As you begin to build your retirement strategy, you may be interested in investments that will allow you to build a steady and reliable flow of income. One of the many investment options worth looking into are annuities. An annuity is an insurance product that provides a future stream of income to someone while they’re still alive. In this way, an annuity is different than life insurance, which only pays after the insured person has died.
How does an annuity work?
The owner of the annuity pays a certain amount—either in a lump sum or in a series of payments— to the issuing company. These payments are deposited into the policyholder’s account. In some accounts, a fixed interest rate of return is guaranteed. In others, the interest is calculated at a variable rate.
As with most insurance products, annuities are available in a multitude of variations. It can quickly become overwhelming to sort out the policy types available. While it’s always best to talk with a certified financial planner about your specific circumstances, it’s also a good idea to understand the basics before making an investment in an annuity.
Who’s involved in an annuity
- An insurance company or financial institution, which offers and administers the policy
- The owner of the annuity, who is the person responsible for the premium payment(s)
- The annuitant, who is the person receiving the annuity payments from the insurance company or financial institution. In many cases, the owner and the annuitant are the same person.
- The beneficiary. With some annuity plans, the beneficiary receives payment(s) from the insurance company after the annuitant dies.
Phases of an annuity
There are two simple phases to an annuity. First, there is the accumulation period. This is the time during which you’re making premium payments to the account. After that, you enter the annuity period. This is when you (or a beneficiary) receives payments from the insurance company.
The accumulation period
During this period, you can make premium payments in three different ways:
- Single premium payment – This is most common option. You pay the total premium owed in a single “lump sum” payment.
- Level premium payment – This allows the policyowner to pay the total premium amount over a period of time. You make payments in set intervals, with equal premium payments made each time. Common intervals are monthly, quarterly, semi-annually, or annually.
For example, if the total premium owed is $20,000, you may pay $5,000 once a year for four years.
- Flexible premium payment – In this arrangement, you can pay your premium in varying amounts over varying intervals. This allows you to change the amount and frequency based on your current budget. The insurer usually sets a minimum and maximum premium payment and interval. Everything in between, however, is flexible.
For example, if the total premium owed is $30,000 and the minimum payment level is $50 a month, you could pay that amount, or you could pay $100 every two months for a while, and then switch to $400 every quarter if/when that makes more sense financially.
The annuity period
Similar to premium payments, there are different options when setting the start of the annuity period.
- Deferred annuity – In this case, the annuity period begins after a specified amount of time. This length of time is set when the annuity is purchased. Various factors, like the amount you want to receive, or the frequency of your premium, can influence this.
- Immediate annuity – If you made a single premium payment, there is an additional option available in some plans. In an immediate annuity, the payments from the company begin immediately after the lump sum payment is made. In essence, this is a way to spread out that lump sum payment over a set period of time, with some amount of added interest.
The length of the annuity period is also variable. Included in the most common types are:
- Straight Life Income Annuity – This provides the annuitant (the person receiving the payment) a guaranteed income for the rest of her life. One important thing to note is when the annuitant dies, the payments stop, regardless of how long the contract has been in place. For example, if the annuitant paid $30,000 in premiums and the annuity has paid $10,000 when the annuitant dies, the insurance company does not have to pay back the remaining $20,000 in previously paid premiums. For this reason, the monthly payment amount of a Straight Life Income Annuity is typically lower.
- Refund Life Annuity – Just like a Straight Life Annuity, this pays a guaranteed income for the rest of the annuitant’s life. However, when the annuitant dies, a beneficiary would receive the balance. Using our example above, the beneficiary would receive the remaining $20,000 with this plan type.
How does an annuity work with taxes?
In most cases, you pay your monthly premium to the insurance company on an after-tax basis. This means that, when the insurance company makes payments to you, you are only responsible for paying taxes on the interest accumulated on the original payment amount. For example, if you receive $300 a month, and $100 of that amount is interest from your original payment, you’ll only owe income tax on $100.
If you want to learn more about annuities and the different types available, check out the following resources:
- The Security and Exchange Commission’s guide to annuities;
- the SEC guide to variable annuities; and
- the IRS’s overview of taxes and annuities.
Want to learn more about other tax consideration you need to be aware of in retirement? Check out the article below to continue reading.