800 Words about Annuity Basics

Many people only think of an annuity as something that pays an income for as long as they live. This is one benefit all annuities – and only annuities – offer. It is also the reason why people buy immediate annuities (also called income annuities). However, the lion’s share of annuities are purchased as saving places and never turned into immediate annuities (the conversion is called annuitization). One of the reason annuities are used as saving places is that taxes on any interest earned may be deferred as long as the interest remains inside the annuity. 
 
There are two main branches on the annuity tree:
 
Variable annuities are registered as securities and offer various investments. Since they are securities they are subject to stock market risk and can lose money. When you hear that annuities have fees, they are usually talking about variable annuities. Variable annuities can be annuitized and turned into a lifetime income stream, but the income will fluctuate depending on how the underlying investments perform.
 
Fixed annuities do not subject principal or interest earned to market risk – in others words, you can never lose what you’ve made because the stock market went down or some bond issuer went out of business. Fixed annuities can also be annuitized, but the income will remain stable and not go down. 
 
Fixed Annuities as Saving Places

Annuities used as saving places are called deferred annuities, because, as mentioned, the annuity owner has control over when to take the interest out of the annuity and pay income taxes on it. All fixed deferred annuities guarantee a minimum return. The three types credit interest in different ways:
 
Fixed Rate Annuities declare a new interest rate each year. It will fluctuate, but will never be less than the minimum interest rate stated in the annuity.
 
Multi-Year Guaranteed Annuities (MYGAs) lock in a rate for the term selected of two to ten years.
 
Fixed Index Annuities base the amount of interest earned on the performance of an external index. Although the degree to which the annuity participates in any gains is locked in, the actual interest earned depends on well the index performs. Since this is a fixed annuity it does not lose any value if the index goes down, instead, zero new interest is earned for the period.
 
 
Fixed Annuities for Income
 
Immediate annuities pay an income for a specified period of years or for life. The biggest concern when getting an immediate annuity with a life income is dying too soon, with the result that the annuity company keeps most of the money. This can be offset by setting up the annuity to pay for the greater of life or a specified period of years (life with period certain). You can also choose a cash refund option that means payments will continue until all of the principal has been returned if early death occurs.
 
Withdrawals are another way to get income. The deferred annuity remains intact, but the annuityowner takes out the interest earned each year. Indeed, most deferred annuities allow the withdrawal of up to 10% of the value each year without penalties.
 
Guaranteed Lifetime Withdrawals Benefits (GLWBs) are withdrawals from the deferred annuity, but they are guaranteed to last a lifetime even if the annuity account goes to zero. The income is stable, but unlike an immediate annuity, here the annuityowner retains control over the remaining account balance. GLWBs are usually an optional benefit for which a fee is charged.    
 
Annuity Vocabulary

Annuities have similarities with other savings choices (and one difference):
 
IRS “Under Age 59½” Premature Distribution Penalty is in addition to the normal income taxes owing, and can be avoided if certain conditions are met. In the case of annuities not held in qualified plans, the penalty only affects withdrawn interest earned over and above the original principal.
 
Penalties for Early Withdrawal (surrender charges) are made if the annuity is cashed in prior to the end of the term initially agreed to. Surrender periods vary in length from one to twelve years. For the vast majority of policies, penalties do not apply if the policy is cashed in due to death of the owner. The annuity may be continued after the penalty period and no penalties are charged.
 
Maturity Date is the longest one can keep annuity interest deferred before it must be taken out. Maturity dates usually occur when the annuitant celebrates their 80th to 90th birthday, but some new policies may be kept until age 100 (the annuitant is the person upon which the annuitization life income is based – usually the owner).  Although many financial writers get this confused, the maturity date is not how long the insurance company makes you keep your annuity with them, but how long the insurer will let you keep your money with them.
 
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For educational purposes only. It does not provide investment, tax or legal advice. Information believed accurate, but is not warranted. Past performance is not an indication of future results. Both investments and fixed annuities involve certain risks; a consumer should consult with their advisor.

Fixed annuities are not bank instruments and are not insured by FDIC.

About Dr. Jack Marrion

Dr. Marrion’s research on senior decision making and the financial world have been featured in hundreds of publications including: Business Week, Kiplinger, Smart Money, and The Wall Street Journal. He is the author of six books and a frequent media guest.