What Is An Annuity?
An annuity is a contract between you and an insurance
company that offers a guaranteed income stream
for life or a specific duration, with payments
starting right away (immediate annuity) or
in the future (deferred annuity). In some cases,
you may surrender the contract and receive
a lump sum.
How Do They Work?
When you purchase an annuity, you pay the insurance
company an amount of money in a lump sum or series
of payments. The insurance company invests this
money and credits interest to your account based
on their investment earnings. The funding period
is called the accumulation phase. Under current
tax law, you pay no federal income taxes on accrued
earnings until payouts begin.
In return, you — or a named beneficiary — receive
an income for a defined period, for your lifetime
or for a beneficiary’s lifetime. This period
is called the distribution phase. Receiving scheduled
payouts is called annuitizing the contract.
When you begin receiving a stream of income,
you receive your contributions plus any earnings
that may have accumulated. You are taxed for
federal income tax purposes only on the amount
of earnings received. Generally, the principal
(the amount you contribute) is not subject to
federal income tax because you pay premiums with
after-tax dollars. If your annuity is an individual
retirement account (IRA), your contributions
may be taxed for federal income tax purposes
when withdrawn.
Who Should Have One?
You can benefit from an annuity if you:
-
Contribute the most you can to employer-sponsored retirement
plans such as 401(k) or 403(b) plans and need to save more
for retirement.
- Have already contributed the maximum to a Roth or traditional
IRA — or your adjusted gross income (AGI) prohibits you from
contributing to such accounts.
- Already have investments or savings accounts that
can be quickly converted to cash.
- Need to generate a guaranteed, steady income for retirement.
- Need to ensure a steady income for your spouse or
another beneficiary after your death.
- Expect to be in a lower tax bracket in the future.
- Want protection, safety and guarantees for your money.
Other Considerations
When purchasing an annuity, you should know the following.
-
Costs may include annual fees, investment management fees,
insurance expenses and other charges. Extra features such
as long-term care riders and liquidity options typically
have costs associated with them.
- Some annuities offer death benefit protection or the
option of continuing payments to a beneficiary after your death.
This may avoid the time and cost of probate for these funds.
- Because earnings are taxed for federal income tax purposes
only when you withdraw funds or receive payouts, you may pay less
federal income taxes than with other investments.
- You can generally withdraw only a certain amount from
your contract without penalties.
- Your scheduled income payments remain the same once you
begin receiving them. (This does not apply to IRA required minimum distributions.)
- There may be a 10 percent Internal Revenue Service (IRS) penalty
in addition to regular federal income tax if you withdraw annuity
savings before age 59½.
- Annuities are guaranteed by the company offering the annuity and
then backed by guaranty associations in most states, not by the federal
government.
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Basic Money Management
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