Types of annuities
There are two types of annuities that investors can choose from when it comes to purchasing these instruments. Immediate annuities will begin paying a stream of income immediately upon issuance for either a set period of time or as long as the annuitant or annuitants are living. Immediate annuities are funded with a single lump-sum purchase. Deferred annuities will grow tax-deferred for a period of time before paying out, and they can be funded with either a single lump-sum purchase or with a series of payments. Some employer retirement plans even offer annuity contracts as investment alternatives for participants. Deferred annuities can be divided into separate categories:
- Fixed annuities pay a guaranteed rate of interest for a set period of time and can offer a variety of interest rate guaranteed periods and payout options.
- Fixed indexed annuities calculate an interest crediting rate according to a formula that is based on the performance of an underlying financial benchmark, such as the S&P 500 Index.
- Variable annuities don't come with a principal guarantee like fixed and indexed annuities. The money that is invested in them is allocated among a selection of mutual fund-like subaccounts, which may rise or fall according to market conditions. Many variable annuity contracts offer living and death benefit riders that provide different guarantees within the contract. They typically come with additional costs.
How does an annuity work?
Regardless of the type of annuity you buy, the primary purpose is to create income for you, and there are different ways to do that. You can set up payments that last for your entire life, a specific period of time, or a combination of both.
For example, you may choose to receive monthly payments for 20 years.
In this scenario, the company will calculate the payment amount based on your premium or the current value of your annuity contract, and begin making payments. Under this plan, you would be guaranteed to receive 240 monthly payments. If you were to die before all the payments were made, your beneficiary would receive the remainder, until all 240 payments were made.
Alternatively, you may want payments for your entire life, with a guarantee that payments will be received for a certain period of time, say 20 years.
In this example, if you were to die before the company made 240 monthly payments (20 years), your beneficiary would get the remaining payments, just like in the situation above. If you lived past the end of the 20-year guaranteed period, however, the insurance company would continue to make payments as long as you lived but your beneficiary would not be entitled to any payments after your death.
If you buy a deferred annuity, you can take withdrawals from the contract, even before your income payments begin. Each annuity has its own rules about how much you can withdraw from the contract without incurring a penalty — called a “surrender charge.” You may also completely surrender a deferred annuity. That means you tell the insurance company to cancel your contract and pay you the surrender value — the value of your contract less any surrender charge the company imposes.
Annuities are commonly used for retirement planning. They allow you to convert a lump sum of money into guaranteed income for the rest of your life, or to invest over time and later convert the annuity contract's value into guaranteed income payments. And, any growth in your annuity value is generally not taxed until you take money out of the contract. This combination of tax deferral and the ability to establish guaranteed income can make an annuity an effective tool for retirement planning and other long term goals.*
As you determine what annuity might be right for you, remember they are intended as vehicles for long-term retirement planning, which is why withdrawals reduce an annuity's remaining death benefit, contract value, cash surrender value and future earnings. Annuities also may be subject to income tax and, if taken prior to age 59½, an additional 10% IRS tax penalty may apply. Because Protective Life and its representatives do not offer legal or tax advice, it is important that you talk with your own legal and tax advisor about your specific situation.
*Annuity payments from a tax-qualified plan will be fully taxable as ordinary income.