Annuities 101: The Basics

I recently taught a new class called Annuities 101: The Basics for a class of older adults. Below are nine key take-aways that I shared with my students:

What Are Annuities?- Annuities are a contract between an investor (annuitant) and an insurance company. The investor makes a lump sum payment or series of payments to the insurer and the insurer agrees to make periodic payments to the investor immediately or at a future date. 

Simple But Complicated- While the concept of exchanging payments to an insurance company in exchange for regular income is easy to understand, there are different types of annuity types and tax implications. Annuity features, such as surrender charges for early withdrawals, also vary widely.

Reasons to Buy Annuities- Common reasons that annuities are purchased are to create a “retirement paycheck” (i.e., regular income stream) in later life, for guaranteed lifetime income, and for tax-deferred growth until withdrawal. In addition, non-qualified annuities (annuities not held in a qualified retirement plan) do not have IRS maximum contribution limits like IRAs and 401(k)s.

Earnings Growth is Tax-Deferred- Earnings on non-qualified and qualified annuities are taxed as ordinary income- not long-term capital gains. Qualified annuities are subject to required minimum distributions (RMDs) and contributions + earnings are taxed. For non-qualified annuities funded with after-tax dollars, only earnings are taxed as income. The amount contributed is not taxed.

Payment Options- Depending on the annuity contract, payment period choices can include the life of the annuitant, the life of the annuitant and spouse, and for a fixed number of years. A beneficiary and contingent beneficiary should be named for any remaining payments or a death benefit.

Insurance Company Ratings- Potential annuitants must determine if an annuity issuer (insurance company) is in good financial health. Annuities are not backed by FDIC insurance, like CDs are, but protected through state guarantee associations. Guarantee coverage varies by state. It is wise to check insurance company ratings by companies such as A.M. Best, Standard & Poor’s, and Fitch.

Annuity Fees- Surrender period fees/penalties apply if annuitants withdraw money or cancel a contract early. However, many contracts offer a penalty-free withdrawal (typically 10%) during the surrender period, which provides some flexibility to access funds. Fees on annuities can range from about 0.50% of the annuity’s value to well over 2%. The industry fee average is 2.24%.

Three Key Elements- Annuities can be classified in three ways: 1. By type (fixed, variable, and indexed), 2. By payout date (immediate or deferred), and 3. By purchase method (single premium or payments over time). Fixed annuities are the most widely sold annuity type.

Specialized Annuity Products- Two annuities that are specifically designed for retirees in later life are Qualified Longevity Annuity Contracts (QLACs) and Medicaid Compliant Annuities. Assistance by a professional advisor is highly recommended.

This post provides general personal finance or consumer decision-making information and does not address all the variables that apply to an individual’s unique situation. It does not endorse specific products or services and should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.