An annuity is a financial product wherein an investor can create their own pension plan that will provide them with supplementary income during their retirement
Annuities are purchased as contracts from insurance companies, often featuring life insurance components, and come in four main forms: deferred variable and fixed annuity, and variable and fixed income annuity.
Tax-deferred annuities have the advantage of letting profits compound over time. Once an investor retires, they have the option to receive their investment income as a lump sum or a lifetime income stream. Taxes are only applied when the amount is withdrawn. Tax-deferred annuities are subject to income taxes on withdrawal and carry a 10% IRS penalty if withdrawn before the investor is 59 ½ years old. Otherwise, the annuity has the possibility of sealing up the investment amount for a set time period, the maximum being 15 years.
Deferred variable annuities are tax-deferred annuities that may provide sufficient investment income if the investor is willing to subject their savings to market risks
Their performance is widely dependent on the performance of financial markets. Variable annuities carry a charge of 2.3% of assets on average, compared to a mutual fund’s average of 1.3%. Variable annuities are recommended for investors with long-term investment goals or investors who can tolerate market volatility.
Deferred fixed annuities carry the same tax-deferred benefits of variable annuities but carry a guaranteed rate of return. Every few years, the interest rate is changed to reflect market conditions, a rate that is usually higher than a bank certificate of deposit. Unlike variable annuities, a fixed annuity factor in any charges into the fixed interest rate. This means fixed annuities don’t carry the same fees as variable annuities. Variable annuities are recommended for investors who are seeking stable returns and don’t want to have to deal with worries about market risks. It is very common for investors to favor fixed annuities during bear markets.
As opposed to deferred annuities
Which are growth-oriented and recommended for investors with long time horizons, income annuities are guaranteed income sources for investors who have less investment time. This includes investors who are in or nearing retirement. Income annuities are purchased for a lump sum and investors start receiving monthly payments immediately. Income annuities allow investors to redirect energy into more aggressive options outside the annuity since they offer a guaranteed revenue stream for the rest of the investor’s life if needed.
Variable income annuities offer guaranteed income with growth potential that may beat inflation. However, like a variable annuity, it is subject to market movements, and while the payment stream is guaranteed, it is dependent upon the annuity portfolio’s performance.
Fixed income annuities offer steady revenue streams that aren’t dependent on market performance
These annuities also include the cost of living adjustments to keep up with inflation. However, in most cases, if a client’s objective is higher monthly income, they have to settle for a lower initial payout. The older an investor is when the annuity is purchased, the higher their payments are.
The existence of minimum required distributions (MRDs) depends on how the annuity is funded. Annuities also carry annual charges that should also be taken into account when comparing them to mutual funds. In addition, annuities are taxed as ordinary income, incurring higher rates than most investments that are taxed the lower capital gains rate. Since most annuities are purchased from insurance firms and carry a life insurance component, if the contract holder passes before they begin cash withdrawals, their beneficiaries are still guaranteed a payout. The minimum payout amount is equal to the investment.