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What Is An Annuity And How Does It Work?

7-Minute Read
Published on May 6, 2022
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For many Americans, saving for retirement is an intimidating challenge. While there are many options available, one worth considering is the annuity.

Annuities can be complex, but they have the potential to lessen your stress as a retiree. According to a 2021 survey completed by TIAA (Teachers Insurance and Annuity Association), 45% of Americans worry about running out of funds in retirement.

That’s where investments like 401(k)s, IRAs and annuities step in. They can offer a source of reliable income during your retirement years. However, they won’t work for everyone.

Here’s a rundown on how annuities work and whether they may benefit you.

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What Are Annuities?

Annuities offer investors a way to guarantee an income during their retirement years. But because of that, they function a little differently than other investment options.

Essentially, annuities are contracts that you can sign with an insurance company. Because of this, they differ from things like IRAs or 401(k)s, where an institution or individual manages your investment. In the case of annuities, you receive a guaranteed payout. Although, the specifics of the payout depend on your annuity’s structure.

Annuities are long-term investments. Because of this and their customization options, they appeal to certain consumers, like retirees. With an annuity, the consumer can achieve investment diversification, financial security and a source of retirement income.

How Do Annuities Work?

As mentioned, annuities are long-term investments sold by insurance companies. There are many types of annuities, including variable, fixed, immediate, registered index-linked, fixed indexed and more.

The goal of an annuity is to ensure you don’t outlive your income. It does this through annuitization, or the process of converting your annuity into scheduled, periodic payments. Depending on your contract, these payments can last you for life.

The payout depends, though. You may purchase an immediate annuity and start receiving payouts within the month, no accumulation necessary. Or you may buy a deferred annuity, letting your premium grow tax-deferred for years. Their tax-deferred status is one of their advantages and if you paid with post-tax money, you only pay taxes on withdrawals.

You receive your payment in one of these ways:

  • Life-only with no survivor benefit
  • Period certain that includes a minimum payout period
  • One lump sum
  • Joint and survivor that guarantee payments for both annuitants

They are a relatively safe investment. However, this varies based on the type of annuity you purchase and the company you purchase it from.

Understanding Immediate And Deferred Annuity Payments

You have options when it comes to your annuity’s setup. For example, you can choose the timing of your annuity’s payout, such as:

  • Immediate annuities: Immediate annuities start distributing payouts soon after the annuity first receives funds. The frequency of these payments will depend on your contract and decisions.
  • Deferred annuities: Deferred annuities allow you to pay into the annuity, but hold off on withdrawals for a period. This gives your investment time to grow. The level of growth depends on the performance of the funds your selected insurance company chooses.

On top of that, you can also choose how to fund your annuities. Options include:

  • Single-premium annuities: In this case, you fund the annuity with a one-lump sum payment. This works well if you want to move a significant amount of money into the annuity at one time.
  • Multiple-premium annuities: With this type, you can pay into the annuity over time. This allows the funds to grow within the annuity itself. Multiple-premium annuities are a stronger option for those who want to put away smaller amounts more frequently.

In addition to choosing the payout timing and the funding method, you can also decide how long you want to receive the payments.

  • Lifetime annuities: With lifetime annuities, you receive a predetermined amount of income for the length of your life. They come in regular installments (monthly, quarterly or yearly) and may shrink over time.
  • Fixed-period annuities: Fixed-period annuities provide payouts for specific term lengths. This usually results in higher value payouts, but you may outlive the annuity’s term.

Types Of Annuities

You can break annuities down into three types:

Fixed Annuities

A fixed annuity is the most predictable option. That’s because you get a guaranteed payout that stays consistent throughout your ownership. Whether you receive money from it monthly, quarterly or annually, it’ll never change on you. In addition, you receive a fixed amount of interest with your annuity that doesn’t change beyond your contract terms.

When the contract ends, you can annuitize it, renew it or transfer the money elsewhere.

Since fixed annuities come with a guaranteed interest rate, they are not impacted by market volatility. That means you’ll always know the exact amount of your scheduled payout.

Fixed annuities are subject to regulation at the state level. They also typically come with lower commission fees than other annuities.

Indexed Annuities

Indexed annuities are a middle ground between their variable and fixed counterparts. It guarantees a specified rate of return, with any return above that tied to an index like the S&P 500. Say the index performs well. Then you could make more money on your next annuity payout. But even if it performs poorly, you’ll still receive your guaranteed amount.

However, there’s a cap on your potential gains. In addition, only a certain percentage of your income is protected if the market drops. So, there’s more risk involved than a fixed annuity.

The Securities and Exchange Commission (SEC) regulates any indexed annuities that are securities. State insurance departments regulate all of them, though.

Variable Annuities  

Variable annuities are tax-deferred annuities where you can invest your cash into sub-accounts along with the annuity contract. They behave similarly to mutual funds, which means they are dependent on market performance. As a result, they are also higher risk than some other types of annuities.

Typically, the annuity company provides you with a guaranteed return of premium (ROP), so you won’t lose your base investment. However, you may not earn additional growth if the portfolio performs poorly. You can receive your periodic payments immediately after funding the portfolio or after a delayed period.

Variable annuities usually come with greater fees and costs than fixed annuities. They are regulated by the SEC.

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Annuity Riders

An annuity rider is an add-on you can purchase for your annuity contract. For an additional cost, these riders offer unique benefits that the standard annuity contract does not include. There are a variety of riders, but they typically fall into one of these two categories:

  • Living benefit: These riders ensure you receive some form of benefit during your lifetime if you maintain the contract. So, it’s an advantage for you as the annuity purchaser.
  • Death benefit: These riders provide a financial benefit for a beneficiary after you pass away. This lets you pass on assets while possibly avoiding the probate process.

Some common forms of annuity riders include:

  • Cash/Installment Refund Rider
  • Cost-of-living Adjustment Rider
  • Commuted Payout Rider
  • Enhanced Earnings Benefit Rider
  • Guaranteed Lifetime Withdrawal Benefit Rider
  • Guaranteed Minimum Income Benefit Rider
  • Guaranteed Minimum Withdrawal Benefit Rider
  • Long-Term Care Rider

Reasons To Buy Annuities

There are a few reasons why retirees may want to consider buying an annuity. For example, they are a better investment option for older individuals. That’s because annuities lock you in for a set number of years, sometimes as long as 30 or 40. That may not work for a young investor who needs to change their strategy more frequently. But by retirement age, you have a better idea of your investing and financial needs.

In addition, being older means you won’t have to wait very long to withdraw your money. And that money will be a consistent source of income. That can help retirees cover regular and monthly costs, thus protecting their savings.

Finally, your annuity can be another way to build up your nest egg. For example, let’s say you already maxed out your 401(k) or IRA. You can put any extra funds into your annuity since there’s no contribution limit.

Benefits Of Annuities

Annuities are usually used to supplement other sources of income, like Social Security or a pension. Here are some reasons why:

  • Foreseeable income payments: Annuities create guaranteed and predictable streams of income. That helps you pay for regularly occurring expenses in retirement, allowing you to protect your savings.
  • Tax-deferred growth: You don’t have to pay income taxes on your annuity’s earnings until you start making withdrawals or receive payments.
  • Death benefits: While it depends on your contract, you may be able to select a beneficiary and pass on any unused funds. That beneficiary can then receive a guaranteed minimum amount or the remaining balance. This often helps the funds avoid probate.

Drawbacks Of Annuities

No investment is perfect. Annuities come with their own challenges and disadvantages. Some that are worth considering include:

  • Illiquid investment with penalties: Generally, annuities are considered illiquid, meaning you cannot easily access the investment’s cash value without loss. Annuities struggle with liquidity due to their early withdrawal penalties, such as the surrender charge.  
  • High commissions or fees: A large challenge to annuities is their hefty fees compared to options like CDs or mutual funds. This may be a strong downside for savings conscious retirees.
  • Complex investment method: Annuities can be difficult to understand, making them unfriendly to new investors. For example, the equity-indexed annuity is complicated and comes with high surrender charges, so a mistake can cost you.

Annuity FAQs 

Annuities are just one investment option among many. If you’re debating whether to purchase one, consider reviewing these common questions first:

What is an annuity fund?

An annuity fund is an investment portfolio that holds the annuitant’s invested funds. It earns returns which then factor into the annuity’s payouts.  

What is the surrender period?

The surrender period is a fixed span of time that the investor waits before they can withdraw any funds from their annuity. These periods vary and can typically last 6 – 8 years. Withdrawing before the period ends may result in a penalty, such as a surrender charge.

How are annuities taxed?

Annuities are tax-deferred plans, meaning your earnings grow tax-free. But your withdrawals or payments face different tax rules depending on your annuity type. If it’s a qualified annuity, then you pay normal income taxes on any payments. On the other hand, non-qualified annuity owners purchased their annuity with taxed funds. So, they may only owe taxes on their earnings or interest.

Withdrawing from either before age 59 ½ can result in a 10% penalty tax on the withdrawn amount.

Who should and shouldn’t invest in annuities?

The answer depends on the individual’s financial situation, goals and investing style. Retirees may be more likely to benefit from annuities than young investors, but it varies. Consider speaking to a financial advisor or professional before purchasing an annuity.

The Bottom Line

Annuities are an investment opportunity that can benefit certain investors, particularly retirees. They can offer a source of income to help support individuals through their retirement. That, combined with their customizable contracts and riders, makes them flexible as well.

But before you invest into annuities, you should consider your investment strategy. If you’re interested in diversifying your portfolio, consider learning more about your other opportunities first – like investment properties.

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Headshot Ashley Kilroy

Ashley Kilroy

Ashley Kilroy is an experienced financial writer. In addition to being a contributing writer at Rocket Homes, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.