Annuity Investment Guide
About the Annuity Investment Guide
In this guide, we cover the basics of the annuities: what annuities are; how annuities work; which types of annuities are available – fixed, variable, indexed, immediate, and deferred; which types are suitable for whom; and the tax benefits of annuity investing. While this guide provides an overview and general advice, we encourage you to seek the advice of a qualified financial advisor in order to receive specific information about your individual financial situation.
What is an Annuity?
Simply put, an annuity is a contract. Life insurance companies sell annuities to investors who want immediate income or tax-deferred growth, whether they're buying the annuity with pre- or post-tax dollars. But annuities are most popular when used as retirement savings investments. An investor pays the premium for the annuity and is then guaranteed a specific return or payments at some point in the future. In some ways, annuities can be compared to bonds. Bonds also provide a stream of income. But bonds are subject to many more market forces than annuities, especially fixed annuities. And, bonds can be called at any time by the issuer. Annuity income provides stability regardless of market conditions. But unlike a bond that can be sold at any point, once an annuity is purchased, an investor will have a hard time getting his money back except in the form of the payouts.
To see anwsers to over 30 of the most common annuity investment questions, visit the Annuity FAQ.
Fixed annuities are almost always purchased with a single lump-sum premium. Investors can use cash from a savings account, money market account, an inheritance, and even the proceeds from the sale of property. An immediate fixed annuity provides a stream of income now rather than at some point in the future. Fixed annuities are a popular choice among those who might not have saved enough for retirement and are worried about outliving their savings.
The most important part of selecting a fixed annuity is the interest rate. The interest rate will determine how much income is earned on the premium, which therefore determines the amount of income you'll receive each month. Do not commit a large amount of money to a fixed annuity in a low interest rate environment. While you may earn more on an annuity than you would on another safe investment such as certificates of deposit or U.S. Treasuries, an annuity will lock up your money. If interest rates are low, buying a smaller annuity that supplements your income is often the better bet.
For more details, visit the Fixed Annuities page.
Variable annuities offer some of the same benefits as mutual funds, but once again, you're money will be locked into an annuity for a much longer period of time. If you're under 40, and especially if you're contributing the maximum amount allowed to a 401(k) or other employer-sponsored retirement fund, a variable annuity can be a good choice.
Like all annuities, variable annuities grow tax-deferred until distributions begin after the age of 59 ½. Even if it is funded with post-tax dollars, funds will accumulate faster because you're not deducting money to pay taxes. However, the drawback of a variable annuity is that once distributions begin, they are taxed at ordinary income tax rates rather than the more favorable long-term capital gains rate.
If you're in a profession whose members tend to be sued – doctor, lawyer, CPA, business owner, etc. – you should consider a variable annuity to protect assets in the event a judgment is entered against you. Whereas the fact that an annuity is a contract can be a negative if you decide you decide to cancel, it's a positive because it cannot be counted as part of your overall assets if you're sued. Annuities (and life insurance policies) are protected from seizure in most states.
For more details, visit the Variable Annuities page.
Indexed annuities provide the best of both worlds. They have the safety features of fixed annuities and the investment features of variable annuities. Indexed annuities invest in both bonds and stocks, which provide some diversification among asset classes and can make certain turbulent markets less risky.
As the name implies, indexed annuities are tied to a specific index. In most cases it's the S&P 500. If the index rises, you participate in the gains. If the index falls, there's usually a floor below which the insurance company will cap losses.
However, because the insurance company is bearing most of the risk, it will usually set a participation rate that will limit the upside potential. In other words, if the participation rate is 85%, only 85% of your indexed annuity will participate in the gain. If the annuity is worth $100,000 and the market rises 4%, only $85,000 of the $100,000 would be used to calculate the earnings.
For more details, visit the Indexed Annuities page.
Immediate vs Deferred Annuities
Immediate annuities provide a guaranteed stream of income immediately after the annuity is purchased. An immediate annuity is a good investment if you're already retired and fear outliving your retirement savings. It is not a good investment if you're not yet retired or if your level of risk tolerance allows you to invest in other more lucrative investments that provide a higher amount of income. For example, bonds and equity dividends will also provide income and the underlying investments will also continue to grow to increase the overall portfolio.
Deferred annuities promise payouts at a future date. Taxes and payouts are deferred until distributions begin, usually after age 59 ½. Deferred annuities are often a great way to save additional money for retirement because of their advantageous tax treatment. Even if the annuity is purchased with after-tax dollars, the earnings compound without taxes begin deducted.
Deferred annuities also typically offer a number of investment options and can be used in place of whole life insurance policies. They can have a death benefit rider, a beneficiary, or can be left as part of a trust. It's important to note, however, that the tax treatment of deferred annuity distributions is not like that of other investment options. The IRS considers annuity distributions to be the return of your own money, so you only pay income tax on the amount that's been earned. But, you pay ordinary income tax rates as opposed to long-term capital gains rates, which are almost always lower. And those who inherit an annuity will not enjoy the lower step-up value that is allowed with stocks, bonds, mutual funds, and property. This means that the taxes owed will be based on the increase from the time the annuity was purchased to the time of inheritance. With other investments, the value to the beneficiary is determined by the market value at the time he or she takes ownership.
For more details, visit the Immediate vs Deferred Annuities page.
Annuities, like all investment products have their pros and cons for each individual investor. Taking the time to fully research and understand the type of annuity that's best for you will go a long way toward ensuring that your assets, beneficiaries, and retirement income will be protected.
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More Annuity Guidance
- Fixed Annuities — Learn about the ins and outs of fixed annuities.
- Indexed Annuities — Learn about the ins and outs of indexed annuities.
- Variable Annuities — Learn about the ins and outs of variable annuities.
- Immediate vs Deferred Annuities — Learn how to choose between annuity types.
- Annuity FAQ — Answers to commonly asked annuity investment questions.