Annuities may seem confusing. That’s due to all the options and fees some carry. This article explains the three ways all annuities are categorized to get you oriented. An annuity is a contract you make with an insurance company. You pay them a premium and, in return, the insurance company pays you an annual amount of money for the rest of your life. It’s called a life annuity.
The life annuity is a unique product that distinguishes it from all other income-based investments. The insurance company can offer it by using its large client base and mortality statistics to confidently assure making its long-lived-client payouts with the premiums and earnings of those shorter-lived clients.
Accumulating vs Payout Annuities
Immediate annuities The above annuity is called an ‘immediate life annuity’. You pay a premium and your annual payments (generally given monthly) begin immediately – or within a year.
If you choose to receive your payments for just a fixed term, you have an immediate term annuity.
Deferred annuities Insurance companies came up with a deferred annuity to help you save up for an immediate annuity. It’s a contract by which you pay premiums – as a series of payments or otherwise agreed – to the company. Your premiums are invested to help grow your deferred annuity funds for later use. Deferred annuities are in the accumulation phase while immediate annuities are in a payout phase.
When you decide, you can either convert your deferred annuity’s fund value into an immediate annuity – a process called annuitization; or you can take your funds for you own use less whatever fees and taxes associated with them.
Annuity Investment Types Another way of classifying annuities – whether deferred or immediate – is the way your premiums are invested.
Deferred and immediate annuities come in 3 types depending on how funds are invested.
- Variable, and
- Fixed index
A fixed annuity earns a fixed interest rate that’s guaranteed by the insurance company. They choose high grade bonds for interest and to secure your investment value. This is a secure investment for which the company assumes the risk.
In a variable annuity the insurance company offers you a range of funds (much like mutual funds) in which to invest your premiums. You allocate your funds among them as you wish; so, you’re responsible for the growth or loss of your annuity’s value according to how these funds perform under market conditions.
Variable annuities may grow much faster than fixed annuities if the stock market rises nicely. Unfortunately, you have little or no protection of your principal because it’s subject to the stock market risks.
A fixed indexed annuity (FIA) tries to give you the best aspects of a fixed and variable annuity – security of principal and opportunity to grow faster than a fixed annuity when the markets increase. It ties your annuity earnings to a major stock market index like the S&P-500. If the index’s annual increase is positive, your rate of interest is increased, subject to a yearly cap. But if it’s negative, you’ll earn only the minimum interest rate (like 1%) that’s guaranteed in the contract.
Your annual increase is limited to help the company guarantee your minimum interest rate when the market turns down. This is how the FIA allows you to partake in market growth while protecting your principal from market loss. Each company has slightly different rules for how their indexed annuity works.
You can annuitize these 3 types of annuity – or buy an immediate annuity of each. Fixed immediate annuities pay you a constant amount for life – or for a term. Variable and Indexed annuity will also pay you for life or a term, but the amount of your monthly payments will vary according to the underlying performance of your funds.
Two Annuity Taxation types One further classification that can be made for all annuities is how they’re taxed. The two taxation classifications are:
- Nonqualified annuities, and
- Qualified annuities
A nonqualified annuity has specific tax-advantages in that its earnings are tax-deferred and when annuitized, its payouts are composed of two parts – a tax-free return of premiums and premium earnings taxed as ordinary income. This two part payout helps lower its annual taxation by spreading it out over the distribution term. Premiums are nondeductible but unlimited when contributed. These annuity payout characteristics and taxation are unique to annuities as an investment.
A qualified annuity is simply any annuity that’s part of a government-regulated retirement savings plan. These qualified plans must adhere to a taxation scheme assigned to it by the government.
Annual contributions to such plans are tax deductible but limited and must come from working income. All plan distributions are taxed as ordinary income and must begin by age 701/2. That’s it!
Fees, penalties, liquidity, risks and safety are other issues to understand. But that’s for another article.