Annuities for Retirement Planning
Before you decide to purchase an annuity for your retirement planning, it is essential that you understand the fundamentals of the product. Below, are the basics for your consideration.
What is an Annuity?
An annuity is a legal contract between a policyholder (owner or annuitant) and an insurance company (issuer). You make the premium payments to the insurer and in exchange, the insurer offers certain contractual promises. The guarantees address a variety of contract components, including income, interest rates, or withdrawals. Premium payments are typically made in a lump sum or a series of payments over time which is specified in the contract.
The objective of an annuity is to furnish an annuitant with a steady income stream during their retirement. Except for immediate annuities, most annuities provide for tax-deferred money growth until the funds are withdrawn.
The Difference between Immediate and Deferred Annuities
Depending on the type of annuity you purchase, you will either start receiving income payments immediately or at some future date. This difference is what differentiates the two primary categories of annuities which are immediate and deferred annuities:
- Immediate annuities – An immediate annuity is also referred to as a “single-premium immediate annuity.” With a single premium immediate annuity, you make one premium payment (usually a one-time lump sum), and in exchange, you start collecting income soon thereafter. Income payments begin no later than twelve months after the original premium payment.
- Deferred annuities – Contrary to an immediate annuity, a deferred annuity starts making income payments many years after the initial premium payment. A deferred annuity has two different parts or periods. During the first period, which is known as the accumulation period – the money you pay into the annuity, less any applicable charges or fees, earns interest. This growth is on a tax-deferred basis as long as the money remains in the annuity.
In some annuities, there is a second period know as the payout period. During this payout period, the insurance company pays income to you or to someone you choose. This is also known as the distribution period, which in the majority of cases you will able to choose how you want to distribute your annuity money. Examples include free withdrawals, annuitization, lifetime income withdrawals, or lump sum cash surrender.
Fixed Annuities and Variable Annuities
Two other types of annuities are fixed annuities and variable annuities. Fixed annuities are insurance contracts that allow growth at a fixed and guaranteed interest rate. Once the primary growth period has passed, the insurance company can change the guaranteed interest rate depending on a number of factors.
In contrast to fixed annuities, variable annuities offer an optional investment component. Premium payments may be allocated to stocks, mutual funds, bonds, or other asset classes. If and when you receive interest credits, premiums and the interest credits are reallocated into this portfolio of investments for further dollar growth possibilities. Then again, since money growth is connected to portfolio growth, your principal and interest are at risk of going down if the investments in which money is allocated have a negative overall performance.
What are the Benefits of using an Annuity for Retirement?
How you benefit from an annuity depends on the type of annuity and its performance. Generally, an annuity owner can expect the following benefits:
- Annuities are a conservative alternative to more volatile investments like stocks.
- There are multiple product selections for different circumstances, needs, and goals.
- Annuities can last a lifetime or can be established for a specific period.
- Annuities will provide guaranteed minimum interest earnings.
- Annuities provided guaranteed income for life or a set period of time.
- Annuities are the only investment vehicle that offers guaranteed lifetime income.
- Annuities provide tax-deferred growth.
- Annuities can be designed to offer a guaranteed death benefit.
- Some annuities offer options for increased interest that are linked to equity index gains.
- Various riders are available to provide additional benefits.
Withdrawing Funds through Annuitization
In simple terms, annuitization is when you begin to withdraw the funds from your annuity. It’s kind of like flipping a switch that replaces accumulation to withdrawal. Please understand, however, annuitization is not the same as making a “withdrawal” from your annuity rather, it is a defined systematic payment plan from your annuity and as such, there are several methods to do so.
It is critical that the contract owner understand the various ways to receive annuity payments and understand the tax liabilities that may or may not be associated with receiving their funds. There are six basic strategies available to receive the funds in your annuity.
Life with Installment Refund
The life with installment refund method is the better choice if you want to receive the highest lifetime income stream possible that will be paid to you or your beneficiary if you die. Any funds that are in your account at the time of your death will then be paid to the beneficiary or beneficiaries that you have listed in the contract. If, however, you are lucky enough to outlive the life expectancy provided in the contract, you would have received all of the available funds and there would be nothing left for your beneficiaries.
Life with Cash Refund
The life with cash refund option is similar to the life with installment refund option except that if you die during the payout and there are funds remaining, your beneficiary would receive a lump sum payment for the balance of the annuity. Using this option does reduce the payout amount because the insurance company must make the lump sum payout to your beneficiaries instead of paying out over time when the annuity could continue to earn interest.
Life with Period Certain
The life with period certain option also provides a lifetime stream of income, however, the annuitant is allowed to choose the minimum number of years that you or your beneficiaries can receive payments. For instance, if you choose Life with a 10-year period certain, you would be paid income as long as you are alive. If, for example, you were to die in the fourth year of the payout, your beneficiary would receive payments for the remaining six years of the payout.
If the annuitant outlives the period certain (in this case 10 years) the annuitant would continue to receive an income stream but there would be no payment to beneficiaries when he or she dies. Practically speaking, the lower the years in the period certain, the higher the lifetime income would be for the annuitant.
You always have the option of not attaching a life contingency when you annuitize your contract. You can always choose to receive payments for a specific period of time. For insurance, a 10-year period certain would pay for 10 years and then the payments would stop. Typically the shortest period you can elect is a 5-year payout. Most annuitants use this option as a bridge to other funds they are expecting to receive in the future like social security or pension benefits. Also, electing a shorter payout will result in higher annuity payments to the annuitant.
Regretfully, most people who own annuities wrongly assume that life only is the only option available to them. Although the life only option will deliver the highest payout to the annuitant, when the annuitant dies, any remaining funds are returned to the insurance company. This type of payout only makes sense for a non-married person with heirs.
Life with Death Benefit
There are some insurance companies that will offer a guaranteed death benefit for the annuitant’s beneficiaries. For example, an annuitant can elect to annuitize with the option of Life with a 25% death benefit. Using this option means that the annuitant would be paid as long as they are living, but in the event of their death, their beneficiary would receive 25% of the initial premium. So then, if you annuitized $300,000 using life with 25% death benefit and lived to 100, the annuity provider would have paid you an income stream up to age 100, and then upon your death, your beneficiary would receive 25% or $75,000.
Annuities are a wonderful tool for retirement planning but how you intend to receive the payout and whether it’s important to you that your beneficiaries receive the income stream when you pass away makes it essential that you discuss your payout options with your insurance professional.
The Purpose of Your Annuity
Although most people think of annuities as a retirement strategy only, there are other purposes when an annuity can become the best vehicle to meet the needs of the applicant.
- Charitable Gifts
- Long-Term Care
- Income Longevity
- Shield Annuity for Investment Protection
- Joint and Survivorship for Married Couples