A fixed annuity is a contract between you and an annuity issuer, usually an insurance company. In its simplest form, you pay money to the annuity issuer; the issuer invests the funds and pays the principal and its earnings back to you or to your named beneficiary. What’s fixed about a fixed annuity? The issuer guarantees (subject to its claims-paying ability) a minimum rate of interest on your investment and a fixed benefit amount if you elect to annuitize.
Annuity contributions are made with after-tax dollars and are not tax deductible. That’s why it’s often advisable to fund other retirement plans first. However, if you’ve already contributed the maximum allowable amount to other plans and want to save more toward your retirement, an annuity can be an excellent choice. There’s no limit to how much you can invest in an annuity, and the funds grow tax deferred until you begin taking distributions.
Once you begin withdrawing from your annuity, you’ll pay taxes (at your regular income tax rate) only on the earnings, since your contributions to principal were made with after-tax dollars. Like a qualified retirement plan, a 10% tax penalty may be imposed if you withdraw from an annuity before age 59½.
Annuities are designed to be very-long-term investment vehicles. In most cases, if you take a withdrawal, including a lump-sum distribution of your annuity funds within the first few years after purchasing your annuity, you may be subject to surrender charges imposed by the issuer. However, many companies allow options for withdrawals or distributions without incurring a charge. As long as you’re sure you won’t need the money until at least age 59½ and you understand the costs (including fees) involved, an annuity is worth considering.
There are two distinct phases to an annuity contract: the accumulation phase and the distribution phase.
In the accumulation phase, you’re putting money into the annuity. You can choose to pay your premiums in one lump sum, or you can make a series of payments over time. These payments can be of equal amounts made at equal intervals, or of variable amounts at irregular intervals, depending on the terms of the contract.
Annuities may be either immediate or deferred; the terms simply refer to when the distribution phase begins. Immediate annuities are typically purchased with a single payment and the distribution phase usually begins within a year of the purchase. While deferred annuities may be purchased with a single lump sum premium payment, they are most often purchased with a series of periodic payments. The distribution period is deferred until some time in the future.
In the distribution phase, you begin taking money out of the annuity. You may withdraw some or all of the money in lump sums, or you may annuitize. Subject to the claims-paying ability of the issuer, annuitization provides a guaranteed income stream for either a specified period or for life.
* These funds are invested as part of the general assets of the issuer and are therefore subject to the claims of its creditors.
** All guarantees are subject to the claims-paying ability of the issuing company.