What is an annuity and how does it work?
You’re not wrong. But you might not be doing everything you can to set yourself up for a long, comfortable life after work.
If you live significantly longer than you expect or incur unexpected expenses in retirement, you run the risk of outliving your savings. And don’t count on Social Security to make up the difference. It probably won’t be enough to maintain your standard of living.
An annuity might offer a partial answer. By providing guaranteed income well into your golden years, it could be the safety net you seek. But first, you’ll want to make sure it’s right for you.
What Is an Annuity?
An annuity is an agreement — a contract — where one party agrees to make a series of payments of a certain amount of money to the other party for a predetermined period of time.
Annuities have existed since antiquity. In the 21st-century United States, they’re generally underwritten by life insurance companies for the benefit of individual contract owners, called beneficiaries.
Annuities are designed to insure the beneficiary against the risk of outliving their income. If your retirement savings and Social Security entitlement provide only enough income to support you until you’re 85, an annuity ensures you’re comfortable for your remaining years — whether you make it to 90, 95, or beyond.
An annuity is guaranteed to pay out at least a certain minimum amount at an agreed-upon frequency, typically monthly, quarterly, or annually. These payments continue even after they exceed the total amount you paid into the contract, plus any accrued interest or gain. However, some annuities have finite terms, meaning payments stop after a certain number of years.
Regardless of term length, all annuities are long-term investments best suited for producing retirement income. Payments typically don’t begin until you’re well into your golden years, and you’re not allowed to withdraw funds from an annuity without penalty until you reach age 59 ½.
How Annuities Work
Depending on the terms of your annuity contract, you can make either a lump-sum payment or a series of payments into the contract. The insurance company uses your payment or payments to purchase accumulation units — basically, shares of the annuity — that accumulate and grow over time.
In some cases, you can begin receiving annuity payments from your insurance company right away. More often, you’ll wait until you hit a predetermined age set by the contract.
The longer you defer payments, the more time your money has to grow. During the deferral period, you can access the money you paid into the annuity under certain circumstances, but you may incur a penalty for withdrawals made before age 59 ½.
Before you can receive any payments, the insurance company must convert your accumulation units into annuity units. This event is known as annuitization.
After annuitization, you no longer have access to the lump-sum amount you paid into the annuity. On the bright side, you’re now entitled to receive guaranteed income for the rest of the contract’s term.
How to Buy an Annuity
You can buy an annuity contract directly from an insurance company or inside a tax-advantaged retirement plan, such as an IRA or qualified plan. In either case, you need to make your initial payment and any subsequent payments by check or electronic transfer.
You can also buy into an annuity through a 1035 exchange, which is a tax-free transaction that converts an existing annuity or cash value life insurance policy into a new annuity.
Basic Characteristics of Annuities
Although there are many types of annuities, all annuity contracts are alike in several respects.
- Tax-Deferred Growth. Annuities grow on a tax-deferred basis even if they’re not held in an IRA or qualified plan. This makes them different from most other types of long-term investments, including stocks and corporate bonds.
- Generous Investment Limits. When an annuity is held outside an IRA or qualified plan with annual contribution limits, it typically has very high investment limits. Each insurance company sets its own limits, but they’re often well over $1 million. This makes annuities appropriate for high net worth individuals looking to reduce taxes on long-term savings.
- Surrender Charges. Like cash value life insurance policies, annuities usually carry surrender charges during the first five to 10 years of their existence. Early on, these charges can be stiff — 7% or more of the amount withdrawn in some cases. The good news is that surrender charges decline over time and eventually disappear, and some insurance companies allow annuity holders over age 59 ½ to withdraw an agreed-upon principal amount each year — up to 20% in some cases.
- Rollover Potential. You may be able to avoid taxes and penalties on annuity withdrawals by rolling your annuity over into a new contract using a 1035 exchange.
Annuity Payout Options
Once annuitization occurs, you can generally choose from several payout methods. Refer to your annuity contract for specific information about your options:
- Single Life. The annuity makes payments during your lifetime based on your life expectancy when you take out the contract. If you outlive your life expectancy, payments continue, even if they exceed the amount you paid in plus interest or other gains. However, payments stop when you die, regardless of how much you’ve received.
- Life with Period Certain. The annuity pays out for a predetermined minimum amount of time, typically at least 10 years. Payments continue even if you die during this time period — they go to your designated heir or heirs.
- Joint Life. This is a popular option for married couples and domestic partners. Payments continue as long as one of the two beneficiaries remains alive.
- Joint Life with Period Certain. This option combines a set period of guaranteed payments with the survivorship component of joint life.
- Systematic Withdrawal. This allows you to drain the annuity’s principal and gains over a period of years. Each withdrawal is typically equal in size.
- Lump Sum. This option pays you or a designated beneficiary a lump sum after an agreed-upon period of time, usually decades after you enter the contract. The lump sum is equal to the value of your contributions plus interest and gains.
How Annuities Are Taxed
Your annuity contributions grow on a tax-deferred basis unless you withdraw them before turning 59 ½. If you withdraw before that point, you’ll pay a 10% tax penalty on the withdrawal amount, plus ordinary income taxes on interest or gains. You don’t pay tax on annuity principal withdrawals.
After age 59 ½, annuity distributions are subject only to ordinary income tax on the interest or gains they earned.
For example, say you contribute $100,000 to an annuity and it grows to $400,000 by the time you begin receiving monthly payments. That makes $100,000 (25%) of the annuity’s value principal and $300,000 taxable gains. If each monthly payment to you is $500, then $125 of each payment — 25% — is considered a tax-exempt return of principal.
Types of Annuities
Annuities take several different forms. These are the most common.
Before entering into an annuity contract, carefully read the agreement and fine print. Insurance agents and financial advisors who sell annuities often operate on commission, meaning there’s no guarantee that the contract is in your best interest. If you’re not sure, have an insurance attorney or fee-only fiduciary advisor review it.
This is the simplest type of annuity. You make a single lump-sum payment and receive your first payment within a year. Payments continue for the length of the term — anywhere from five years to the year you die.
Some immediate annuities come with guaranteed cost of living increases that protect you from inflation. Others make flat payments that don’t adjust for inflation. Cost of living increases generally range from 1% to 5% of the total payment.
Because your money has less time to grow in an immediate annuity, the minimum investment is steep — typically at least $25,000.
A deferred annuity promises periodic or lump-sum payments at some future point in time, often decades after the contract begins. The initial investment is smaller than an immediate annuity — as low as $2,500 to $5,000, depending on the issuer.
In the meantime, the value of the payments you’ve made to date — your principal — grows based on the contract’s structure. How this growth occurs depends on the type of deferred annuity you choose:
- Fixed Annuity. The rate of return is set by the contract and doesn’t change over time. Think of it as a fixed interest rate. During periods of low inflation, it’s higher than the inflation rate, and the real value of your annuity grows. When inflation is higher, your annuity may lose value relative to inflation. However, your annuity won’t lose value in absolute terms because you have a guaranteed rate of return.
- Variable Annuity. The rate of return is tied to a mix of subaccounts that you choose. Usually, these subaccounts are mutual funds that mirror the return of specific market sectors or indexes. When the underlying assets lose value, the subaccounts can lose value as well.
- Fixed-Indexed Annuity. The rate of return is tied or “fixed” to a specific market index, such as the S&P 500. However, when the underlying index falls, the annuity loses value in absolute terms, exposing you to significantly more risk than a traditional fixed annuity.
- Registered Index-Linked Annuities. This type of annuity is similar to a fixed-indexed annuity but has a “stop loss” feature that lets you limit your potential losses. This is useful during significant stock market downturns.
Qualified vs. Nonqualified Annuities
A qualified annuity is an annuity funded with pretax dollars. Generally, you hold a qualified annuity in a tax-advantaged retirement plan, such as an IRA or 401(k). You generally don’t pay taxes on contributions to qualified annuities.
A nonqualified annuity is an annuity funded with after-tax dollars — dollars you’ve already paid taxes on. If you buy an annuity directly from an insurance company outside of a tax-advantaged account, it’s likely to be nonqualified.
Pros & Cons of Annuities
Guaranteed income in your later years sounds great, and it is. But annuities are complicated and have some notable drawbacks too.
Pros of Annuities
Annuities have powerful tax advantages and promise long-term income with few conditions. They have some other notable benefits too.
- Tax-Deferred Growth Outside of a Retirement Plan. An annuity is one of the few investments that offers tax-deferred growth outside the confines of a tax-advantaged account, such as an IRA or 401(k). And with much higher contribution limits, the potential tax savings are far higher than your IRA or 401(k).
- Guaranteed Income for the Full Term. An annuity promises steady, predictable income for the full term, whether that’s five years or the rest of your life.
- Benefits for Survivors and Heirs. If you name a beneficiary or set up your annuity as a joint contract, it passes to your heirs without going through the probate process. This eliminates the costs associated with probate and may shorten the waiting period for your heirs to take ownership of the contract.
- Potential for Inflation Protection. Some annuities have built-in cost-of-living increases that reduce the impact of inflation. Most other fixed-income securities don’t offer this protection.
Cons of Annuities
Annuities’ downsides include hefty fees, costly surrender charges for early withdrawals, and a long time horizon that may not be suitable for all investors.
- Potential for High Fees and Commissions. Annuities have much higher fees than stocks or mutual funds. Most have commission charges as well — up to 10% of the contract value, charged over a period of years.
- Low Liquidity. Annuities are not as liquid as bank balances or market-traded securities. Early withdrawals can incur stiff penalties.
- Taxed as Ordinary Income, Not Capital Gains. The taxable portion of an annuity distribution is taxed as ordinary income, not capital gains. Your actual ordinary income rate depends on how much you earn, but it’s generally higher than the capital gains rate.
- Not FDIC-Insured. Although they’re guaranteed by the issuer — typically a deep-pocketed insurance company — annuity balances aren’t FDIC-insured. This missing layer of protection could matter if you’re very risk-averse.
Still have questions about annuities? We have answers to some of the most common queries about this type of long-term investment.
How Much Do Annuities Cost?
Before you begin receiving payments, much of your annuity’s cost is the amount of money you put into it, or principal.
If you make a lump-sum payment of $50,000 to start an immediate annuity, your principal is $50,000. If you put $5,000 per year for 20 years toward a deferred annuity, your principal is $100,000.
In either case, you can count on getting this money back. Or, if you die prematurely, your survivors will get it back. So it’s debatable whether principal payments qualify as a true “cost” for annuity investors.
Annuities do have plenty of actual expenses, however:
- Commissions. Most annuities build commission charges into the value of the contract, so you don’t make a separate commission payment. They’re typically trailing commissions, meaning they’re spread out over a period of years. They can be steep though. Depending on the type of contract, expect to pay 1% to 10% of the total value in commissions.
- Administrative Fee. This is an annual management fee that’s charged as a percentage of the contract value or as a flat fee. It’s generally less than 0.3% of the contract value.
- Surrender Charges. If you withdraw principal in excess of any scheduled payments during the first few years of your contract, known as the surrender period, you may face a surrender charge. Surrender charges are higher early on — they often start at 7% and decline until disappearing sometime between the 5th and 10th year.
- Investment Expenses. These are fees charged by the funds that the annuity invests in. The issuer can’t directly control these expenses, which vary depending on the fund type and management style. Actively managed funds can charge upwards of 1% of the asset value per year, while passively managed funds generally charge less than 0.3% annually.
- Mortality Expenses. This is a surcharge that compensates the annuity issuer for the financial risk inherent in annuities. It typically ranges from 0.5% to 1.5%.
These aren’t the only fees you might pay as an annuity owner. Carefully review your contract for other line items, like distribution fees, third-party transfer fees, and underwriting fees.
How Are Annuities Taxed?
Annuities grow on a tax-deferred basis. You don’t pay any tax on the value of your annuity or its gains if you don’t make withdrawals.
Once you do make withdrawals or take distributions, the principal portion is not taxed. The remainder is taxed at the ordinary income rate, not the lower capital gains rate.
If you do make a withdrawal from your annuity or cash it out entirely before age 59 ½, you may have to pay an additional 10% tax penalty. However, your contract may allow you to withdraw a portion of the annuity without penalty each year.
Can You Cash Out an Annuity Early?
Yes. But if you cash out too early, you could face hefty penalties and fees.
If you cash out the full value of your annuity before age 59 ½, you’ll pay an additional 10% tax penalty on the taxable portion. That’s any interest and gains earned by the annuity. You’ll also pay ordinary income taxes on the taxable portion.
If you cash out after 59 ½, you won’t have to pay the 10% tax penalty, but you’ll still pay income taxes on the taxable portion.
In either case, you may also have to pay a surrender charge if you cash out during the surrender period. You won’t pay taxes or fees on principal withdrawals, however.
What Happens to an Annuity if the Stock Market Crashes?
It depends on the annuity type.
If you have a fixed annuity that offers a guaranteed rate of return regardless of what happens to stocks, you can safely ignore the market’s ups and downs.
If you have an index-linked annuity, stock market movements can significantly affect the value of your contract. The good news is that annuities generally have built-in principal protection, which means the contract’s value can’t decline below what you put into it. In the absolute worst-case scenario, you won’t earn any income from the contract, but you can still recover your principal.
What Happens to My Annuity if I Die?
It depends how it’s structured.
If you have a joint annuity with a spouse or domestic partner, you can structure it so that your partner continues to receive payments after your death. Likewise, a period-certain contract transitions payments to your heirs if you die during the guaranteed payment period.
In most cases, you can also add a death benefit rider to your contract to ensure your heirs continue to receive payments if the contract still has value after you die.
An annuity sounds like a great deal. It offers the promise of long-term or lifetime income that could even outlive you. Although the contract’s gains could evaporate if you’ve chosen riskier investment options, your principal is protected even in a worst-case economic scenario.
Well, as long as the issuing company remains solvent.
But annuities aren’t for everyone. They come with high fees and commissions, and the investments underlying them aren’t always properly diversified. If you’re young, historical stock market returns suggest you’d be better off investing in a diversified stock and ETF portfolio with alternatives like real estate and bonds thrown in at the margins.
Before investing in an annuity, consult a fiduciary financial advisor to make sure it’s the right move for you. It could be — but don’t just take the word of the person selling it, who stands to make a hefty commission off your decision.