How do annuities work?
An annuity could be a valuable addition to your retirement plan. Here's how they work and what they are.
What is an annuity?
Typically, an annuity is one option of accumulating money prior to retirement, and eventually distributing money during retirement or at your death. A significant concern for many people nearing or in retirement is the thought of outliving their money. A retirement annuity, sometimes referred to as a life annuity, is an insurance contract you purchase that can provide an income for life no matter how long you live, or for a specific time period. It’s your choice.
Why buy an annuity?
None of us know how long retirement is going to last. That means one of the biggest risks you face is outliving your money. During retirement, you’ll continue to face the basic costs of living, such as housing, groceries, utilities, healthcare and taxes. By combining the income from an annuity along with Social Security benefits, you can help ensure that these basic costs are covered.
How does an annuity work?
An annuity is a contract between the owner of the annuity and the company issuing it. You buy the annuity, and the company pays you interest on the money. At a certain age, you start taking the money out and you could receive payments for as long as you live. Some annuity types may help reduce the chance of outliving your retirement income.
Annuities and life insurance are often mentioned in the same conversation because most annuity contracts are written by life insurance companies. However, life insurance is intended to meet the needs of the beneficiaries after the death of the policyholder. With annuities, the intention is to provide additional income to policyholders during their retirement years.
There are distinct phases of annuity contracts.
- Accumulation phase: The period of time after you purchase your annuity and before you start receiving payments. During this phase, your investment will grow at a guaranteed or a variable rate of return, typically tax-deferred. Keep in mind that immediate annuities will not have an accumulation phase, as payments begin right after a person purchases the product.
- Annuitization phase: When you start receiving payments, typically at retirement. This phase is also called annuity or payout phase. Depending on the annuity product you purchase, the amount and length of the payouts is different.
Categories of annuities
There are various types of annuities including immediate, deferred, fixed and variable annuities. The immediate vs. deferred category has to do with when your income payout begins. The fixed vs. variable category has to do with how your contributions are invested.
Immediate annuities generate income immediately after purchase. Your money provides guaranteed payments to you that begin soon after you make your initial payment. Depending on the tax-qualified or non-tax-qualified status of your annuity, a portion or the entire payment can be included in your taxable income. The owner can elect to receive guaranteed payments for life, or elect payments to be made over a specified length of time (period certain).
Deferred annuities allow your investment to grow tax-deferred until you decide to start receiving income payments at some point in the future. And you can choose when you want to start receiving income payments. Deferred annuities may also make sense for people who are looking for an additional way to save money for retirement, even when it is a few years down the road.
With fixed annuities, as with variable annuities, there is a risk component to consider. An insurance company accepts the investment risk and places money in high quality fixed-rate investments such as bonds. This allows the company to earn a stable fixed interest rate for a certain period of time.
With variable annuities, the risk is taken by the policyholder, rather than by the insurance company since the money is placed in market-based investments. This may include stocks, bonds, mutual funds or money markets. You may have the option to move the money around among the different investments. In addition, the rate of return can vary based on the performance of the investments.
Indexed annuities have both fixed and variable annuity features. They offer a base guaranteed interest rate along with a rate of interest based on a stock market index, like the S&P® 500 Index. This provides the opportunity for investment growth when the market performs well. An indexed annuity can be a complex product. Consider discussing all the features, fees, surrender charges and any tax penalties with your insurance agent so that you understand how they work together before you purchase.
Annuity payout options
When you purchase annuities, there are many payout options available. Here are some you can choose from:
- Life annuitization option. With this option you will get a payment for life and the amount is calculated based on the annuitant’s life expectancy.
- Joint-life annuitization option. This option will allow your spouse to receive payments after you die. The payments are usually lower than the option above, as it is calculated based on life expectancy for both you and your spouse.
- Period certain. The annuity is paid for the period of time you choose, and in the case that you die before the period ends, your beneficiary will receive payments for the remaining of the chosen term.
- Life with guaranteed term. With this option you will receive income for life and may choose a guaranteed period for your beneficiaries. In the case that you die before the guaranteed period, your beneficiaries will receive payments until that chosen term is over.
- Systematic withdrawals. You decide payment amounts and the number of months you want the payments to be, depending on how much your account is. You may outlive your payments with this option.
- Lump sum payment. If you decide to take a lump sum payment, you will need to pay ordinary income taxes on the investment gain portion of your annuity.
Consider having a conversation with a financial professional to help you decide if an annuity makes sense as part of your retirement plan. If you'd like to talk about your retirement goals and learn more about annuities, your local State Farm® agent may be able to help.