What is an Annuity?
An annuity is an investment type. Retirement plans can be invested in mutual funds, stocks, bonds, CD’s, and annuities.
An annuity contract is a type of insurance contract that functions as an investment account and pays that annuitant (usually the employee) monthly payments, for a set period of time, or until the annuitant dies.
The annuitant makes an investment in the annuity either in a lump sum or a series of payments. The annuity then makes payments to you on a future date or series of dates.
The size of payments is determined by several varying factors, including the length of your payment period. Your payments also vary depending on whether you opt for a fixed or variable annuity. A fixed annuity gives you a guaranteed payout, for each period.
A variable annuity provides you with a payout stream that is determined by the performance of your annuity’s underlying investments.
There are two major types of annuity contracts: immediate and deferred. These both refer to when you begin to receive payments from your annuity. An immediate annuity begins paying out immediately, upon investment.
What is a Deferred Annuity?
A deferred annuity is an annuity that begins payments to the annuitant, at a preset date in the future. These plans can be either variable or fixed.
Deferred annuities have two main phases: the savings phase (when you invest money into your account), and the income phase (when the plan is converted into an annuity and the payments are received).
Because payments are delayed, deferred annuities generally pay more than immediate annuities.
How Do Deferred Annuities Work?
Deferred annuities begin when funds are deposited with the life insurer. These funds are then credited to an account in the name of the annuity owner. The life insurer then credits the account balance with a fixed rate of interest.
This interest rate is guaranteed for a certain amount of time, generally from one to 10 years. When this initial period is over, the interest rate is reset, usually for one year periods.
Many annuity contracts guarantee that even if interest rates fall too low, the account will not fall below the minimum. Withdrawals from deferred annuities are usually allowed, but with certain limitations.
If a withdrawal exceeds 10 percent of the entire account, the insurer will charge a surrender fee on the excess. This fee can range from 7 to 15 percent on a declining schedule. Each year, the surrender fee drops by one percentage point, to zero.
After the surrender fee reaches zero, the annuity owner can withdraw any amount of funds without a penalty. Still, even without this fee, any withdrawals are taxed as ordinary income.
Any withdrawals, as with a traditional IRA, made before the age of 59 ½ are subject to a 10 percent penalty.