What is an Annuity?
Despite the fact that many people are familiar with the term ‘annuity’, many might not understand what it actually means or how it can be used to help them plan ahead for a successful financial future.
Simply put, an annuity is an insurance product that will pay you income based on money that you have previously put in. An annuity is commonly used as part of a retirement strategy. They are often popular choices for investors who wish to see a regular and steady income stream in their retirement. According to the Government Accountability Office, annuities can be an important part of an overall retirement plan.
Basics of How an Annuity Works
An annuity begins by you making an investment in the product. Over time, the annuity company will make payments to you on a series of dates. Income received from an annuity typically comes in an annual, quarterly, monthly, or even a lump sum payment basis. The size of the payments you’ll receive from the annuity company is based on many different factors, including the length of your payment period and the amount of funds invested into the annuity.
You might choose to receive payments over the course of the rest of your life for a set period of years. How much you actually receive from the annuity will be based on whether the payout stream is determined by underlying investments in the annuity and how they perform in a variable annuity, or whether you opted for a guaranteed pay out in the form of fixed annuity when you started using the product. It is imperative to be knowledgeable about how annuities work and how to choose the right one for you in order to maximize the benefits reaped from this product.
Potential Advantages of an Annuity
There are many different advantages to using annuity that go beyond simply retirement planning. If you have maxed out your contributions to other accounts that provide tax free retirement growth, such as an IRA or a 401(k), an annuity gives you an additional place to stash money in a nest egg form.
Since there are no annual contribution limits with an annuity, this is one of the primary reasons that sets this form of saving apart from other tax deferred accounts like IRAs or 401(k). An additional benefit of an annuity is that it does not need to be included on a free application for federal student aid submitted by parents when applying for financial assistance with their child’s college education.
Money inside an annuity should not be subject to probate fees or delays if you pass away so long as you assign a beneficiary appropriately. The benefit to the beneficiary is that the current value of the annuity is higher than that total amount of money you actually paid into it. Finally, many investors simply prefer the stability and general safety associated with the guaranteed returns linked to annuities. Although annuities do not provide the same kind of growth possibility that other investments like stocks do, in light of the recent recession many individuals especially those approaching retirement are more interested in steady and safe investments.
• Annuities provide lower risks than traditional investments, allowing you plan ahead
• Annuities do not need to be included on student financial aid applications
• Annuities give you the opportunity to set aside retirement money after you have maxed out other options
What You Need to Know About Ages and Annuities
The investment earnings inside an annuity can compound and accumulate untouched from local, state or federal income taxes until you begin making withdrawals. The primary reason that many people choose to use an annuity is to save for their retirement. Withdrawals made from your annuity prior to age 59 and a half will be taxed as ordinary income and could be also subject to the 10% federal tax in addition.
You should also bear in mind that the annuity company likely has its own surrender charges associated with withdrawals that you take out during the early period of your contract. This is why you need to think of an annuity as a long-term strategy rather than tapping into it for a short-term withdrawal potential. While you can do this with many annuity products and access the funds you’ve put into the product, doing so is associated with not just taxes but also potential penalties on the part of the annuity provider.
How Deferring Taxes Can Build Value in Your Annuity
There is substantial growth opportunity with tax deferred annuities when you compare this with other taxable investments. When looking at other investments like a 401(k) or an IRA, you have much more control over the annuity income. Here are several ways to maximize the value of your own annuity:
• Select an annuity with multiple investment options. While the majority of financial experts working with individuals in their 30s and 40s will point long-term investment strategy towards stocks, these investments do carry a high level of risk. Diversifying your investments to reduce investment risk can be done with an annuity.
• Consider dollar cost averaging. Using dollar cost averaging can potentially boost the long-term return of your annuity. Investing an identical amount at regular periods allows you to buy more when prices are low and less when prices are high.
• Take advantage of low fees with annuities. While the fees typically associated with annuities are similar to other kinds of investments, you want to compare the insurance charges, sales charges and annual expenses associated with your annuity. This also means delving into more detail about the surrender charges so that you are well aware of all the potential fees.
• Use annuities for giving money to heirs more quickly. There are many different advantages of using annuities in estate planning. If you set your family members as beneficiaries to the annuity, your loved ones will usually be able to receive this benefit directly without having to wait for your estate to be settled.
Fixed or Variable?
Two of the most common annuity types are fixed and variable. While a fixed annuity gives the guarantee of the principal amount along with a minimum interest rate, a variable annuity’s value depends on performance on an investment portfolio. Interest credited to a fixed annuity account is based on the company’s declared rates, and these rates only change on an annual basis. A variable annuity, however, could fluctuate in value daily based on the portfolio’s investment performance.
Deferred vs. Immediate Annuities
As their names suggest, there are some differences between deferred and immediate annuities. Read on to learn more so you can determine which one is most appropriate for you or whether you may benefit from both.
An immediate annuity starts the payout to the owner very shortly after the premium has been paid in. A single premium is used to purchase an immediate annuity, such as a lump-sum deposit of $100,000.
Most of the time, an immediate annuity contract will be irrevocable, so that you cannot change the contract after you have entered into it. You’ll know upfront how much you’ll be paid from the annuity contract, giving you a good sense of what to expect when the payments begin.
A deferred annuity, however, has a payment date that starts in the future. This means the amount inside the annuity can accumulate over time, and the premiums can be periodic or a lump sum. After you pass through any surrender period on the annuity, you can exchange it or surrender it without charges. A deferred annuity, therefore, has more flexibility based on how much you put into it and how it grows.
In an immediate annuity, assets do not accumulate tax-deferred. They are distributed to you based on an already-determined formula, like in a fixed amount, for a fixed period, or over the course of your life. Assets inside a deferred annuity, though, do accumulate tax-deferred. Distributions are made first from interest or gains earned and are taxed at ordinary income rates.
Returns of Annuities
There is a great deal of variation when it comes to what returns are provided by an annuity. In many cases comparing this with more traditional investment vehicles indicates that the growth potential with an annuity is much lower. However, in many cases this is because of the safety and stability associated with annuities.
Research conducted by Advantage Compendium looked at fixed indexed annuity average returns and determined that the average annual return for all fixed indexed annuities included in the study hovered around 3.27%. The range of return stretched from 5.5% average (on an annualized basis) to 1.2% average. As you can see, this is significantly higher in most cases when compared with another investment vehicle such as a CD.
When used appropriately, an annuity can be an important part of your investment portfolio. You should carefully evaluate your needs both in the short-term and long-term before committing to an annuity. As part of a diversified portfolio, an annuity gives you stability, strength and safety and allows you to set aside money for your retirement planning.
There are pros and cons to annuities as there are with all types of investment savings but doing more research to determine what is most appropriate for you can be extremely helpful. Many people identify significantly with the potential returns of an annuity because of the safety and strength of the products on the market today. Planning ahead now can help you enjoy a better retirement when you are knowledgeable about annuities.