Frequently asked questions about annuities
Are annuities a good retirement investment?
An annuity gives you the certainty of receiving an agreed-upon monthly income for the rest of your life, and for the life of your spouse in the case of a joint-and-survivor annuity.
A fixed annuity pays a regular stream of income while you live. An immediate annuity is purchased with a lump sum and begins to generate income immediately. Annuities offer many payout options. Each one is guaranteed by the insurance company. Generally, the longer you obligate the company to pay benefits, the lower your monthly check. Each company determines its payout scale by estimating survival rates and the company's expected earnings on investments.
A variable annuity provides an alternative should you seek an investment with the potentially higher return of equities or to be more involved with the investment decisions. For example, the Vanguard Variable Annuity Plan offers these investment choices: Money Market Portfolio, High-Grade Bond Portfolio, Balanced Portfolio and Equity Index Portfolio.
The investment alternatives offered by variable annuities give you flexibility to tailor your portfolio to meet your particular needs. Since variable annuities are not guaranteed, you're assuming a greater degree of risk, but your return is potentially higher than with a fixed annuity.
With a fixed annuity you're buying the guarantee of a fixed income, but you lose control of your capital. An alternative bond investment might pay you as much or more than an annuity, have lower expenses and commissions, and you would retain control of your money.
A fixed annuity offers a guaranteed rate of return, typically 3% to 4%. It also offers a current rate set by the company board of directors. The current rate is paid as long as it is equal to or greater than the guaranteed rate.
You can withdraw money from either a fixed or variable annuity as long as you have not annuitized it. Once the annuity is annuitized, the company pays only an income and no withdrawals may be made. You basically exchange the annuity value for an income stream that lasts, depending on the options you select, from a fixed number of years up to the remainder of your life.
What are the basic types of annuities?
An annuity is a contract, usually sold by an insurance company, that makes periodic payments to the holder at a future date, usually beginning at retirement. A fixed annuity pays a guaranteed rate and guarantees principal. A variable annuity produces investment returns based on the performance of the investments made through the annuity. An immediate annuity begins making payments right away, rather than several years from now. All annuities are tax-deferred, meaning that the income resulting from the growth of the assets within the annuity is deferred until withdrawals are made from the annuity. The term "tax deferred annuity" actually refers to certain pre-tax savings programs available to public school employees and the employees of nonprofit organizations defined in section 403(b) of the Internal Revenue Code. Variable annuities typically offer mutual fund accounts that are managed identically to well known retail mutual funds. Such funds are called clones since they are patterned after other mutual funds and often have the same investment policy, name and manager.
What is a charitable gift annuity?
A charitable gift annuity is an arrangement that allows you to give something to a charity in return for a set amount of income for the rest of your life. You can even arrange a program that allows payments to be collected by your spouse after you die. Say you purchased some stock several years ago, and since then its value has skyrocketed. If you sold the stock today, youd get hit with a big tax bill on your capital gain. Instead, you could give the appreciated stock to a charity and, in exchange, the charity would provide you with income for the rest of your life. You would avoid having to pay capital gains on the stock, guarantee yourself income for as long as you live, and maybe even qualify for a handsome tax deduction for the gift.
What is an immediate annuity?
Younger workers often purchase tax-deferred annuities, but you may want to purchase an immediate annuity if you are about to retire. When you buy an immediate annuity, payouts from the annuity will begin shortly after you purchase the contract, i.e., it annuitizes immediately. The size of the monthly payouts will primarily be based on how much you paid for the annuity. Part of each payment you receive will be considered a return of your original investment; the rest will reflect interest earned during the payout period. Remember, you wont be able to withdraw any cash other than the payments because the annuity was annuitized at inception.
What are joint and survivor annuities?
A joint and survivor annuity pays a lifetime income to the annuitant and to another person, most often a spouse. If you are married or if someone depends on your income, you may want to select this option, which provides regular, fixed payments until both you and your spouse or dependent die. When you die, your spouse or dependent receives payments that are usually less than the amount you received, but by law they cannot be less than 50% of your payment. The joint and survivor plan generally offers the lowest monthly payments among most available annuity options. However, it is also the safest plan because it ensures that your spouse or dependent will continue to receive income after your death.
What is a life or period certain annuity?
When its time for payouts to begin from an annuity, one way to receive the money is called life or period certain. This guarantees that you will receive monthly payments for the rest of your life or a specified period of time, whichever is longest. You get to pick the "period certain" -- it could be 10, 15 or even more than 20 years. Say you choose the common life or 10 years certain schedule. The company guarantees a minimum of 10 years payments. All the payments will go to you for as long as you are alive. If you die after just six years, payments would go to your beneficiary for the final four years and then cease. If you lived beyond 10 years, you would still collect payments. But when you die, your beneficiary would collect nothing.
What is a private annuity?
A private annuity usually involves two parties. The annuitant transfers property to another party, who is often the annuitants grandchild or even great-grandchild. That party makes periodic payments for the life of the annuitant, with the life expectancy based on tables published by the Internal Revenue Service. When the annuitant dies, no federal estate tax will be owed on the property that was sold or transferred regardless of how many payments have been made. Instead, the property belongs to the party outside of the annuitants estate and no further payments will be due. The private annuity thus reduced the size of the estate and averted what could have been a sizable tax bill.
What is a single life annuity?
A single life annuity, sometimes called a straight life annuity or pure annuity, is a pension that provides you with a regular payment every month after you retire. If you choose a single life annuity and live longer than actuarial tables suggest you will, the payments will keep coming and the annuity will have worked in your favor. But if you die before the average age, the remaining cash will either revert to the pension fund -- or, if insured, to the insurance company.
What is a split annuity?
A split annuity can help you increase the after-tax earnings from other fixed-rate investments you have made, such as a certificate of deposit. Say you have a $100,000 certificate of deposit that earns 7% and that you are in the 30% income tax bracket. The CD would generate about $4,900 of after-tax income. In 10 years, you will have received $49,000 (assuming the income is spent, not saved and earning compound interest) of after-tax income and will still have $100,000 in principal. You could collect a lot more than $49,000 in after-tax income by purchasing a split annuity. The $100,000 in principal could be divided for investment purposes between a deferred annuity and an immediate annuity. If approximately $50,000 is put into an immediate annuity at 7%, it will provide $6,200 of annual after-tax income for a period of 10 years. This includes a return of principal and interest. After 10 years, the annuity will end. The other $50,000 would be invested in a single-premium deferred annuity. At 7% per year, this amount will grow back to the original $100,000 in 10 years, and the process can be started all over. Before you rush out to purchase a split annuity, there are a few issues you need to consider. For one, annuities arent as liquid as CDs. They also involve higher surrender charges. And unlike most CDs, annuities arent insured by the federal government. Its also important to remember that annuities have different estate and income tax implications at death than CDs do. And if interest rates are low, you might have to choose an annuity that has a variable rate rather than a fixed-rate -- a selection that may result in higher returns but will also increase your risk.
What is a tax-deferred fixed annuity?
All annuities sold by insurance companies are tax deferred. The term, "tax-deferred annuity" refers to a tax-favored savings program available under code section 403(b) to public school employees and the employees of nonprofit organizations. A fixed annuity contract is a contract between you and an insurance company in which the company, in exchange for a single or flexible premium, guarantees a fixed payment at a future date. Fixed annuities are "fixed" in two ways: (1) The amount you invest earns tax-deferred interest at a guaranteed rate (typically 1% to 3% under long-term U.S. government bonds) while your principal is guaranteed not to lose value. (2) When you withdraw or opt to annuitize (begin taking monthly income) you receive a guaranteed amount based on your age, sex, and selection of payment options. Be careful to ask about the many fees attached to every annuity contract. Most companies do not charge an initial commission, or load. Instead, they levy a substantial surrender charge of up to 10 percent of your principal if you want to cash out or transfer your annuity to another company within the first five or 10 years of the contract. However, some annuities permit a free withdrawal provision after the first year and for every year thereafter that surrender charges apply. This allows you to withdraw a certain percent (usually 10 percent) of the accumulated account value. Note that prior to age 59 1/2 these partial withdrawals would be subject to a penalty by the IRS unless you meet an exception. Most annuity sellers also charge annual maintenance fees of $25 to $50. Most annuity charges do not apply to so-called immediate annuities because, once you have purchased the contract, it cannot be surrendered.
What is a variable annuity?
An annuity in this context is simply a contract between you and an insurance company. You pay the insurer a specified amount of money and, in return, youll receive regular payments either for life or for a stated period of time. The money grows on a tax-deferred basis until you begin receiving it, usually after age 59 1/2. At that point, you can continue to postpone the tax bite by annuitizing the money - in other words, converting the assets into a monthly stream of income. There are two basic types of annuities: fixed and variable. If you choose a fixed annuity, it earns a fixed rate of return on your premiums. A variable annuity works more like a tax-deferred mutual fund. Your premiums could be invested in a variety of items, ranging from stock and bond funds to real estate investment trusts and certificates of deposit. Your return will vary depending on the success of the portfolio -- hence the term "variable."
What are the differences between a variable annuity and a fixed annuity?
If you choose a fixed annuity, the premiums you pay will be invested by the insurance company. The company board will declare a current rate of interest each quarter. If the rate declared is less than the guaranteed rate, the guaranteed rate will be paid. A variable annuity works more like a mutual fund. Your premiums will be invested in stock funds, bond funds, real estate funds or other kinds of cloned mutual funds that have no guaranteed rate of return. Instead, your return will vary based on the portfolios performance - hence the term "variable."
What kinds of charges are involved when purchasing an annuity?
Be careful to ask about the many fees attached to every annuity contract. Many companies do not charge an initial commission, or load. Instead, they levy a substantial surrender charge of as much as 10% of your principal if you want to cash out or transfer your annuity to another company within the first five or 10 years of the contract. However, some annuities permit a free withdrawal after the first year and for every year thereafter that surrender charges apply. This allows you to withdraw a certain portion (usually 10%) of the accumulated account value. Note that withdrawals are subject to income tax and, prior to age 59 1/2 withdrawals would be subject to a 10% penalty tax by the IRS. Annuity surrender charges do not apply to immediate annuities because, once you have purchased the contract, it cannot be surrendered. There are also annual expenses to be considered. Most annuity sellers also charge annual maintenance fees of $25 to $50. Variable annuities have higher expenses than fixed annuities because of the various sub-accounts, often running up to 3% or more. In fact, many experts say that you need to own a variable deferred annuity for at least 15 years to make it a more worthwhile investment than doing so on your own with, say, a mutual fund. That number is somewhat less for fixed annuities, but its still something to consider. If youre talking about immediate variable annuities, higher expenses mean lower monthly checks to you.
What costs are involved if I invest in a tax-deferred annuity?
Some tax-deferred annuities are annuities purchased by the employees of school districts or nonprofit organizations under a 403(b) plan sponsored by their employer. The eligible employees use pre-tax salary deferrals to purchase their annuities. Other tax-deferred annuities are simply those annuities bought by people who want their investments to grow tax deferred for many years, then convert to a payout schedule once they retire. When purchasing such an annuity, be particularly wary of potentially high fees and expenses. Many companies do not charge an initial commission, or load. Instead, they levy a substantial surrender charge of as much as 10% of your principal if you want to cash out or transfer your annuity to another company within the first five or 10 years of the contract. However, some annuities permit a free withdrawal provision after the first year and for every year thereafter that surrender charges apply. This allows you to withdraw a certain percent (usually 10%) of the accumulated account value. Note that prior to age 59 1/2 these partial withdrawals would be subject to a penalty tax by the IRS. Most annuity sellers also charge annual maintenance fees of $25 to $50 to cover the administrative costs of maintaining an account. Most annuity charges do not apply to immediate annuities because once you have purchased the contract, it cannot be surrendered. One way to get around high fees is to purchase a low- or no-load annuity.
What is the accumulation phase of an annuity?
The accumulation phase of an annuity is the time during which the value of the annuity is growing. This phase ends when the annuitization or payout phase begins (the day you start receiving payments).
What is annuitization?
When an insurance company begins paying out the proceeds of an annuity on a monthly basis, the annuity is said to be annuitizing. The process is called annuitization. You should not annuitize his annuity without careful thought. Once an annuity is annuitized, the annuitization cannot be reversed. Also, withdrawal of the funds within the annuity is no longer possible. Annuitization effectively exchanges the cash in the annuity for a guaranteed income stream, and as a result, it is quite inflexible.
Why is the decision of when to annuitize an annuity so important?
Once an annuity is annuitized (and you start taking regular income payments), there are no other options. The income is distributed as the contract requires, but there is no flexibility to increase or decrease the payments or to make cash withdrawals from the principal.
Whats the difference between the current rate and the guaranteed rate on an annuity?
The guaranteed rate of an annuity contract is the rate defined in the contract. Typically this is the minimum rate the contract will pay. The current rate is the rate, higher than the guaranteed rate, paid by the company when the company chooses to pay a higher rate. The current rate is not contractual and is established by the insurance companys board of directors. It varies according to company needs. The higher rate is usually established to meet marketing objectives.