What is an Annuity?
An annuity is a contract between you and an insurance company that allows your earnings to grow and compound tax deferred. This is a powerful benefit that you can use to help accumulate wealth for your retirement or other long-term financial goals.
The word annuity literally means ìannual payments.î Annuities have an ìaccumulationî phase as well as a payment phase. When you buy an annuity, the insurance company agrees to pay you an income for a specified period of time. Whether you prefer that these income payments start right away or after an accumulation period ends dictates what type of annuity you select.
As an investment in securities, the principal amount and investment earnings in a variable annuity are not guaranteed and will fluctuate with the performance of the underlying investments such that when redeemed, an investor's units may be worth more or less than their original cost. Annuities and insurance products are not deposits or obligations of, or guaranteed by any bank, nor are they insured by the FDIC; they are subject to investment risk, including the possible loss of the principal amount invested.
How is an Annuity Structured?
In general, there are three parties to an annuity (plus the insurance company): the owner, the annuitant and the beneficiary.
The owner controls incidents of ownership in an annuity and has the right to the cash surrender value. The owner can also name the beneficiary, assign the policy and make withdrawals. Oftentimes, the owner is also the annuitant. The owner may be an individual or a trust.
Most importantly, the owner is the person (or trust) who receives the tax benefit of the annuity during the accumulation phase of the contract. The owner does not pay annual taxes on the income earned (the tax deferral), however, the owner does pay the taxes on withdrawals made during the accumulation phase. The owner is normally the person who receives the payments during the income phase but can also assign these payments to the annuitant.
The annuitant is the person on whose life the terms of the annuity are measured (depending on the particular annuity, the terms could include age, gender or state of residence.) Again, the annuitant may also be the owner.
As in other life insurance policies, the annuitantís beneficiary is the recipient of the death benefit, should the annuitant die.
What Types of Annuities Are Available?
There are two main annuity types: deferred and immediate. The differences between the two are very simple.
With an immediate annuity, your income payments start right away. You choose whether you want income guaranteed for a specific number of years or over your lifetime. The insurance company calculates the amount of each income payment based on your purchase amount and your life expectancy.
A deferred annuity has two phases: the accumulation phase, where you let your money grow, and the payout phase. During accumulation, your money grows tax-deferred until withdrawn, either as a lump sum or as a series of payments. You decide when to take income from your annuity and therefore, when to pay the taxes.
The payout phase begins when you withdraw income from your annuity. For most people, this is during retirement. As your needs dictate, you can take partial withdrawals, completely surrender your annuity, or convert your annuity into a stream of income payments, (known as annuitization). This last option is essentially the same as buying an immediate annuity.
What Are The Differences Between Fixed, Variable and Equity Indexed Annuities?
Fixed and variable annuities differ in the way they generate earnings and also in the amount of risk involved.
When you buy a fixed annuity, the insurance company guarantees you an interest rate for an initial period of time. At the end of this initial guarantee period the insurance company will declare a renewal interest rate and another guarantee period. In addition, most fixed annuities have a minimum interest rate that is guaranteed for the life of the contract. In other words, regardless of market conditions, you will never receive less than your guaranteed percentage rate (typically between 3% to 4%). Fixed annuities typically appeal to investors who feel more comfortable knowing exactly how much their money is earning.
With a variable annuity, you have added control over your investment dollars. You allocate your funds among a variety of investment options with objectives ranging from aggressive to conservative (insurance companies call these sub-accounts). Your rate of return is tied to the performance of the underlying investments of the sub-accounts. Variable annuities typically appeal to investors who are willing to accept a higher level of risk in return for higher growth potential.
An Equity-Indexed Annuity is a Fixed Annuity, either immediate or deferred, that earns interest or provides benefits that are linked to an external equity reference or an equity index. The value of the index might be tied to a stock or other equity index. One of the most commonly used indices is Standard & Poor's 500 Composit Stock Price Index (the S&P 500), which is an equity index. The value of any index varies from day to day and is not predictable.
When you buy an equity-indexed annuity youown an insurance contract. You are not buying shares of any stock or index.
An equity-indexed annuity is different from other fixed annuities because of the way it credits interest to your annuity's value. Some fixed annuities only credit interest calculated at a rate set in the contract. Other fixed annuities also credit interest at rates set from time to time by the insurance company. Equity-indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited. How much additional interest you get and when you get it depends on the features of your particular annuity,
Your equity-indexed annuity, like other fixed annuities, also promises to pay a minimum interest rate. The rate thatt will be applied will not be less than this minimum guaranteed rate even if the index-linked interest rate is lower. The value of your annuity also will not drop below a guaranteed minimum.
Both fixed and variable annuities offer you the wealth-building combination of compound interest and tax deferral. When your earnings are not eroded by taxes each year, they compound faster. Faster growth of your money means more spendable income for you in the long run.
The Power of Tax Deferral!
The ability to shelter your earnings from the impact of taxes is one of the most powerful tools available for helping you to build and preserve wealth for retirement or other long-term goals.
Without the continuous drag of taxes, your money grows faster. Faster growth means a larger nest egg. And here's how it works:
First, your principal earns interest each year. Then, your accumulating interest earns interest. Finally, the money you would have ordinarily paid to the IRS in taxes (and possibly to state and/or local agencies) remains in your annuity to earn even more interest for you.
Over time, the additional interest earnings on these tax savings can really add up. Depending on your tax bracket, tax deferral can mean as much as a 30% to 40% increase on the growth of your money compared to a taxable account paying the same rate.
Separate vs. General Accounts
A separate account is an account maintained separately from the insurerís general (investment) account that is solely for the purpose of making investments for the contractholder. This transfers the risk from the insurer to the contractholder. The separate accounts are not insured by the carrier, except in the event of the ownerís or annuitantís death. Account values on variable annuities will fluctuate, depending specifically on the performance of the underlying investments. Fixed annuities can also be held in a separate account and offer fixed interest guarantees. In the highly unlikely event the insurance company becomes insolvent, separate accounts are not attachable by the insurerís creditors and are normally distributed immediately to the contractholders. A wide variety of funds and fixed options are available to the contractholder in the separate account.
The general account of an insurance company houses all of its assets. Within the general account, the insurance company offers some product fixed account options that complement the variable and fixed annuity separate account choices. The fixed account can be structured in any number of ways, but it most frequently resembles a traditional fixed annuity, many with multiple-year interest rate guarantees.
Annuity Payout Options
Whether you're buying an immediate annuity or converting a deferred annuity into income payments, your options are essentially the same. You can choose to receive payments monthly, quarterly, semi-annually or annually. You can receive a specific amount or choose a specified period of time in which to receive payments. You can choose an option that will guarantee income payments for as long as you live.
The most popular income options are:
Life Only or Straight Life - Income payments are guaranteed for as long as you live. At death, income payments stop. This option may be a good choice if you think you will live longer than the average life expectancy.
Cash Refund - Payments are guaranteed for life. Plus, if you die before all of your original purchase payment has been returned to you, your beneficiary(ies) receives the balance in a lump sum.
Installment Refund - Similar to cash refund option, except in this case, your beneficiary continues to receive income payments until the principal has been returned in full.
Period Certain - Income payments are guaranteed for a specified period of time. If you die before the end of the ìperiod certainî, payments continue to you beneficiary(ies).
Life with Period Certain - Income payments are guaranteed for a specific number of years. Plus, payments continue beyond the "period certain" for as long as the annuitant lives.
Joint and Survivor - Based on the lives of two people, income payments continue until the death of both annuitants. The plan can be structured so that upon death of the first annuitant, payments continue in the same amount or a lesser amount.
What are the Tax Advantages During the Payout Phase?
When you buy an immediate annuity or ìannuitizeî a deferred annuity, a portion of each payment is considered earnings and a portion is tax-free return of your principal. You are only subject to taxes on the portion of each payment that represents earnings. Once enough payments have been made that you recover all of your tax-free principal, each additional payment will be fully taxable.
Annuitization is an irrevocable decision and there are other, more flexible ways you can access the accumulated value in your annuity
Instead of annuitizing you might want to take withdrawals. In that case, distributions represent taxable earnings first. After all earnings are distributed, tax-free return of principal remains.
If your annuity is inside an IRA, 401(k) or other qualified retirement plan, 100% of each payment will be subject to taxes (unless a distribution represents after-tax contributions into the plan). You should consult your tax advisor regarding your particular situation.
What Other Ways Can I Access My Money?
Most annuities allow withdrawals at least once a year (usually up to 10% of the accumulated value in your annuity) without a company charge.
Another way to receive income from your annuity is through systematic withdrawals. A systematic withdrawal program allows you to enjoy a steady stream of income on a monthly, quarterly, semi-annual or annual basis. Unlike annuitization, which is a permanent decision, systematic withdrawals allow you to start and/or stop your income payments as your needs dictate. You can have the amount of your payments increased or decreased - it's up to you. Systematic withdrawals give you added flexibility without giving up control of your money or your taxes. Systematic withdrawals tax your earnings first. So when all earnings have been exhausted, tax-free return of principal remains.
Ultimately, you can cancel your annuity altogether if you need to access to your money. Insurance companies call this ìsurrendering your contractî. If you surrender your annuity in the first few years, the insurance company will probably deduct a surrender charge. Surrender charges vary from plan to plan, but typically start at about 8% in the first year and decline by 1% each year thereafter until they completely disappear. If you surrender a contract (or make partial withdrawals) and you are under the age of 59&Mac189; you may be subject to a 10% federal tax penalty. For most people this isnít a problem because the money they have in their annuities is long-term, or earmarked for retirement.
Recently, some of the more forward-thinking insurance companies have introduced products with no back-end surrender charges.
What is a Market Value Adjustment?
The market value adjustment (MVA) in selected Integrity fixed and variable annuities enables the insurance company to credit competitive interest rates on an array of interest guarantee periods.
The MVA either adjusts positively or negatively. The adjustment applies in the following situations, unless the transaction occurs within 30 days at the end of the related guarantee period:
- Transfers of funds among guarantee periods.
- Partial withdrawal in excess of the free withdrawal amount
- Full withdrawal
No MVA applies if funds are simply held until the end of the guarantee period.
