There are seven major things that you consider when you are choosing annuities
Updated: January 31, 2023
Annuities are one of the ways to receive income when you are retired. It is long-term agreement in which you (the annuitant) transfer property or assets to another person (the obligor) in return for regular payments to you. Most annuities are protected from probate court, estate taxes, and creditors.
Annuities are essentially insurance that can protect you from the risk of outliving your assets. One of the drawbacks of this security is that the return on investment of annuities is usually less than other investment choices, often referred to as opportunity cost.
Another drawback is that you purchase annuities from a life insurance or investment company. Setting up most annuities is expensive, those sold by traditional insurance companies through insurance agents even more so.
The earnings from the annuity (capital gains, dividends, and interest) accumulate tax-free.
Like a 401(k), you must be at least 59½ years old to begin withdrawals without penalties. Once this starts, you will get payments for a specific time, usually the rest of your life. How the withdrawals are taxed, how much can be invested, and how long you can defer withdrawals are based on whether the annuity was funded with pre-tax or after-tax dollars.
While you can withdraw money from your annuity at any time, there may be additional taxes, surrender fees, and other penalties that may be included in your contract.
While your choices of annuities can seem quite complicated, it really comes down to choosing among multiple available options for funding, investing, withdrawing, and passing on your annuity.
There are seven major things that you consider when you are choosing annuities
Annuities can be funded as lump sums and/or discrete payments (premiums) over time. There is no limit the amount that can be invested in an annuity
The period over which you add funds to your annuity is known as the accumulation phase. Your choices will usually depend on your personal preferences and financial circumstances.
|Qualified Annuities||Non-Qualified Annuities|
|Funding||Funded with pretax dollars or assets created with them, such as an IRA, or a 401K||Funded with after-tax dollars or assets created with them, such as savings, stocks, and other investments|
|Annual limit on funding||Yes||No|
|Withdrawal income taxed as ordinary income||Total withdrawal, even money that was withdrawn before 59½ years old for which you paid a surrender fee.||Earned income portion only|
Qualified annuities are treated like tax-deferred (traditional) retirement plans. They may be purchased through an employer tax-deferred retirement plan or with money from a traditional IRA, 401(k) — Qualified Longevity Annuity Contract, or another account that is tax deferred.
Unlike non-qualified annuities, qualified annuities have caps on how much money may be invested in them. These caps are governed by your income and whether you participate in other qualified pension plans.
When funds from a qualified annuity purchased with pre-tax dollars from a traditional IRA or other retirement account are distributed to you, the entire amount is taxable because taxes have not yet been paid on that money.
Non-qualified annuities are treated like Roth retirement plans and are purchased with after-tax dollars. When money from a non-qualified annuity is withdrawn there are no taxes due on the principal, since the money has already been taxed. Income taxes are levied only on the earnings, capital gains, and interest.
The IRS determines which portions of a non-qualified annuity withdrawal are taxable by using a calculation known as the exclusion ratio. This ratio is based on the length of the annuity, the principal and the earnings.
If a non-qualified annuity is set up to pay you for your entire life, the exclusion ratio will take your life expectancy into consideration. This can be found in the Internal Revenue Service (IRS) life expectancy table.
The idea is to spread the total of the principal and earnings of the annuity in regular payments over your lifetime. If you live beyond your calculated life expectancy you have received the entire principle of the annuity.
If your predicted life expectancy is 90 years old the exclusion ratio will calculate how much of each payment from your non-qualified annuity will be considered taxable earnings until then. After the age of 90 you have received all of your principal and all of the payout amount from the annuity is considered taxable income.
It may be possible to transfer your funds between annuities if you feel the need. There may be many reasons for this.
With non-qualified annuities (funded by after-tax dollars), you can transfer the funds between different kinds of annuities, such as fixed and variable, without facing an early-withdrawal penalty. These exchanges are guaranteed by Section 1035 of the Internal Revenue Code and are known as 1035 exchanges.
With qualified annuities (funded by pre-tax dollars), you can transfer the funds between different kinds of annuities, such as fixed and variable, but the transfers are limited to funds in the annuity that are considered tax-deferred. These are your contributions to an IRA or 401K, not the earnings.
Choosing how much risk you want to take with your money, when you have a choice, is an important part of determining what your money will be invested in. The level of risk is usually determined by individual preference and when you would like to begin getting income from your investment. In general, high risk investments are more judicious when it will be a long time before you will need the income from the investment.
You may not have control over investment risks with many annuity companies, but some will give you limited choices in investments, either by:
When you begin getting payments it is called the annuitization phase. This can begin when you are over 59½ years old, although most people wait until they retire.
If you withdraw funds before this, called the surrender period, you will be subject to surrender fees, unless you have a hardship rider.
Despite the surrender fees, you can consider this if you need cash for emergency situations, such as a terminal illness.
If you begin receiving the income within a year of purchasing the annuity, it’s known as an immediate income annuity, also called a single premium immediate annuity. Typically, you would purchase immediate annuities with a single lump sum payment if you were approaching retirement. Your payments can either be a fixed amount or a variable one, depending on your choice and the contract.
You might choose this type of annuity as you get close to retirement if you:
If the payout or distribution phase begins a year or more later, the income annuity falls into the category of deferred income annuity (DIA). Most DIAs are purchased well in advance of retirement, with the average length of deferment being 20 years.
DIAs can be purchased three ways.
The income payments from a DIA are typically higher than payments from an immediate annuity for two reasons.
The choice of duration of your payments is probably the most important choice when it comes to annuities, but it is the most difficult to anticipate. You can choose to receive withdrawals until a certain total amount is reached, or spread payments out either over your lifetime or a more limited time frame. Trying to make your annuity last until your death involves predicting your life expectancy, which is based on the IRS table and can vary depending on who is predicting it.
A life option is the choice of getting payments from the annuity for the rest of your life.
There may be three ways to reduce the odds of the company getting the rest of your annuity after your death.
The choice of a period certain or income for a guaranteed period annuity allows you to decide when and how long to receive payments. The duration of payments will determine the monthly payment amount.
The systematic withdrawal schedule allows you to get payments from your annuity account in the amounts and with the payment frequency that you specify, until your account is emptied. As opposed to the period certain option, it is the payment choice that determines the duration of the payments.
Although there is a risk of the company getting the remainder of your assets if you die before the account is empty, unlike the period certain payment option you may be able to increase your payment amounts, especially if you have an emergency. This may allow you to empty the account before your death.
If you have been building up your annuity for retirement, there is the option of getting the entire annuity as a lump sum payment.
Once you have decided to start your withdrawals and how long you want to get payments the amount of each payment amount will be calculated. Your withdrawals can be fixed or change over time, as either variable or fixed-indexed.
Yes, but many be higher
No, fluctuates with the market
6%-8% or more
4%-7% or more
The company’s actuaries calculate your fixed annual and taxable annual payment amount according to a complex formula that includes the duration of payment, payment amount choice (either as fixed or variable payments), the current dollar value of the account, your current age (the longer you wait before taking an income, the greater your monthly payments will be), the expected future inflation-adjusted returns from the account’s assets, and your life expectancy based on industry-standard life-expectancy tables.
Taxable Income Portion of Annuity Payment = Annual Payment – (Excludable Amount + Gain Amount)
Annual Payment = Fair market value (FMV) of Property Transferred ÷ Present Value of Annuity Factor (1 – (1+r)-n/r: r is the expected interest rate and n is the number of years until expected lifetime date)
Gain Amount = FMV of Property – Property’s Basis [original cost of property]) ÷ Life Expectancy of Annuitant
Excludable Amount = Exclusion Ratio × Annual Payment
Spousal or other beneficiary provisions and riders are then factored into the equation. The more provisions and riders in the contract the more guarantees you have, the higher risk the insurance company will have, and the lower the annual payments.
This will be divided by the number of yearly payments. Most people choose to receive monthly payments, so the result would be divided by 12.
An indexed withdrawal amount may start with this calculation, but may need to be repeated when the investments do well and you are entitled to a higher payment.
The variable withdrawal amount is a more complex calculation since it varies with the success of the investments
Each has a different risk associated with it, so choose the one that you are comfortable with.
A fixed annuity payment is where you receive either a lump sum of money or the same amount for the remainder of the term of the annuity, whether you opt for the life option or period certain method. This fixed payment is based on the interest rate guaranteed at the time of purchase.
Fixed withdrawals provide a predictable source of retirement income during the terms of the policy.
As insurance products, your state’s department of insurance has jurisdiction over fixed annuities. Advisors have a license to sell fixed annuities, so make sure yours does. You can find contact information for your state’s insurance department on the National Association of Insurance Commissioners website.
Indexed annuity payments, also called equity-indexed or fixed-indexed annuities, are a form of fixed annuity but include the chance of a higher payment if the investment/stock markets indices, such as the S&P 500 do much better than predicted.
A variable annuity is the riskiest choice for payments in that they will vary over time with the success of the annuity’s investments.
Like traditional 401(k)s and IRAs, qualified annuities are tax-deferred investments which have a limit on how long you can defer withdrawals. The SECURE act sets this at 72 years old (70½ if you turned that age before 2020).
Like any insurance policy, you can add any number of provisions and riders to annuities. There are provisions and riders that will protect you under a number of situations. They can be divided into living and death benefits.
Like any provision and rider, you need to consider the chance of needing the protection with the potential cost of:
Living benefits riders are any that apply to circumstances that may occur while you are alive and may include:
Death benefits riders are any that apply if you die before you have received all of your principal.
If desired, you may use most types of annuities as an inheritance tool by naming beneficiaries for annuities if you die before the end of the annuity period.
The payment method may be determined by the company holding your annuity or they may offer your beneficiaries distribution options similar to yours when you first opened the annuity.
Capital gains from annuities are not stepped up like real estate, so the capital gains are calculated from the value at the time of purchase of the annuity, not the value at your death.