Many people planning for their retirement overlook using annuities primarily because they seem complex and difficult to understand. This is true to the extent that there are many different types of annuities. Each has different elements depending on the situation and age of the purchaser, who is referred to as the owner. When choosing an annuity, one size definitely does not fit all.
One type of annuity may work for someone planning to retire in 20 years and another type for a person who retired last week. Using an annuity that will work in the best interest of the owner can provide confidence to retirees who are worried about outliving their money.
Annuities for dummies
An annuity is a contract purchased by an individual from an insurance company. It is essentially a contract in that the purchaser agrees to pay a premium and the seller agrees to accumulate the premium in a certain way and/or pay that money back to the purchaser in a certain way. In some cases, the purchase may not offer the ability to liquidate the annuity installments. This makes it extremely important for the purchaser to educate themselves about the advantages and disadvantages of various types of annuities before making a decision that may be permanent.
Overview of various types of annuities
There are two phases to a deferred annuity. The accumulation phase, where the owner makes regular premium payments (Flexible Premium) to the annuity over a period of time or makes a one lump sum premium payment (Single Premium). The interest accumulates in the contract tax-deferred.
The second phase is the payout phase. The owner receives regularly scheduled payments, which are taxed at the owner’s income tax rate at the time of the withdrawal. If the annuity is non-qualified, meaning that the premiums were after-tax dollars, then a portion of the payouts to the owner will be considered a return on premium and will not be taxed.
A lump sum is used to purchase an annuity. In exchange for the premium, the insurance company agrees to pay the owner on a periodic basis, usually monthly. Payments may start as soon as 30 days after the annuity is purchased.
The amount of the payment depends on the amount of the premium payment and whether payout is over a designated period of time or for the owner’s lifetime. In addition to age and gender, other factors that influence the amount of the payment is whether or not the payout ends at the death of the owner or whether the payments continue for the heirs.
This is a basic annuity where the interest crediting works similar to a bank CD. The interest is fixed for a certain period of time. The interest stays within the annuity and unlike a CD it is tax-deferred until the funds are withdrawn.
Fixed Indexed annuities
This provides the owner with protection of premium from market downturns and a minimum interest rate guarantee. In addition, indexed annuities afford the potential for higher excess interest rates over the long term by using crediting methods linked to an index (like the S&P 500). The index is only a factor that in part determines the interest to be credited, an indexed annuity does not participate directly in the stock market or in an index's gain or returns.
A variable annuity offers the potential for higher returns but also has a higher risk in that no minimum amount of interest is guaranteed, and the owner assumes the risk of the underlining investment in the contract. With a fixed annuity the risk is assumed by the insurance company. Most variable annuities offer a representative selection of stock, bond, and money-market type sub-accounts. Your return is directly correlated to the performance of the sub-accounts.
Qualified versus non-qualified annuities
All annuities are either qualified or non-qualified. A qualified annuity is where taxes have not yet been paid on the premiums. Non-qualified means taxes have been paid on the premium paid by the owner.
As there are so many variables in choosing an annuity, potential purchasers should educate themselves on all types and seek tax advice in determining the best annuity for their needs. You can also benefit by seeking the advice of a trained independent insurance agent.