An annuity is a contract with an insurance company to enable a tax-deferred investment of funds that combines features common to both life insurance and mutual fund investments. It is a vehicle intended to provide a regular stream of income either for retirement or investment accumulation, or for guaranteed payments to a spouse or beneficiary. Returns may include the purchase payments plus any gains (or minus any losses) as a lump-sum payment, or as a stream of payments at regular intervals or options for payout payments for a set time period, or for a lifetime.
Variable Annuity
A variable annuity is a contract offering a guaranteed death benefit to a designated beneficiary of the higher amount of either the value of investments, or the amount of premium payments minus withdrawals. Variable annuities are designed to be long-term investments because substantial taxes and insurance company charges may apply if the money is withdrawn early.
Additional unique features and options are designed to achieve certain financial goals, which carry associated costs affecting the value of the investment. Risks include the possible loss of principal.
Variable annuities have an accumulation phase, during which money is deposited via an up-front lump-sum payment or periodic premium payments, and a payout phase, during which payments are received from the insurance company, with the value depending on the performance of investments and the lifetime of the designated recipient. This features offers protection against the possibility of outliving annuity assets. IRS rules generally forbid withdrawal of annuitized funds until age 59½ with a 10% IRS penalty. Additional surrender charges may apply if greater amounts are withdrawn than permitted or if withdrawn before the end of the holding period.
Annuity payout options can be tailored significantly, with some variable annuities allowing allocation of portions of the payments to an account with a fixed rate of interest to protect against market fluctuations. Rates of return are not guaranteed.
Annuities can be immediate annuities, where the annuity is purchased with a lump sum payment and the payout begins immediately, or a deferred annuity, which is usually used to provide retirement or investment income. Benefits include tax-deferred growth until withdrawal with gains taxed at ordinary income rates (lower than capital gains rate).
Various fees may apply such as mortality and expense fees covering the insurance risks assumed by the annuity contract and the sales commission. These and other fees are a percentage of the average account value each year, including administrative fees, contract maintenance fees, sub-account management fees, and other possible fees listed in the specific contract.
Fixed Annuities
A fixed annuity is a contract with a life insurance company guaranteeing to pay a periodic fixed amount over time. Fixed annuities are usually to accumulate funds on a tax-deferred basis for retirement, with withdrawals of interest (or up to 15 percent of the principal) being possible without penalty.
An initial rate of return is guaranteed for a set period, with the rate adjusted after that time. Various companies offer comparable rates to government and tax-exempt bonds. Withdrawals are subject to regular income tax and 10-percent early withdrawals penalties.
Most fixed annuities are sold without a sales commission, with the salesperson receiving a percentage of approximately 5 percent from the investment amount, which ultimately reduces the return on the annuity.
Fixed annuities are normally thought of as long-term commitments. Even though, in most cases, the insurance company will be paying interest on the entire investment, there are costs associated with the contract that they will recover over time. The contract normally spells out how long any surrender charge will last for early withdrawals.
