Annuities are one of the most confounding and controversial products in the “investments” world. I put investments in quotation marks, since annuities are actually life insurance products, and not strictly investments. You may find these definitions helpful.
What are Annuities?
Annuities are life insurance contracts designed to exchange premium payments for lifetime income. The conversion to lifetime income – called annuitization – is usually irreversible, meaning you can’t get your principal back.
Annuity Company Reviews
Annuity company ratings are very important. Unlike government bonds or FDIC insurance, the guarantee to pay is only so good as the strength and integrity of the life insurance company.
What Is An Annuity?
A special kind of life insurance contract designed to pay lifetime income. At their simplest, these are basically pension-type products where you irreversibly trade a lump sum for guaranteed lifetime payments. Note the guarantee is only as good as the company, there is no FDIC insurance.
Who Should Invest In An Annuity?
People looking for guaranteed lifetime income similar to pensions or Social Security, which themselves are actually forms of annuities.
Annuity Types
Include fixed, variable, equity index, deferred, and immediate.
Annuities And Income Taxes
Annuities grow tax deferred until withdrawals begin. If before 59 ½, a 10% excise tax is levied in addition to the ordinary income tax. After that, all gain is taxed before the initial investment is recovered tax free. This is called last-in-first-out or LIFO tax treatment.
If annuitized, part of each payment is taxable in proportion to the total profit over initial investment. This is called an exclusion ratio.
In many ways, annuities are taxed much more harshly than alternatives like stocks or mutual funds.
When to Invest In An Annuity
This is a highly subjective topic, depending on individual investor facts and goals. However, annuitizing during periods of low interest rates such as prevail in the early 21st century can run the risk of significant inflation erosion if rates later rise, since payments on most annuities won’t rise with inflation, and because the size of the payment itself is a function of the interest rate, just like a fixed mortgage payment.
For more on this, see When should I buy an annuity? below.
Additional Annuity Resources
Annuities can be extremely complex, and those considering purchasing them – or those who own them and wonder if they need a “rescue” strategy – are wise to deeply study and understand these products before making what could be expensive decisions.
For a very detailed plain language guide called “The Unvarnished Truth About Annuities” written by this author, click here.
I already have a 401(k) or an IRA so why should I consider an annuity?
The annuity decision is different from the tax-type of account used to hold it. While annuities have a number of tax characteristics that are similar to IRAs/401ks, which are basically redundant in these kinds of accounts, as mentioned above, their core function is to provide lifetime income.
The tax-deferral features of annuities often cost more tax in the end than other types of investments, particularly where capital gains treatment is possible (it never is for annuities or IRA-type accounts).
The decision to buy an annuity really boils down to whether it makes sense to exchange principal for lifetime payments, essentially giving up access to capital to buy a pension. This is a very complex decision which will be different for each investor.
What are the two phases of annuities?
These are the accumulation and the annuitization phases.
During accumulation, the balance builds from cash deposits, plus interest or other forms of investment return, and minus fees, charges, and any commissions or surrender charges encountered.
During the payout or annuitization phase, the access to the accumulation account is given up, and payouts for life occur.