Annuities 101: Most commonly asked questions and answers
Read some of our most commonly asked annuities questions and answers and see how they may help you plan for the future.
Information courtesy of USAA Life Insurance Company and USAA Life Insurance Company of New York
Video Transcript: What is an annuity?
Video Duration: 1 minute 50 seconds
Transcript Date: August 4, 2023
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There's a lot to consider when it comes to retirement planning. You might ask questions like: How can I protect my hard-earned retirement savings from market fluctuations? How can I cover basic expenses without a regular paycheck? Will I run out of money if I live a long time? If you're looking for some peace of mind in retirement, an annuity could be a great option.
So, what's an annuity? It's an insurance product that helps protect you against the risk of outliving your money. Here's how it works. When you buy an annuity, you enter a contract with an insurer. You give them money, in exchange, they promise to give the money back to you plus interest at a later date or in the form of a reliable income stream.
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Annuities come in two main forms: deferred and immediate.
Deferred annuities are great long-term savings options. They allow you to grow money tax-deferred with the option to turn into income later. Your money will either grow at a fixed rate or a market-based rate, depending on the annuity you choose. When it comes time to retire, you can take the money out in a lump sum or start receiving scheduled payouts.
Immediate annuities, sometimes called income annuities, work best if you're close to retirement. They let you quickly turn some of your savings into a reliable income stream. When you buy an immediate annuity, you open with a lump sum and start receiving payouts shortly after. You can choose to get guaranteed payouts for the rest of your life, a set number of years or both. You can also add beneficiaries to your contract. That way, you can rest easy knowing your family will be taken care of.
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Ready to find out if an annuity is the right or you? Schedule a call with one of our Retirement Income Specialists.
Description of visual information: [See note1Annuitization permanently converts your principal into an income stream. Once you annuitize, you will no longer have access to your principal as a lump sum. It has no cash value.
See note2Guarantees apply to certain insurance and annuity products and are subject to product terms, exclusions and limitations and the insurer's claims-paying ability and financial strength.
Money not previously taxed is taxed as income when paid. Withdrawals before age 59½ may be subject to a 10% federal tax penalty.
An annuity is a long-term insurance contract sold by an insurance company designed to provide an income, usually after retirement, that cannot be outlived. There are fees, expenses and surrender charges that may apply.
Life insurance and annuities provided by USAA Life Insurance Company, San Antonio, TX and in New York by USAA Life Insurance Company of New York, Highland Falls, NY. All insurance products are subject to state availability, issue limitations and contractual terms and conditions. Each company has sole financial responsibility for its own products.] End of description.
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Although annuities have been around a long time, people still feel confused about what they are and what they do. Read on for a roundup of some of our most commonly asked annuities questions — and answers — that may help you plan for the future.
What's an annuity?
In its simplest form, an annuity is a contract between you and an annuity provider — usually an insurance company. You give the insurer money, and in return, they give you a guaranteeSee note1 to return the money plus interest (deferred annuity) or an income stream starting fairly soon (immediate annuity).
Life insurance versus annuity
It's been said that life insurance can offer protection from dying too young and an annuity can protect us from living too long. Like life insurance, annuities are designed to protect you from risks that might be difficult to manage by yourself. For example, life insurance helps protect us from the risk of dying before or without the means to cover our financial responsibilities. On the other hand, an annuity helps protect us from other risks that come with the need for reliable income, usually for the later stage in life.
Annuities versus investments
Annuities are insurance solutions, not investments. Although some annuities can carry similar features, an apples-to-apples comparison between the two isn't fair. Since annuities are a form of insurance, we buy them to help protect us from some risks where investments alone might not be enough.
IRA versus annuity
An individual retirement account (IRA) and an annuity are similar in that they both provide tax deferral and are generally intended for retirement. An IRA is like a box that can hold certain IRS-approved assets and where earnings are tax-deferred. Although an annuity may be owned as an IRA, deferred annuities are tax deferred products themselves. So, holding an annuity as an IRA might be common, but it doesn't offer any extra tax-deferred benefits.
What types of annuities are there?
Although there are many kinds of annuities, they can be broken down into two basic types: deferred and immediate annuities. A deferred annuity is generally designed to pay out a lump sum or income stream at a later date. An immediate annuity — sometimes referred to as a single premium immediate annuity (SPIA), or an income annuity — pays out income now.
Deferred annuities
A deferred annuity can provide income in the future. It can be purchased with a lump sum or with payments. It becomes tax-deferred over time and can pay out later through withdrawals or by annuitizing (turning all or part of the annuity into an income stream). Deferred annuities are usually offered in three general categories: fixed annuities, fixed indexed annuities and variable annuities. Some annuities, such as fixed indexed annuities and variable annuities, can carry extra features or benefits that might not be needed but carry an additional cost.
Although there are many types of deferred annuities, here are some of the most common types people ask about:
- Deferred fixed annuities could serve as a close replacement for other interest-rate-sensitive investments, with guaranteed growth and without the risk of loss. Deferred fixed annuities may grow in value based on prevailing interest rates. Typically, the interest rate is guaranteed for a period of time, such as five years. After that, a new rate will be set for the next guaranteed period.
- Deferred fixed indexed annuities might provide a lower level of equity participation with protection against losses, but they shouldn't be compared to variable annuities with significant equity holdings. These annuities might give you more risk (but more potential return) than fixed annuities but less risk (and less potential return) than variable annuities. They may also be sold with higher fees than simple deferred fixed annuities.
- Variable annuities can be complex, but at their core, these annuities are intended to provide the buyer with a larger degree of market participation by using investment sub-accounts. Variable annuities can carry a variety of other guarantees, such as minimum growth, protections against some market losses, minimum withdrawals and minimum income. The guarantees can come at a price, so it's important to review these contracts carefully.
- Deferred income annuities (also known as DIAs, QLACs and ALDAs) are designed to address one of the key problems in retirement planning: estimating how long someone will live. Planning for uncertain longevity can be difficult, but a DIA can offer an insurance solution. For example, a 65-year-old who purchases a DIA that pays lifetime income beginning at age 85 (a 20-year deferral period) doesn't have to worry about making savings last for an unknown future lifetime. Instead, they can focus on making savings last 20 years (age 65 to 85). If held within a retirement plan, a DIA, under Qualified Living Annuity Contract (QLAC) rules, allows for the deferral of required minimum distributions (RMDs) until age 85.
Immediate annuities
An immediate annuity offers immediate income. They're usually purchased with a single lump sum and start paying out an income stream within a year of purchase. Immediate annuities have been around for centuries as a tool for providing stable retirement income during retirement.
- When people include immediate annuities in their retirement planning, they could reduce the risks of outliving their resources, reduce volatility in their overall retirement portfolio and help minimize the impact of retiring during a time of low or negative market returns. At a minimum, consider using an immediate annuity to create an income floor that covers any gap between your guaranteed income and essential retirement expenses, such as food, shelter, utilities and insurance.
- A unique feature of immediate annuities is what's known as longevity crediting or mortality crediting. This feature allows the insurer to pay out a guaranteed benefit over a longer time period. With an immediate annuity, premiums paid by those who die earlier than expected contribute to gains for the group of immediate annuity contract owners. As a result, survivors in the group, known as a pool, receive a higher yield, or credit, than could be achieved through individual investments outside of the pool.
Although there are many types of immediate annuities available, here are two of the most common types that people ask about:
- Fixed immediate annuities have periodic payout amounts that stay the same, or are fixed, for life or a stated period. This type of annuity can be useful for those seeking safe, steady income, and who may have other resources to manage inflation.
- Variable immediate annuities start paying out right away, the same as a fixed immediate annuity. But unlike fixed immediate annuities, the periodic payment amount from a variable immediate annuity can fluctuate based on the underlying portfolio's performance. This kind of annuity might work best for those who want steady income but are willing (or who need) to take on a degree of risk with fluctuating payments.
How does an annuity work?
It's important to understand how annuities work when it comes to the accumulation versus payout (or annuitization) period, some tax considerations, and how minimum required distributions work with annuities.
Accumulation period versus annuitization period
During the accumulation period, you put money into the deferred annuity to grow over time. When the money is needed later (usually for retirement), the annuity can pay out either a steady stream of income (annuitization) or variable sums.
Tax options for owning an annuity
Annuities can be owned inside or outside of an IRA or retirement account (qualified accounts). Deferred annuities grow on a tax-deferred basis. Withdrawals or income are taxed as ordinary income if held in a qualified account, tax-free if held in a Roth account or partially taxed if held in a nonqualified account. Immediate annuity income from a qualified account is fully taxable, tax-free if held in a Roth and partially taxed using what is called an exclusion ratio calculation if held in a nonqualified account. With most nonqualified annuities, the idea is for the owner to wait at least until age 59½ before making withdrawals without penalties or fees.
Annuity minimum distributions
If the annuity is held in a traditional IRA or retirement plan (qualified accounts), the IRS-required minimum distribution rules apply. For qualified accounts, the amount annuitized is considered by the IRS to have met the minimum distribution requirements. Although there are no minimum distribution requirements for nonqualified annuities, the earnings on the annuity are taxable as ordinary income.
What are the pros and cons of different annuities?
Think of an annuity as a tool in your tool chest. Each tool usually performs different functions, and some might be able to do more than one task. Still, just as it's hard to compare the pros and cons of a screwdriver versus a wrench, the same thing applies to annuities. Similarly, a $5 screwdriver may be all you need for a simple task, versus a $30 ratchet. As such, it's more important to consider the type of annuity best for you based on your needs and goals. The following can help point you in the right general direction.
Which type of annuity fits your needs and goals?
Consider the following two scenarios:
- Retirement is far away, but you want some guaranteed savings, OR
- Retirement is getting closer, and you will need some guaranteed income.
If you'll need the money in the future, then a deferred annuity may be appropriate. The following explains which might best fit your needs if you also want the following features or benefits:
- If you want a guaranteed rate of return, you may want to consider a deferred fixed annuity,
- If you want some potential for market gains, you may want to consider a deferred indexed annuity,
- If you want more potential for market gains, you may want to consider a deferred variable annuity.
- If you want more potential for market gains and an option that includes minimum income and withdrawal benefits, you may want to consider a deferred variable annuity with guarantees for minimum income or withdrawals.
- If you want guaranteed income starting much later, you may want to consider a deferred income annuity.
Now, consider this third scenario:
- You're retired and want or need guaranteed income now.
If you'll need the money now, an immediate annuity might be appropriate. The following explains which might best fit your needs if you also want the following features or benefits:
- If you want income for as long as you live, you may want to consider a life only immediate annuity.
- If you want income for a fixed period of time only, you may want to consider an immediate annuity with a period certain. You can also add a beneficiary who may continue getting paid if you die before the guaranteed period ends.
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Note: You can combine the first two benefits to achieve income for life and a guaranteed period of time. You can also add a beneficiary who may continue getting paid if you die before the guaranteed period ends.
- If you want inflation protection, you may want to consider an immediate annuity with a future increase rider.
- If you want a return on your money if you die early, you may want to consider an immediate annuity with return of premium benefit.
What's the best age to get an annuity?
A lot of the decision-making boils down to your needs and goals (see previous), your age and your life expectancy. Consider the following:
- Deferred annuities could be a good choice when you have some time for accumulation, you want to dedicate a portion of your assets to a particular want or need, such as establishing a stable floor to generate retirement income, or you're seeking a degree of creditor protection.
- Immediate annuities might make sense if you need a stable source of retirement income or want to supplement other retirement income. Since immediate annuities include three payout components — return of principal, interest earned and longevity credits — the timing matters. You can think of longevity credits as the money unclaimed by those in the insurance pool who die early. Those who continue to live are the beneficiaries of these credits. Although it's complicated, the initial payout rate for immediate annuities is generally higher the older you are.
Annuities are not a one-size-fits-all solution. It's important to educate yourself about annuities before you make a decision (visit the FINRA websiteSee note2). To learn more about how annuities can fit in your retirement strategy, call a Retirement Income Specialist at 800-531-3392.
Comparison of Features with Different Types of Annuities
IMPORTANT: Annuity features, requirements and alternatives should be discussed with your financial advisor or qualified legal and tax counsel. Consider the following:
- Annuities may not be as liquid as other alternatives and usually requires a long-term time commitment.
- Initial sales charges, commission and ongoing fees can vary between types of annuities and providers.
- Annuities could be subject to surrender charges by the provider or IRS penalties for withdrawals before age 59½.
- Most annuities are backed by the ability of the provider to pay. Therefore, the financial strength of the provider is vitally important.
- Understand how annuities can be owned (usually must be a natural person).
- Consider estate planning and gifting considerations before purchasing an annuity.
- Consider the taxation of annuities upon distribution or for beneficiaries.
- Know the required minimum distribution (RMD) rules for qualified annuities and how they can affect your beneficiaries. The ability to aggregate RMD rules within a qualified annuity contract can vary among providers.
- Understand the different parties involved with an annuity: contract owners, annuitant and beneficiary.
- Consider how other fixed income financial solutions may serve as alternatives to annuities.