What is an annuity?
Contract between purchaser and insurance company
An Annuity is a contract between you (the purchaser or owner) and the issuer (usually an insurance company). In its simplest form, you pay money to the annuity issuer, the issuer invests the money for you, and then the issuer pays out the principal and earnings back to you or to a named beneficiary.
Two distinct phases to annuities
There are two distinct phases to the life of an annuity contract. One phase is called the accumulation (or investment) phase. This phase is the time period when you invest money in the annuity. You can invest in one lump sum (called a single payment annuity), or you can invest a series of payments in an annuity. The payments may be of equal size over a number of years (e.g., $5,000 per year for 10 years), or they may consist of a series of variable payments. The second phase to the life of an annuity contract is the distribution phase. There are two broad options for receiving distributions from an annuity contract. One option is to withdraw earnings (or earnings and principal) from an annuity contract. You can withdraw all of the money in the annuity (both the principal and the earnings) in one lump sum, or you can withdraw the money over a period of time through regular or irregular payments. With these withdrawal options, you continue to have control over the money that you have invested in an annuity. You can withdraw just earnings (interest) from the account, or you can withdraw both the principal and the earnings from the account. If you withdraw both the principal and the earnings from the annuity, there is obviously no guarantee that the funds in the annuity will last for your entire lifetime. A second broad withdrawal option is the guaranteed income (or annuitization) option.
Guaranteed income (annuitization) option
A second broad withdrawal option for annuities is the guaranteed income option (also called the annuitization option). If you select this option, you will receive a guaranteed income stream from the annuity. The annuity issuer promises to pay you an amount of money on a periodic basis (monthly, quarterly, yearly, etc.). You can elect to receive either a fixed amount for each payment period (called a fixed annuity payout) or a variable amount for each period (called a variable annuity payout). You can receive the income stream for your entire lifetime (no matter how long you live), or you can receive the income stream for a specific time period (10 years, for example). You can also elect to receive the annuity payments over your lifetime and the lifetime of another person (called a "joint and survivor annuity"). The amount you receive for each payment period will depend on how much money you have in the annuity, how earnings are credited to your account (whether fixed or variable), and the age at which you begin the annuitization phase. The length of the distribution period will also affect how much you receive. If you are 65 years old and elect to receive annuity distributions over your entire lifetime, the amount you will receive with each payment will be less than if you had elected to receive annuity distributions over 5 years.
Example(s): Over the course of 10 years, you have accumulated $300,000 in an annuity. When you reach 65 and begin your retirement, you annuitize the annuity (i.e., elect to begin receiving distributions from the annuity). You elect to receive the annuity payments over your entire lifetime--called a single life annuity. You also elect to receive a variable annuity payout whereby the annuity issuer will invest the amount of money in your annuity in a variety of investment portfolios. The amount you will then receive with each annuity payment will vary, depending in part on the performance of the mutual funds. In the alternative, you could have elected to receive payments for a specific term of years. You could have also elected to receive a fixed annuity payout whereby you would receive an equal amount with each payment.
Caution: Guarantees are subject to the claims-paying ability of the annuity issuer.
Cannot outlive payments to you if you elect to annuitize for your entire lifetime
One of the unique features to an annuity is that you cannot outlive the payments from the annuity issuer to you (assuming you elect to receive payments over your entire lifetime). If you elect to receive payments over your entire lifetime, the annuity issuer must make the payments to you no matter how long you live. Even if you begin receiving payments when you are 65 years old and then live to 100, the annuity issuer must make the payments to you for your entire lifetime. The downside to this ability to receive payments for your entire life is that if you die after receiving just one payment, no more payments will be made to your beneficiaries. You have essentially given up control and ownership of the principal and earnings in the annuity.
Immediate and deferred annuities
There are both immediate and deferred annuities. An immediate annuity is one in which the distribution period begins immediately (or within one year) after the annuity has been purchased. For example, you sell your business for $1 million (after tax) and then retire. You purchase an immediate annuity for $1 million and begin to receive payments from the annuity issuer immediately.
A second type of annuity is a deferred annuity. With a deferred annuity, there is a time delay between when you begin investing in the annuity and when the distribution period begins. For example, you may purchase an annuity with a single payment and then not begin receiving payments for 10 years. Alternatively, you may invest a series of payments in an annuity over a period of 5 years before the distribution period begins.
Earnings tax deferred
One of the attractive aspects to an annuity is that the earnings on an annuity (i.e., the interest earned on your money by the issuer) are tax deferred until you begin to receive payments back from the annuity issuer. In this respect, then, an annuity is similar to a qualified retirement plan. Over a long period of time, your investment in an annuity may grow substantially larger than if you had invested money in a comparable taxable investment. (However, like a qualified retirement plan, there may be a 10 percent tax penalty if you begin withdrawals from an annuity before the age of 59½.)
Four parties to an annuity
There are four parties to an annuity: the annuity issuer, the owner, the annuitant, and the beneficiary. The annuity issuer is the company (e.g., an insurance company) that issues the annuity. The owner is the individual who buys the annuity from the annuity issuer and makes the contributions to the annuity. The annuitant is the individual whose life will be used as the measuring life for determining the distribution benefits that will be paid out. (The owner and the annuitant are usually the same person, but they do not have to be.) Finally, the beneficiary is the person who receives a death benefit from the annuity upon the death of the contract owner.
Forefield Inc. does not provide legal, tax, or investment advice. All content provided by Forefield is protected by copyright. Forefield is not responsible for any modifications made to its materials, or for the accuracy of information provided by other sources