In this article, we’ll be breaking down what are annuities, how it works, and the pros and cons of buying an annuity.

What are annuities?

An annuity is an insurance product designed to provide periodic payouts at certain intervals, typically during retirement. You can buy an annuity contract through your employer or purchase a commercial annuity on your own through insurance companies, banks, brokerage firms and mutual fund companies. Annuities aim to offer guaranteed lifetime income and protect against running out of money during retirement. Annuities can be characterized by several factors the type of payout which can either be fixed or variable the timing of when income is payable, either immediate or deferred the frequency and flexibility of the premiums, either single or flexible how they’re funded with pre tax dollars or after tax dollars, which determines how distributions are taxed.

Types of annuity contracts

So there are three types of annuity contracts, the first being a fixed annuity. So this is the most conservative type of annuity where your payments are fixed dollar amounts that are determined when those annuity payments begin. The second type of annuity is a variable annuity, which has a variable rate of return based on the overall market return since your funds are invested by your insurer in a series of subaccounts similar to mutual funds. The third type of annuity is an equity index annuity, also known as an index annuity. This combines the characteristics of both fixed and variable annuities. You’re provided with a guaranteed rate of return, much like a fixed annuity, and you also have the potential for market gains. As part of your annuity is tied to the performance of a specific market-based index.

Rules of an annuity

There are several rules of an annuity, and the first part has to do with immediate versus deferred annuities. So immediate annuities can be paid out in as short as a month, and they’re usually purchased in a one-time lump sum payment. The amount due to you is based on your age, interest rates, and how long the payouts are expected to continue. With a deferred annuity, this delays your payout until a future date. You can purchase a deferred annuity with a one-time lump sum payment, or you can pay into it periodically.

After a length of time of your choosing, you elect your payout to begin. So an annuity has two phases the accumulation phase and the annualization phase. The accumulation phase of an annuity is the amount of time where you’re making payments. With deferred annuities, this takes place over time within the annuity. For immediate annuities, this accumulation of funds comes from some other source, such as life insurance, retirement savings, or an inheritance.

The annualization phase is when you actually begin to receive payments from the annuity, much like a regular paycheck, this can last for a set number of years or for the rest of your life. Payouts include the principal along with any investment gains. Premiums on annuities vary in terms of the frequency and the flexibility of the payment. So there are single premiums and then there are flexible premiums. So a single premium annuity is purchased with a lump sum payment that could come from life insurance, retirement funds, or savings. A flexible premium annuity allows the owner the option to vary premium deposits over time. That can be made in equal installments or can vary in terms of amount and timing.

How are annuities taxed?

Before you begin receiving payouts, annuity, income, and investment gains grow tax-free the taxes you pay on that income and investment gains depend on if you paid for your annuity. Pre-tax or post-tax. Annuities purchased with after-tax dollars are nonqualified annuities and there are no taxes due on the principal income. Taxes are levied only on earnings and interest. Annuities purchased with pre-tax dollars are qualified annuities.

When funds from a qualified annuity are distributed to an annuity holder, the entire amount is taxable because taxes have never been paid on those funds. Consider fees before deciding to buy an annuity because they can sometimes eat into your rate of return and make the annuity contract less worthwhile. So here are some of the common fees that are associated with an annuity. Although this list is by no means exhaustive and it doesn’t apply to all annuities. So first there is an annual fee, which is a flat fee charged for the administration and record-keeping of the contract.

It’s sometimes waived for contract fees over a certain amount. Then you have administration fees which are charged by the issuer to cover the cost of recordkeeping and managing your annuity. This can be charged as a flat rate or as a percentage of your total contract value. Next, you have commission fees, which often contribute to an annuity’s price and are there to pay the person who sold it to you. You can likely avoid annuity commissions by buying from a fee-only advisor who is paid only by you and as a Fiduciary is required to act in your best interest.

Then there are fund expenses, which are the costs that come with the funds your annuity may invest in, like mutual funds. Next, there are mortality and expense risk charges, which pays the annuity issuer for the risk of offering the annuity, such as the annuity holder’s death. It equals a percentage of your annual account value. Penalties Applied if you withdraw from an annuity before you’re 59 and a half, the IRS will levy a tax penalty on top of regular income taxes you owe for the withdrawal amount. Surrender charges apply to variable annuities when you sell or withdraw money during the annuity’s surrender period, often six to eight years after buying the annuity.

Pros of an annuity

You’ll get a guaranteed source of income during your retirement which protects you from outliving your money. Payouts can last throughout your lifetime or over a set number of years, depending on whatever you prefer. You’ll get a stable rate of returns on your investment. The growth on your annuity will be tax deferred, which means you won’t pay taxes on it until you take out the money. And there are no contribution limits, unlike something like an IRA or a can put in as much money or as little money as you want. Here are some of the cons of annuities

Cons of an annuity

You’ll face high fees. There are many fees that you can pay with an annuity, and a lot of them can actually eat into your rate of return. Commercial annuities also aren’t adjusted for inflation and don’t protect you from the risk of losing purchasing power over time. With some annuities, you’re also unable to access your money for several years, meaning your assets are illiquid and in most cases, you’ll pay penalties on early withdrawals. Annuities are also considered taxable income, so you’ll have to pay taxes on your payouts as you receive them. Annuities may also be difficult to understand.