Annuities are insurance products designed to help you invest for retirement and provide supplemental income during your retirement. The most common form of annuity is income annuity where the investor pays the insurance a sum of money in exchange for a series of regular payment for a period of time, up to a lifetime contract.
What are the different types of annuities?
There are two categories of annuities and each has two types:
Deferred annuity allows you to invest for retirement on a tax deferred basis, while delaying payments of income. This allows you to contribute to your savings and let it grows faster without the burden of taxes. There are two types of deferred annuity:
- Deferred fixed annuity allows you to save money while your investment grows with a guaranteed rate of returns.
- Deferred variable annuity allows you to save money, but the performance fluctuate based on the performance of the underlying investments. This type of annuity provides you with a potential to earn superior returns.
Once you are ready to retire, you can convert your deferred annuity into an income annuity (also known as immediate income annuity or immediate annuity), which will provide you with a source of guaranteed lifetime income.
Some points to consider regarding deferred annuity:
- You should make the maximum allowable contributions to traditional retirement savings plan such as 401k and IRA before considering a deferred annuity.
- The IRS does not limit the amount you can contribute to a deferred annuity.
- Some annuities come with additional options, however you should consider the cost versus benefits when buying these options.
- Just like any other investment, high expenses will reduce your overall performance and long-term results.
- Be aware that if you withdraw your money too soon, you could be hit with big surrender charges.
- Like 401k and traditional IRA, you don’t have to pay taxes until you start the distribution.
- Taxable amount is taxed as ordinary income.
- Distributions made prior to age 59 and a half may be subject to a 10% IRS penalty.
Income Annuity (Immediate Annuity)
Income annuity allows you to convert a portion of your retirement savings, such as part of your 401k, IRA, and deferred annuity in to a source of guaranteed lifetime income stream. Essentially, you are giving the insurance company a lump sum in exchange for a stream of income until the day you die. There are two types of income annuity:
- Fixed income annuity provides you with a guaranteed lifetime payments regardless of the stock market and the economy. Some annuity will increase payment by a certain percentage to give you a level of inflation protection.
- Variable income annuity also provides you with a guaranteed lifetime payments. However, the amount will vary depending on the performance of the annuity. This type of income annuity has the potential to provide you with greater income compared to fixed income annuity.
Some points to consider regarding income annuity:
- Income annuity reduces the uncertainty of outliving your assets.
- It gives you a level of confidence to work with, or withdraw from, your remaining retirement savings.
- Payments from income annuity could work in conjunction with other sources, such as Social Security and pension to cover essential living expenses.
A Personal Perspective
Annuity may sound appealing, but remember that insurance companies are in the business of making money…a lot of it. In essence, you are playing the game of probability that favors the insurance company most of the time. However, I think annuities have their places and could be the right choice for some individuals.
Here are more articles about annuity:
- A Look at an Equity-Indexed Annuity at All Financial Matters
- The Financial Freedom Ratio: A Better Way To Measure Your Net Worth? at My Money Blog
- Be Careful When Your Financial Advisors Tries To Sell You An Annuity at My Investing Blog
- Lies Annuity Salesmen Tell: A Dateline Undercover Investigation at Consumerism Commentary
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.
I am sure that annuities are a good idea for some people, especially as you near retirement who need consistent income. I think that for most people they are not a good deal. Remember, the insurance company needs to make a profit. They make a killing on annuities. You can do better with other income streams. I also think that most annuities get a bad rap because of how they are sold. 99% of the people below 55 should never own one. They should also never be put into a retirement account. They are already tax deferred. I do know… Read more »
Pinyo this is a really clear and concise summary of a difficult subject. Especially liked the flow chart at the start it really makes it so much easier to understand.
any insurance company also have this kind of annuity?
Every retiree has his own savings that they need to turn into a source of income. And annuity is designed exactly to do so. That’s why there will always be a logical appeal to annuity. But I think annuity is not an easy product to deal with as it comes with many hidden features and variety. Moreover the high withdrawal fees left the investee with no control over the investment.