Author: Rob Sevilla
Agency: Agape Insurance & Financial Group, Tupelo, MS
When planning for the future, you have likely heard of 401(k)s and IRAs. But one tool often remains a mystery: the annuity. Clients frequently ask us, “What exactly is an annuity?”
Simply put, an annuity is a contract between an investor and an insurance company. It is designed to provide guaranteed income for the rest of your life. Unlike life insurance policies, which protect your family if you die too soon, annuities protect you against the risk of outliving your savings.
In this guide to annuities, we will explain how the annuity work, the tax benefits, and how different annuity products can fit into your retirement plan to create lifetime income.
How Does an Annuity Work? Defer Growth vs. Immediate Payout
To understand annuity work, you must look at the timeline. You make a premium payment (often a lump sum) to the insurance carrier. In return, they promise to make regular payments back to you at a future date.
Most people choose deferred annuities. These allow you to defer taking periodic payments for years. During this time, your money grows on a tax-deferred basis. You do not pay taxes on the interest or investment gains while they stay in the contract.
When you are ready, you enter the payout phase. You can choose to withdraw a lump sum or convert the balance into a guaranteed income stream. This payout structure is what makes an annuity type unique among retirement savings vehicles.
Different Types of Annuities: Fixed, Variable, and Indexed
Not all annuities offer the same features. The type of annuity you choose depends on your risk tolerance.
1. Fixed Annuities
Fixed annuities are the safest option. They offer a guaranteed interest rate and a high level of protection. Fixed annuity guarantees your principal, meaning you won’t lose money if the market crashes.
2. Variable Annuities
Variable annuities are more aggressive. Variable annuities allow you to invest in sub-accounts that function like mutual funds. Variable annuities offer the potential for a higher rate of return, but they come with market risk. Because variable annuities may lose value, they are an investment suited for those willing to accept volatility. Note that variable annuities often include mortality and expense charges.
3. Indexed Annuities
Fixed index annuities (and registered index-linked annuities) track a specific index, such as the S&P 500. An annuity tied to an index allows you to share in growth while limiting losses. Indexed annuities act as a bridge between the safety of fixed products and the potential of variable annuities.
Turning Savings into Income: Immediate vs. Deferred Income Annuities
The primary goal of any income annuity is to generate income in retirement.
- Immediate Annuities: With immediate annuities, you provide a lump-sum payment and receive income right away. These income annuities create an instant payout.
- Deferred Income Annuities: These allow you to defer the income stream until later in life (e.g., age 85).
Both options provide payments for life, ensuring a portion of your retirement savings lasts as long as you do. Annuities offer a guaranteed income floor that investment accounts generally cannot match.
Annuity Riders and Withdrawals: Accessing Your Money
Many annuity contracts allow you to add a rider. An annuity with a guaranteed lifetime withdrawal rider lets you withdraw a set percentage of your funds annually for life, without giving up control of the asset.
However, liquidity is limited. Most insurance companies impose a surrender charge if you withdraw funds during a specified period (e.g., the first 7 years). If you buy an annuity, ensure you have other liquid investment funds available for emergencies.
Additionally, most deferred annuities include a death benefit. If the annuity owner passes away, the remaining value goes to the beneficiary, avoiding probate in many cases.
Tax Implications and Retirement Planning
Annuities allow for tax-deferred growth, which is a powerful advantage. You only pay taxes on the earnings when you actually withdraw them.
However, be aware that annuity payments are taxed as ordinary income, not capital gains. Whether you have a variable annuity or a fixed one, the IRS treats the income from the annuity the same way.
When considering an annuity, view it as a way to complement other retirement assets. Annuities often work best alongside an IRA or retirement accounts.
Annuities can also serve as a safe harbor. While variable annuities involve investment risk, fixed annuities protect your lump sum. Annuities are often used to secure the essential retirement income you need to cover bills.
If you are ready to purchase an annuity or just have questions about different types of annuities, Agape Insurance is here to help. We can explain how variable annuities differ from fixed index annuities and help you decide if you should defer income or start a payout now.
Call Rob Sevilla today at 662.260.5188 to get your Guide to Annuities and secure your future.
Disclaimer: Agape Insurance & Financial Group does not provide tax or legal advice. Guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. Withdrawals may be subject to ordinary income tax and a 10% federal penalty if taken before age 59½.