Annuity – Annuities are generally understood to be safe, secure investments largely free from the ebbs and flows of market volatility. Of course, to get the most bang for your buck, you should choose an annuity that reflects your willingness to take on risk, your financial goals, and your preferred payout options. A multi year guaranteed annuity may or may not be the right one for you.
We’ll help you identify the differences between different types of annuities to see which is best suited for your goals.
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What Is an Annuity for?
At the most superficial level, it is a contractual agreement between you and your insurance company. You pay money upfront, either in a lump sum or a series of premium payments (often 5-10 years), and the insurance company is contractually obligated to pay you an annual income over a set period of time. These payments are tax-deferred, meaning that you will likely pay less tax when you withdraw your annuity since odds are, you’ll be in a lower income bracket.
Each type of annuity incurs some level of risk, some more than others, and each has differing payout options. There are two distinct ways to categorize annuities: by payout option and by type. Think of the annuity ‘type’ as choosing the payout option, the risk you’re willing to incur, and the premium type.
Annuity Payout Options
Categorizing annuities by payout is relatively simple: determining when you start receiving payments and for how long you receive them. The two categories of annuity payout options are immediate and deferred annuities.
Immediate annuities, sometimes referred to as income annuities, allow you to start receiving payments as soon as you purchase your annuity. Individuals often rely on this option when they are ready to leave the workforce but still want to keep a steady income.
For example, people often use a 401(k) to fund an immediate annuity, maintaining financial stability by “locking away” the money in exchange for a steady income.
Deferred annuities, as the name suggests, are annuities that start paying out at a later date. Most people who choose deferred annuities aren’t ready to retire yet, but they have a rough date in mind. As a result, they decide to invest in a deferred annuity.
These types of annuities have a slight advantage over immediate annuities in that they are tax-deferred, meaning that you will pay less tax on your annuity income when you withdraw it, providing stable, protected income for a lifetime after retirement, protecting against the risk of outliving retirement savings.
Annuity Types Based on Payout
In addition to when you start receiving your money, payout options are categorized by how long you continue to receive payments.
Lifetime annuities guarantee income for the duration of your lifetime, even potentially allowing your beneficiary to continue receiving payments after you are gone. However, this classification of annuity is subject to case-by-case terms, influenced primarily by your health and age.
By contrast, fixed-period annuities offer income over a period of 20-30 years, sometimes more. These annuities are extremely simple by design, giving you a clear picture of what you’ll get out of your annuity over a 20 to 30-year period. Unlike lifetime annuities, the income you receive from fixed-period annuities does not change.
Annuity Types Based on Risk
How you choose to receive your payouts is an integral part of your annuity, but another factor to consider is risk. As mentioned, annuities are a relatively safe investment, even compared to other “safe investment options” that are subject to market volatility.
However, different annuity types can yield different rewards: low-risk and predictable reward, a high-risk opportunity for a significant reward, or a moderate reward with the promise that the annuity won’t sink below a certain threshold.
The most stable choice is a fixed annuity because it offers the least risk and the greatest predictability. They come with a fixed interest rate relating to the contract terms. Regardless of how the insurance company’s investments perform, your interest rate remains steady.
There are a couple of exceptions. Some fixed annuities will ‘reset’ the interest rate based on market factors, potentially harming the fixed interest rate you are receiving. In a similar manner, multi-year guaranteed annuities offer a fixed interest rate over a short period of time—anywhere from 3-10 years. These investments are ideal for people trying to defer taxes and still guarantee a solid return on their investment.
Variable annuities are the riskiest type of [annuity]. since the amount of income you get is relative to the performance of the subaccounts funding the annuity’s growth. Financial institutions and insurance companies earn most of their money by lending and investing their customers’ wealth.
As such, you share in the profits and losses that the insurance company experiences. If the subaccounts perform well, you benefit. If they do not, then you will receive smaller payments accordingly.
Posing a moderate level of risk, fixed-index annuities answer to a market index. The S&P 500, for example, is an index of 500 of the largest companies listed on the US stock exchange. If those companies do well, it’s a good indicator that the stock market is healthy, which means profit for the insurance company and, by proxy, you.
However, an upper and lower threshold limit the amount you receive, which isn’t always bad. Fixed-index annuities can help prevent you from bottoming out, locking in your minimum payment.
Annuity Types Based on Payment
You have a couple of options to pay for your annuity. You can either pay in one lump sum, referred to as an immediate annuity, or over a period of time, called a flexible premium annuity.
An immediate annuity allows quick access to income for people close to retirement. In contrast, a flexible premium annuity is more common and will enable individuals to prepare for retirement via a deferred annuity.
The Bottom Line
Annuities can seem rather complex, but in reality, they’re just broken up into several categories: how you want to pay for them, when (and for how long) you receive payments, and how much risk you want to undertake for the chance of a higher payout. Ask your trusted insurance agency what annuity types they offer and highlight your financial goals to find the right annuity plan for you!