this a huge advantage.
Pressuring sales tactics and less-than-transparent disclosure have also tarnished the image of annuities, so wise investors should be sure to read these disclosure materials and ask his or her financial consultant plenty of questions.
Ultimately, the appropriateness of an annuity is dependent on the investor's financial goals, tax situation, and the types of annuities available. Inflation and interest rate expectations may affect the type of annuity an investor chooses, as will the investor's wishes for his or her dependents and heirs.
How It Works
Let's assume you put $300,000 into an annuity at age 60 and the insurance company offers to pay you $1,000 per month for the rest of your life.
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According to our math, you will have to live until age 85 to break even on the investment, and if you live past 85 the insurance company must continue making payments.
To invest in a variable annuity, the buyer makes an investment with the insurer and allocates this money according to a menu of mutual funds allowed by the contract. Some insurance companies also offer asset-allocation funds, which automatically allocate the money in a range of stocks, bonds, treasuries and other investments. The contract grows tax-deferred until the buyer chooses to receive payments ("annuitizes the contract"). Unlike investors who directly own mutual funds, annuity holders may switch in and out of funds and receive year-end distributions from those funds on a tax-deferred basis until the contract is annuitized.
It is important to know that buyers cannot begin receiving annuity payments before age 59 1/2 without paying a 10% federal tax penalty. When payments begin, the contract's investment gains are taxed at the buyer's ordinary income tax rate. Some insurers allow buyers to make small emergency withdrawals without penalty. In some circumstances, buyers may also exchange an annuity tax-free for another annuity with a different insurance company, which is known as a 1035 Exchange and is governed by Section 1035 of the Internal Revenue Code.