Are you considering investing in an annuity? If so, you’re not alone—annuities are a popular form of retirement income and can be a great way to supplement your Social Security payments. But before getting started, it’s important to understand the different types of annuities available and how they work.
In this blog post, we’ll cover the basics of annuities so you can decide which one is right for you.
Definition of annuity
An annuity is a contract or agreement between an individual (annuitant) and an insurance company. In an annuity, the insurer pays a certain amount for a specific period or until the annuitant’s death. To receive this money, you buy the annuity by paying a lump sum, which is invested in mutual funds. Payouts depend on the type of annuity you pick.
Why purchase an annuity?
Compared to other forms of retirement investments, annuities offer more benefits. No matter how the market performs, there is a guaranteed income for the defined period. Additionally, you can use your money if you don’t want to leave it to others.
Types of annuities
There are different types of annuities, so selecting one that suits you best is crucial. Let’s dive deeper and have a look at the different types. Ready?
- Fixed annuities
Fixed annuities guaranteed fixed interest and several periodic payments. They pay defined rates of interest, often higher than bank CDs. You have the freedom to draw income immediately or defer it. If you want a modest, no-cost, and guaranteed fixed investment, buy fixed annuities. You can learn more here about fixed annuities.
- Variable annuities
With variable annuities, you can choose from mutual funds to invest your funds. Your payment will be based on the performance of your investment. You can purchase a rider to lock in a guaranteed income stream regardless of market performance. Buy variable annuities if you want a shot at capital appreciation in tandem with guaranteed lifetime income.
- Fixed-indexed annuities
Fixed indexed annuities give you more potential growth than fixed annuities. They are tax-deferred, long-term savings options that offer guaranteed minimum income benefits, principal protection in a down market, and opportunity for growth. Returns here are based on the performance of an underlying index such as the S&P 500.
They are ideal if you want to participate in potential market appreciation without worry and with principal downside protection.
- Immediate annuities
With immediate annuities, you pay the insurer a lump sum in return for a guaranteed income stream for a specific period. You can receive the payment immediately or twelve months after receipt of the investment.
Payments are usually higher than other annuities because they include principal and interest, so they also offer favorable tax treatment. Choose these annuities if you need a higher-than-average income stream and are comfortable sacrificing principal for a higher lifelong income.
- Deferred annuities
Payments are delayed until a future date. Payment may be paid as a single premium or in installments. Deferred annuities for retirement can remain in the deferred stage for decades. The premium payment continues until the annuitant’s death or the stated date for the start of the installments.
Qualified vs. nonqualified annuities
Qualified annuities are used to invest and move money in a tax-favored retirement plan such as a Keogh or IRA. Qualified annuities are funded with pre-tax dollars. Taxes are deferred until withdrawals are made after retirement.
Nonqualified annuities are purchased separately from or outside of a tax-favored retirement plan. Contribution to nonqualified annuities and funded with post-tax dollars. They are taxed in the years they are earned.
Single premium vs. flexible premium annuities
A single premium is simply an annuity funded by a single payment. The payment may be invested quickly, after which payouts start or for an extended period. Single premiums annuities are funded by selling an appreciated asset or by rollovers.
A series of payments fund a flexible premium annuity. As you make fresh premium payments and accumulate interest, money in the annuity grows on a tax-deferred basis. No paying taxes until you start taking payments.
Classification of annuity according to the number of lives
- Single life annuity
With this option, one person is contracted. This makes this annuity suitable if you have no dependents and want to use all your savings during your lifetime.
- Multiple life annuities
Here more than one life is contracted. You can choose between a Joint life annuity and a last survivor annuity.
With the joint-life annuity, payouts of the annuity stop at the first death. If you pick the last survivor annuity, payments continue until the last person in the group dies.
Classification of annuities according to the mode of premium
- Level premium annuities
With level premiums annuities, you deposit some amount periodically so that, in the end, you get a sufficient amount of annuity in equal installments. When accumulating the money and before the payment of the annuity, you have two options:
- Get the paid-up values reduced in proportion to the premium paid to the premium payable or
- Get the surrender value in cash
If you die, beneficiaries can get the premiums or surrender values, whichever is higher.
- Single premium annuities
You purchase an annuity by payment of a single premium. The life insurance amount is used for obtaining this annuity.