Kiplinger

Confused by Annuities? Making Sense of the Different Types

By Kris Maksimovich, AIF®, CRPC®, CPFA®, CRC®,

1 day ago

The purpose of annuities is to create a guaranteed fixed income stream, either now or in the future, as part of your investment portfolio. While many older investors use annuities to create a guaranteed income in retirement, they are not generally recommended for younger investors because they are illiquid and subject to withdrawal penalties.

The sheer number of annuity options can be dizzying, making it difficult to determine if an annuity is right for you. Allow your personal objectives to be the driver before you make a selection and sign a contract. Your trusted financial adviser can help you work through the range of options.

What is an annuity?

Annuities consist of a written contract between you and an insurance company, where the insurance company provides a series of payments in return for a premium you pay. Products are regulated by the SEC , and FINRA requires any brokers selling annuities to hold a state-issued life insurance license. For variable annuities, they must also hold a securities license.

Annuity contracts generally involve a variety of players that include:

Provider. While annuity providers consist of insurance companies, financial advisers, banks and brokers who hold a state-issued life insurance license, only an insurance company can issue the contract.
Owner. The person who purchases the annuity and pays the premiums.
Annuitant. The individual whose life expectancy will be used to calculate the benefits and payment.
Beneficiary. If you pass away before the payments begin, some annuity providers may offer death benefits to a beneficiary.

Annuities can be categorized in several ways, such as how you pay your premiums, how you receive your payout and how the annuity grows in value. These options can even be combined, helping you select an annuity that meets your specific goals.

Annuity premium options

Depending upon the type of annuity you select, you have several possibilities for paying your premiums:

Single premium payment. You may choose to fund an annuity through a single premium payment. In this instance, your contract will require you to fully fund the annuity in one lump-sum payment.
Multiple premium payments. Your annuity may allow funding through multiple premium payments that are either scheduled or flexible. With scheduled payments, funding is made through consistent payments made on a set schedule. With flexible payments, funding is made by paying the amount you wish on the date you want, within specific limits.

How is the money invested?

Money invested in an annuity is typically used to purchase a variety of investments, such as bonds, stocks and real estate. The specific investments used generally depend on the type of annuity and the investment options offered by the insurance company. The insurance company typically manages these investments and takes on any risk of investment loss.

Types of annuities

Immediate annuities. As income annuities, these allow you to begin receiving payments within a year after purchase and are often funded by a retirement account.
Deferred annuities. These annuities typically grow tax-deferred and include a specific delay where you receive payments later, often when you retire.

How benefits are paid to you

Depending on the type of annuity and contract terms, annuities can be paid out in various ways. Here are a few common annuities based on their payouts:

Immediate annuities. This type of annuity generally begins paying income right away. The individual exchanges a lump sum for a stream of income payments. Immediate annuities are popular because fees are often baked into the payout. The types:

Immediate fixed. These annuities are less risky than variable because they are based on a guaranteed interest rate that remains unaffected by market volatility. Keep in mind that with immediate annuities, you are trading liquidity for a guaranteed income.
Immediate variable. These may offer larger future payments, should the investments do well. Conversely, they can provide less stable cash flow if the investments do poorly.

Deferred annuities. These are popular because you can accumulate money on a tax-deferred basis, and unlike your 401(k) and IRA , there are no contribution limits. The types:

Deferred fixed. One of the key features of a deferred fixed annuity is that the payments are guaranteed and not based on the performance of underlying investments. This can provide a predictable stream of income in retirement, which can be especially useful for individuals who are concerned about outliving their savings.
Deferred variable. One of the key features of a deferred variable annuity is that the individual has a degree of control over the underlying investments, which can offer the potential for higher returns than a fixed annuity. However, the returns are not guaranteed and can fluctuate depending on the performance of the underlying investments.

How long are annuities paid?

The answer to this question depends on the type of annuity.

Lump-sum payment. Some annuities can be cashed out in a single payment. This may be useful for individuals who need a large sum of money to pay for a specific expense, such as a home purchase or a medical procedure.
Lifetime annuities. Some annuities are set up to provide income for the lifetime of the annuitant, regardless of how long they live. These types of annuities are known as life annuities.
Fixed periodic payments. Many annuities are structured to provide a stream of periodic payments, which can be made on a monthly, quarterly or annual basis. These payments can continue for a set period of time, such as 10 or 20 years, or for the lifetime of the annuitant.
Variable payments. Variable annuities pay out an amount that can fluctuate depending on the performance of the underlying investments.

Annuities based on growth potential

When choosing an annuity based on growth potential, consider your risk tolerance and anticipated return. Below are some additional things to consider:

Fixed indexed annuities. The payout from this type of annuity is linked to a stock market index, such as the S&P 500. These types of annuities are typically marketed as a low-risk way to participate in the stock market, but they do have some downsides. One of the downsides is that the returns on indexed annuities are typically lower than the returns on a stock market index. Additionally, indexed annuities often have high fees and surrender charges, which can make them a less attractive option for some investors.
Multi-year guaranteed annuity (MYGA). This type of annuity provides a fixed interest rate over a specific timeframe and is best suited or people nearing retirement or who are seeking a tax-deferred investment and guaranteed return.
Variable annuity. This type provides periodic performance-based payments tied to sub-accounts that fund the annuity.
Fixed annuity. This type offers a guaranteed set interest rate and is considered the least risky.

Pros and cons of annuity investments

Annuities can be a useful tool for retirement planning, but they also have many drawbacks. Below are some pros and cons you should consider before you dive into the world of annuities.

Pros:

Guaranteed income. Annuities can provide a guaranteed stream of income in retirement, which can be especially useful for individuals who are concerned about outliving their savings.
Tax-deferred growth. Annuities grow on a tax-deferred basis, which means that the earnings on the investments within the annuity are not subject to taxes until they are withdrawn. This can help the annuity to grow faster than a taxable investment.
Death benefit. Some annuities include a death benefit that can provide a payout to beneficiaries if the annuitant dies before all of the payments have been made.

Cons:

Penalties for early withdrawal. Annuities often have penalties for early withdrawal, which make them less flexible than other types of investments.
Complexity. Annuities are often complex products that contain a lot of fine print, making it difficult for many investors to understand.
High fees. Some annuities have high fees and expenses, which can eat into the returns earned on the investment.
Low returns. Some annuities may have low returns compared to other types of investments, especially if they are fixed annuities.

Taxes and fees for annuities

Another key consideration before investing in annuities is the associated taxes and fees. Annuities are taxed differently depending on how and when the money is withdrawn from the annuity.

Tax-deferred growth. Earnings on the investments within the annuity are not subject to taxes until they are withdrawn. This means that the money in the annuity could potentially grow faster than it would in a taxable investment.
Taxable withdrawals. When money is withdrawn from the annuity, it is taxed as ordinary income. This means that the money is taxed at the individual's marginal tax rate for that year.
Penalty for early withdrawal. If money is withdrawn from the annuity before age 59½, there could be a penalty imposed by the IRS of 10% on the amount withdrawn.
Required minimum distributions (RMDs). Once the annuitant reaches age 72 they are required to take RMDs from their annuity each year. These distributions are taxed as ordinary income.

If you decide an annuity is for you, it’s important to carefully read the entire contract and understand the effect your annuity may have on your tax burden and whether the potential for income makes it worth the risk.

The last words

When it comes to annuities, it’s buyer beware. Annuities often have penalties for early withdrawal, which can make them less flexible than other types of investments. They also have complex rules and regulations, making them difficult for some individuals to understand. As with any retirement and financial planning strategy, it's important to consult with a financial professional before considering an annuity, as the tax implications can be complex and may change depending on the individual's unique circumstances.

Guarantees are subject to the claims-paying ability of the issuing insurance company.

Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Variable annuities are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information, can be obtained from a financial professional. Be sure to read the prospectus carefully before deciding whether to invest.