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The Facts About Retirement Annuities, Part 1

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What exactly are these things, and why should you care?

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You've heard the term. You know it's something that some people use for retirement income. But, if you're like millions of pre-retirement-aged Americans, you might not know exactly what an annuity is. This is part one of a series of articles about annuities. These articles are designed to present the facts—and hopefully dispel some of the myths—about annuities in an effort to help you decide if they may be something you'd like to consider as part of your retirement strategy.


So what, exactly, is an annuity?

An annuity is a type of insurance designed to meet long-term needs for retirement income, either in a steady stream or in a one-time payment. You put money in, either in a lump sum or over a period of time. At some point after you’ve paid premiums, you can begin to receive income payments. The income may be paid out monthly, quarterly, yearly, or in a one-time lump sum, depending upon how you set up the annuity. You can choose to receive payments for the rest of your life, or you may select to get payments for a set number of years.


Because an annuity is an insurance product, it must be issued by an insurance company. This does not mean that only insurance companies can sell annuities. Independent brokers, banks, and other financial institutions sell annuity contracts. Most in the U.S. are sold by the same corporations that sell life, home, and automobile insurance. The person who is issued the annuity is called the annuitant. There are annuities available for couples that continue to pay a surviving spouse after the other dies. Annuity guarantees are backed by the financial strength and claims paying ability of the issuing carrier.


The two types: immediate and deferred


There are two basic types of annuities:


1. Immediate annuity. As the term implies, payments from this type start as soon as the annuity is purchased, or at a maximum, one year from the date of purchase. It is purchased with a single lump-sum payment. It provides guaranteed income for the life of the annuitant. Once purchased, it is irreversible. The payments stop when the annuitant dies, and the issuing company gets any amount that is left. There are different payout options available and these will impact the amount of income you receive. Most are familiar with the “life only” payout option, which guarantees income payments for life until once the annuitant dies and payments cease. There are other options that guarantee payments for a set period of time and if the annuitant dies prior to this time frame, payments will continue to a select beneficiary. It’s important to review the payout options prior to making a purchasing decision. This may be something to consider for people who think that they might outlive their savings.


2. Deferred annuity. In this type, you make purchase payments over a certain length of time and the income comes at some later time. The two phases, therefore, are the accumulation phase (you put money in) and the income phase (you get payments). The payouts can be in installments or in a lump sum. These annuities can be fixed or variable. Variable materials involve market risk and will not be covered in our materials. We will focus on how fixed annuities work. Fixed annuities accumulate interest on a tax-deferred basis. Withdrawals are taxed as ordinary income and if taken prior to 59 1/2, a 10% federal tax penalty. Fixed annuities provide a death benefit for beneficiaries in circumstances where the annuitant dies prior to beginning income payments. However, any withdrawals that have been taken will reduce the contract value. Once the contract has been annuitized, any payout to beneficiaries will depend on the payout option selected.


Some important facts about annuities:


1. Annuities are tax deferred. Any interest your annuity earns is tax-deferred, so you don’t pay ordinary income tax until you take a withdrawal or begin receiving income payments. If the contract is funded with qualified funds, then taxes will apply to the premium and the interest. If it is funded with non-qualified funds, taxes will only apply to the interest earned.


2. You can get penalized if you withdraw your money early. However, many have provisions for emergency withdrawals. Deferred annuities have surrender charge periods that can range in the number of years they’re applicable for. It’s important to review the terms of any contract you are considering prior to making a purchasing decision. Any distributions may be subject to ordinary income tax and, if taken prior to age 59 1/2., an additional 10% federal tax. Early withdrawals may result in loss of principal and credited interest due to surrender charges.


3. There are fees associated with annuities, which we will discuss in more detail later in the series. Make sure that you know how those fees are determined and charged before you enter an annuity contract.


4. The size of the payments is determined by a variety of factors, including overall interest credited, any withdrawals or surrenders made, the payout option selected, age and gender of the annuitant.


5. They aren’t for everyone. While annuities can be very good retirement tools for many people, everyone’s financial situation is unique. Consider annuities if you are looking for a retirement income product that may help you achieve your long-term income goals, including guaranteed lifetime income.


As with any financial vehicle, you should have a thorough understanding of the risks and benefits relative to your financial situation before you make any decision. Weigh all of your options carefully. If you'd like more information about annuities, call Stratton & Company to participate in an in-office Annuities 101 class and insurance sales presentation. By attending, you may be offered a meeting to discuss the purchase of insurance products.


This article is for informational purposes only and is not intended to provide any tax or legal information. We encourage you to speak with a qualified tax advisor and/or legal professional.

Learn more in our free Annuities 101 booklet

download ebook