For many people, the biggest fear in retirement isn’t boredom; it is running out of money. As pensions disappear, retirees are looking for ways to create their own guaranteed income. This is often where the conversation turns to annuities. But how do annuities work?
Simply put, an annuity is a contract between you and insurance companies. You make a payment (or series of payments) to the insurer, and in return, they agree to make payments back to you. The primary goal is to turn your money in retirement into a steady income stream that you cannot outlive.
Unlike a bank account, an annuity product is an insurance product designed to protect you from longevity risk. Below, we explain how the annuity contract functions, the tax benefits, and how to use them in your retirement plan.
How Does an Annuity Work? Accumulation vs. Payout Phases
To understand how do annuities work, you must look at the two main phases:
- Accumulation: When you buy an annuity, you typically fund it with a lump sum or installment payments. During this phase, your money grows on a tax-deferred basis. You do not pay taxes on the growth while it stays in the account.
- Payout: Eventually, you elect to receive payments. This is known as the payout phase (or annuitization). You can choose to receive a stream of income for a set number of years or for the rest of your life.
The annuity contract dictates how your money grows and how the insurance companies calculate your payment. Whether you are looking for accumulation or immediate cash flow determines the type of annuity you should buy.
Different Types of Annuities: Fixed, Variable, and Indexed
There are different types of annuities designed for different goals.
- Fixed Annuities: These provide a guaranteed interest rate. Fixed annuities are predictable and safe from market loss.
- Variable Annuities: Variable annuities allow you to invest in sub-accounts similar to a mutual fund. Because they depend on underlying investment options, variable annuities carry risk. Your payment amounts can fluctuate based on the market.
- Indexed Annuities: Indexed annuities offer interest based on a market index but usually have a floor to prevent loss.
The type of annuity you choose acts as the engine for your retirement savings. While variable annuities offer investment options for growth, fixed annuities offer security.
Immediate vs. Deferred Annuities: When Do You Need Income?
Another way annuities offer flexibility is timing.
- Deferred Annuities: Most people purchase an annuity to defer income until later. Deferred annuities allow your retirement savings to grow tax-deferred until you are ready to retire. Deferred income annuities are specifically designed to turn on a guaranteed income stream years in the future (e.g., at age 85).
- Immediate Annuities: Also known as income annuities or immediate annuities, these start paying you right away. You give the insurance companies a lump sum, and they begin sending you a monthly payment immediately.
If you need income in retirement now, immediate annuities are the solution. If you want to build wealth, you use deferred annuities.
Tax Benefits: How Annuities Grow Tax-Deferred
A major reason people buy an annuity is the tax treatment. Annuities are designed to grow tax-deferred.
This means you do not pay tax on the interest or investment gains while the money is in the annuity contract. You only pay taxes when you make a withdrawal or receive a payment.
However, be aware of how annuities are taxed upon withdrawal:
- Non-Qualified Annuities: If you bought the annuity with after-tax money, only the earnings are taxed as ordinary income. The principal is returned tax-free.
- Qualified Annuity: If the annuity is in an IRA or 401(k), the entire payment is subject to ordinary income tax.
Because income from the annuity is taxed as ordinary income rather than capital gains, it is important to work with a tax professional.
Liquidity and Fees: Surrender Charges and Withdrawals
An annuity work differently than a savings account. It is a long-term retirement vehicle.
Most annuity products have a surrender charge—a penalty for taking a withdrawal larger than the contract allows during the early years. For example, if you take a large withdrawal in year one, the insurance companies may deduct 7% from your balance.
Additionally, if you take a withdrawal before age 59½, you may face a 10% IRS penalty because it is a retirement plan asset. While most annuities offer some liquidity (like 10% penalty-free withdrawals), they are not meant for short-term trading.
Life Insurance Companies and the Death Benefit
What happens if you die before you receive payments? Unlike a pension, annuities offer protection for your heirs.
Most deferred annuities include a death benefit. If you pass away during the accumulation phase, the insurance companies typically pay the remaining account value to your beneficiary. This ensures your retirement savings are not lost.
Because these guarantees are backed by life insurance companies, the claims-paying ability of the insurer matters.
Is an Annuity Right for Your Retirement Plan?
Annuities offer a unique safety net. Annuities are a contract designed to ensure you never face the risk of running out of money.
By providing lifetime income, an annuity product can serve as a powerful addition to your retirement portfolio. Whether you choose income annuities for immediate cash or deferred annuities for growth, having a guaranteed payment can stabilize your retirement plan.
If you are worried about market volatility or taxes, purchase annuities that fit your specific needs.
Rob Sevilla at Agape Insurance can help you understand the kinds of annuities available. We will help you compare payout options, review surrender charge schedules, and decide if you should buy an annuity to secure your retirement income.
Call us today at 662.260.5188 to learn how annuities can work for you.
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.