How do annuities work? It’s a simple insurance contract. When you buy an annuity, you give an insurance company money and they invest it. Over time, that money earns interest. At a specified date, usually when you’re ready to retire, the insurance company starts paying you back that money, plus the interest it earned.
Why should you care how annuities work? Because it's the only financial product that can guarantee you’ll keep getting paid until the day you die.
This is a huge deal. According to the Center for Retirement Research at Boston College, 50% of US households are at risk of not having enough income to maintain their current standard of living during retirement.*
Annuities are designed to provide you with a steady, reliable stream of income you can’t outlive. Your annuity will keep paying you until you pass away. Compare that to your 401K: when it’s empty, it’s empty. The same applies to IRAs. Other investment options? You’re vulnerable to market drops and downturns. That’s what makes annuities so special.
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How Do Annuities Work? Part One: Accumulation
There are multiple types to choose from: fixed annuities, variable annuities, and indexed annuities, for starters. The differences are in how your account earns interest, but they all function the same way.
The first stage of an annuity is called the “accumulation” phase. This means funding your annuity and letting it grow. There are different types of annuities, so you can pay into it over time, or fund it all at once with a lump sum of cash. If you fund all at once and begin taking payments right away, it’s called an “immediate” annuity.
- The Purchase. When you buy an annuity, you send your payment(s) (all at once or over time) to the annuity issuer with after-tax funds. You can invest an unlimited amount into your annuity.
- The Interest Rate. The annuity issuer then puts your money in their general account. Your contract specifies how your money will be returned, as well as what rate(s) of interest you'll earn during the accumulation phase.
- The Tax Benefits. The compounding interest on your cash accumulates tax deferred. You won't be taxed on the interest you earn until you make a withdrawal or start receiving payments.
- The Fees. The issuer can collect fees to cover the cost of managing your account (after all, they're doing the work to invest that money to earn the interest they're required to pay you). If you withdraw money in the early years of your annuity, you may also have to pay a surrender charge.
How Do Annuities Work? Part Two: Distribution
The second stage of an annuity is called the “distribution” phase. This means you’re over age 59 ½ and eligible to start receiving payments. Because annuities are intended to support you during retirement, you can’t start taking regular payments before that age - just like with your 401(k) or IRA. If you’re not ready at age 59 ½, that’s fine! You can choose when to start receiving payments.
- Early Withdrawals. If you withdraw money from your annuity before you reach age 59½, you'll not only have to pay tax (at your ordinary income tax rate) on the earnings portion of the withdrawal, but you may also have to pay a 10 percent premature distribution tax, unless an exception applies. Your contract will have all the details you need about any penalties for early withdrawals.
- Withdrawals after Age 59 ½. After age 59½, you can make withdrawals from your annuity without any premature distribution tax. Since annuities have no minimum distribution requirements, you don't have to make any withdrawals (if you're still working, for example, and don't need the money yet). You can let the account grow tax deferred for an indefinite period. However, your annuity contract may specify an age at which you must begin taking income payments.
- Getting Paid. When you're ready to retire or just want to start receiving annuity payments, you can annuitize. This means you're exchanging your account's cash value for a series of periodic income payments. The amount you get in each payment depends on a number of factors, including the cash value of your account at the time you decide to start taking payments and the payout option you choose. It's also affected by your age and gender, since statistically, these two factors affect how long you'll live - information the annuity provider needs in order to make sure your annuity payments last throughout the rest of your life.
- Income Tax. You'll have to pay taxes (at your ordinary income tax rate) on the earnings portion of any withdrawals or annuitization payments you receive. These funds are invested as part of the general assets of the issuer and are subject to the claims of its creditors. This is why it's important to pick a strong, financially stable annuity provider - and I can help you do just that.
- After You Die. Many life insurance companies that offer annuities let you pass the remainder of your available cash to a beneficiary as a death benefit. Not all insurers offer this option, however – so if it’s important to you, give me a call and we can look specifically for annuities that offer this as an option.
Is an Annuity Right for You?
That depends – are you worried about running out of income during retirement? Almost 2/3 of Americans say it’s impossible for the average worker to save enough for retirement on their own, according to a 2021 survey by the National Institute on Retirement Security.*
No other insurance products can offer the peace of mind of an annuity. Owning an annuity means you’re guaranteed to get paid until the day you die. If that kind of security sounds like something you need, give me a call! We can talk about how an annuity fits into your retirement plan, or how to combine it with life insurance to make sure you and your loved ones are taken care of.
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*Annuity.org: “Running Out of Money in Retirement: What’s the Risk?”