Annuities have developed a somewhat negative reputation in the past few decades as people became aware of the massive sales charges that are embedded (hidden in the fine print) in an annuity contract. Thankfully, there is a growing shift towards “fee-only” annuities, typically arranged through fee-only financial planner channels, that remove most of these annoying sales charges.
Moreover, after a long decline in interest rates, which reduced the monthly income streams that a contract could produce, interest rates are now on the rise. As a result, annuities are once again becoming an appealing alternative for investors that are seeking guaranteed income streams in their retirement.
Let’s start with a look at key types of annuities and their features:
Annuities are typically structured in a pair of key ways: to provide monthly income streams for the remainder of your life (single life or straight life) or as a joint and survivor annuity, which covers the life of two or more people (often a spouse). You can also select a 75% or 50% joint policy, which reduces the payments to your widowed spouse by a certain amount.
In addition, there are broad range of riders which are add-on features that provide other benefits. Typically, these riders will reduce the amount of monthly income that is produced for the same-priced policy.
Immediate annuity: These are often purchased with a single lump-sum payment, and the monthly income streams start almost right away. These can be bought within a retirement plan, or outside of such a plan.
Deferred annuity: These are funded with a single up-front premium, or can be funded with periodic payments for a number of months or years. Those payments can be designed to stop at a certain point, often well before the actual annuitization (i.e. when the monthly income streams start)
Flexible premium annuity: allows you to vary how much you pay into the annuity each month.
Single premium annuity: Purchased with a lump-sum, often as an option in pension plans or other retirement plans.
Fixed annuity: Pays a specific rate over a specified period.
Variable annuity: Fluctuating payments, often tied to an underlying index such as the S&P 500.
One unusual feature to know about it a Section 1035 exchange. This allows you to convert one annuity for another, or more commonly, a life insurance policy for an annuity (though not the other way around).
The risk/reward of purchasing a single life annuity relates to how long you live. If you live longer than your life expectancy, then the annuity is a great deal. If you do not live long enough, the investment in the annuity will not have fully paid off.
This can be offset with certain riders. For example, a life annuity with period certain guarantees that you (or your estate) will receive a minimum number of set payments (typically 10 or 20 years), even if you die prematurely. And if you do live a long time, the payments keep coming. Of course, there is no free lunch. This kind of rider leads to lower monthly income streams compared to a straight life annuity.
While premature withdrawal of funds can lead to a surrender charge, many annuities allow you to withdraw up to 10% of your accumulating cash balance each year without a penalty. Still, such withdrawals may trigger an income tax bill.
How are Annuities Taxed?
Any income that accumulates while you are paying into an annuity is tax-deferred (unless it is owned by a corporation). If you do withdraw funds from an annuity during this phase, all of the amount may be taxed as ordinary income, at least until the earnings part of the annuity has been accounted for. And if you’re under 59 ½ you’ll also pay a 10% early penalty tax.
If you own an annuity within a retirement plan, much or all of the monthly income streams will be taxed as ordinary income when the annuitization phase begins.
If you bought an annuity with regular funds (i.e. outside of a retirement plan, then only the earnings portion of the annuity is taxable. Here’s an example. An annuity is bought for $400,000 and based on a person’s life expectancy, the policy will produce an expected $600,000 in proceeds over the life of the contract. Only 1/3 of each payment (the $200,000 earnings part of that $600,000) is subject to tax.