Annuities are one of the ways to receive income when you are retired. 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. 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.
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.
Some annuities will give you some choice in the investments, either by letting you or your financial advisor pick some of the investments or determining the amount of risk you want to take. Your money will get interest at a fixed rate in the accumulation phase.
Like any insurance policy, you can add any number of provisions and riders to annuities. Like any provision and rider, you need to consider the chance of needing the protection and comparing the cost of adding the provision or rider to your annuity, adding them to a different type of insurance, or taking out a separate policy. There are provisions and riders that will protect you under a number of situations. They can be divided into living and death benefits.
The earnings from the annuity (capital gains, dividends, and interest) accumulate tax-free. Withdrawals and lump sum distributions from an annuity are taxed as ordinary income, even money that was withdrawn before 59½ years old for which you paid a surrender fee.
Your choices for your annuities can be quite complicated. There are 4 major things that you consider when you purchase annuities.
Annuities can be funded as lump sums and/or discrete payments (premiums) over time. The period over which you add funds to your annuity is known as the accumulation phase. Your choices will usually depend on circumstances.
Whether the withdrawals are taxed, how much can be invested, and how long you can defer withdrawals are based on what the annuity was funded with.
|Feature||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||Total withdrawal||Earned income portion only|
|Age limit for deferral||70½ years||No Federal limit, but states vary|
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), 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 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.
When you begin getting payments it is called the annuitization phase. If you are over 59½ years old, this can start right away or be deferred. If you withdraw funds before this you will be subject to a surrender fee, unless you have a hardship rider. These fees can be 10% or more, although the penalty typically declines annually over the surrender period.
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 (SPIA). 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). Deferred annuities purchased three ways.
The income payments from a deferred annuity 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. It all comes down to predicting your life expectancy, who is predicting it, and trying to make your annuity last until your death.
A life option is the choice of getting payments from the annuity for the rest of your life, even if you live much longer than your life expectancy and get back more than you put in and earned. In this case your life expectancy is based on the IRS table.
The risk of this option is that you will not receive the full value of the annuity if you die sooner than expected. Unless you have a death benefit, the company holding your annuity keeps the remainder of the account after your death.
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 period certain option does not protect you from outliving your assets, if you do not have other assets to rely on once this happens. It may be the most useful if you use the annuity to fill the gap until another retirement income source matures.
This option has the risk of the company holding your annuity getting the remainder of your annuity if you die before the period ends, unless you have named beneficiaries to receive the payments until the end of the period.
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 that determines the duration of the payments.
Like the period certain option the monthly payouts are higher and you may be:
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 you must then figure out how much each payment amount will be. If you opted for specific withdrawal amounts, you would need to figure out how long you would be getting payments.
The company’s actuaries calculate your 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 = 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.
Annuities are available as fixed, indexed, or variable products. Each has a different risk associated with it, so choose the one that you are comfortable with. For indexed and variable payments, the amounts will be adjusted yearly based on the performance of the annuities investments.
A fixed payment is where you receive 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 guarantee 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 markets used by the annuity do much better than predicted. You are guaranteed a minimum payment which will be higher if the annuity does very well; you are not at risk if the annuity does poorly, but the baseline amount may be lower.
A variable annuity is the riskiest choice for payments in that they will vary over time with the success of the annuity’s investments. As the value of a variable annuity grows or shrinks over time, so does the payment.
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.
If desired, you may use your annuity as an inheritance tool. As mentioned above, you can name 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 choices similar to yours when you first opened the annuity.