An annuity is a contract between the investor and a life insurance company. All annuities have two things in common:
1. There is no tax deduction for the money used to purchase the annuity [exception: tax-sheltered annuities in 403(b) plans].
2. Inside the annuity, the money compounds tax-deferred. Beyond this, each annuity has its own cost structure, characteristics, and rate of return. Taxes are paid on the earnings when money is withdrawn at retirement, either in a lump sum or as a series of periodic payments.
Annuities are sold by bankers, stockbrokers, financial planners, insurance agents, or through mutual funds, but regardless of who makes the sale, an insurance company always backs the annuity. If the annuity holder (investor) dies during the so-called accumulation phase, that is, before receiving any payments from the annuity, the beneficiary is guaranteed to receive the amount of the original investment.
Investors purchase an annuity by paying a lump sum of money (required minimum purchases generally range from $1,000 to $25,000, depending on the issuer) or by making deposits over time. An annuity may be either an immediate annuity or a deferred annuity.
An immediate annuity pays a lifetime income starting now. In return for a lump sum of money, the purchase of an annuity guarantees a fixed stream of income. To determine where to buy the right annuity, check the Annuity & Life Insurance Shopper or Best's Retirement Income Guide for the companies that pay the five highest monthly incomes per $1,000 invested. Go with a quality company (one that has paid consistently above average returns) that pays the most. To spread your risk, you may want to buy annuities from two or more companies or buy annuities in subsequent years.
Deferred annuities may be purchased in one of two ways. Single premium annuities are purchased with a lump sum and flexible payment annuities may be purchased by installment payments over a period of years. Deferred annuities accumulate money for the future and come in two types. A fixed annuity pays a specified interest rate for a period of time. A variable annuity puts your money in stock, bond, or money market mutual funds, and returns are dependent on the financial market volatility and performance. An equity indexed annuity offers a guaranteed minimum return plus a variable rate based on the return of a specific stock market index, generally the Standard & Poor's 500.
The payout from annuities may be taken in several ways. Taxes are owed when the money comes out, and there is 10% penalty on earnings withdrawn before age 59 1/2. You can take monthly payments for the rest of your life, or you can make periodic withdrawals. If you make regular withdrawals, part of each withdrawal is treated as taxable income, and the rest is a nontaxable return of your own capital. If you make occasional withdrawals, the entire withdrawal is treated as taxable income. Taxes are levied until you have taken all of the earnings on the original capital invested. Other payment options include taking the money in a lump sum or rolling your savings into another annuity tax-free.
When you buy an annuity, you are making a long-term commitment (15-20 years). Moving the money to another annuity may be difficult, and quitting is expensive. You usually have to pay a surrender fee to the insurance company for selling an annuity too soon (e.g., withdrawing money from an annuity after the third year). A common fee is 7% the first year which is reduced to 0% by the seventh year. Because annuities are purchased with after tax-dollars, it is usually recommended that pre-tax investment plans [e.g., IRAs, 401(k)s] be funded to the maximum first.