July 4, 2016
Benefits of an Annuity
Individuals hold more than $2.0 trillion in annuity contracts; a tidy sum considering an estimated $7.4 trillion is held in all types of IRAs.1
Annuity contracts are purchased from an insurance company. The insurance company will then make regular payments — either immediately or at some date in the future. These payments can be made monthly, quarterly, annually, or as a single lump-sum. Annuity contract holders can opt to receive payments for the rest of their lives or for a set number of years.
The money invested in an annuity grows tax-deferred. When the money is withdrawn, the amount contributed to the annuity will not be taxed, but earnings will be taxed as regular income. There is no contribution limit for an annuity.
There are two main types of annuities.
Fixed annuities offer a guaranteed payout, usually a set dollar amount or a set percentage of the assets in the annuity.
Variable annuities offer the possibility to allocate premiums between various subaccounts. This gives annuity owners the ability to participate in the potentially higher returns these subaccounts have to offer. It also means that the annuity account may fluctuate in value.
Indexed annuities are specialized variable annuities. During the accumulation period, the rate of return is based on an index.
Case Study: Robert’s Fixed Annuity
Robert is a 52-year-old business owner. He uses $100,000 to purchase a deferred fixed annuity contract with a 4% guaranteed return.
Over the next 15 years, the contract will accumulate tax deferred. By the time Robert is ready to retire, the contract should be worth just over $180,000.
At that point the contract will begin making annual payments of $13,250. Only $7,358 of each payment will be taxable; the rest will be considered a return of principal.
These payments will last the rest of Robert’s life. Assuming he lives to age 85, he’ll eventually receive over $265,000 in payments.
Robert’s annuity may have contract limitations, fees, and charges, including account and administrative fees, underlying investment management fees, mortality and expense fees, and charges for optional benefits. His annuity also may have surrender fees that would be highest if Robert took out the money in the initial years of the annuity contact. Robert’s withdrawals and income payments are taxed as ordinary income. If he makes a withdrawal prior to age 59½, a 10% federal income tax penalty may apply (unless an exception applies).