Typically, annuities are an investment which can be paid either in single lump sum or through installments over a period of years in return for which a specific sum is received every year, every half year or even every month either for life or for a fixed number of years of the annuitant.
Most often annuities provide income and solace during one's retired life by offering a solution to one of the biggest financial insecurities of old age, that is outliving one's income. That is why they are also called pension plans.
In a way, annuities can be described as a type of insurance plan, akin to the social security in the US, where a planned amount of money is deferred into a fund which can be accessed by the owner at discretion anytime after a particular age or time period.
Types of annuity
Fixed annuities and Variable annuities
In case of a fixed annuity, a guaranteed interest rate is earned over a specific period of time. As and when this period expires, a new interest rate is set for the next period of time. However, fixed annuities are not backed by the Federal Deposit Insurance Corporation.
Variable annuities offer a much wider range of investment funding options. Since the performance of variable annuities depends on the investment options of the principal, returns are not guaranteed. However, there are a few variable annuities which offer fixed accounts alternative that guarantee principal and interest similar to the fixed annuities. The funds can be divided between low risk and high risk option such as stocks.
How annuities work?
In a tax sheltered annuity which is a kind of retirement plan, a fixed amount of money is deducted from paycheck, prior to taxes and taken as contributions to the retirement plan. Here the taxes on the earnings of the retirement plan are deferred until the annuitant decides to take money from it. Investment on such annuity plans tend to grow faster than any savings account as the tax free interest accumulates over time and provides a higher income in retirement. The principal amount is protected in this kind of annuity and the plan also fetches income which consists of interest or the earnings that the retirement plan would earn.
In order to make more people reap the benefit of this annuity plan, tax sheltered annuities are made available even to persons who work for non tax exempt organizations as well.
This can be done in two ways. Either premium amount can be paid in one lump sum or make ongoing contributions and buy flexible payment annuity. In case of the latter, one can contribute money any time. Variable annuity also allows one to transfer money from one account to another without having to pay taxes on earnings as a result of the transfer. However, variable annuities are likely to cost more than a fixed annuity and one ends up paying higher fees than with a fixed annuity.
If annuity is for saving money for retirement, a fixed tax deferred annuity should be the best option. Greater money can be accumulated over an extended period of time. But if the money is needed before age 59 then heavy penalties may be applied for the withdrawal. Therefore think carefully before opting for tax deferred annuity. This will not suit short term withdrawal options.
Purchased life annuities can be bought anytime with one's own funds. They are not pension based and do not provide any retirement income. They are taxed differently from pension annuities.
Another type of annuity that can be purchased is immediate annuity. One time payment should be made and usually distributions begin within 30 days. Immediate annuities can either be fixed or variable. Immediate annuities can provide a stable guaranteed income for a selected period of time. It is a wise option if a financial vehicle that can provide guaranteed income for life is sought.
Payments from annuity
Income from annuity may be immediate or deferred. As such there are three common choices for annuity payment terms:
Life only annuity payments: Here the payments continue as long as one lives but stops immediately upon death of the annuitant. Even if it is forty or fifty years, the guaranteed payments will continue, provided the insurance company also stays in business. It should be remembered that even if the annuitant passes away one year later, the insurance company will not return the principal to the heirs. This plan suit singles with no children and is not ideal for married couples. However, a life only annuity term yields higher monthly income than a joint life term.
Joint life annuity payments: This is more suitable for couples and is structured similar to life only, by payments will continue as long as either spouse lives. In this plan income will continue to the surviving spouse though it is a lower monthly income than life only option. There are pension plans which allow an option of 50% benefit or 75% benefit instead of 100% benefit to the surviving spouse. This option allows the spouse to utilize a portion of the pension income upon death of the husband/wife though not all of it.
Term certain annuity payments: means that payments are guaranteed to be made for a minimum of ten years. This means payments will continue to the named beneficiary until ten years from the first payment had passed. After ten years the payments stop. This plan should be a good way to provide income in situations where a secondary source of income will start at a later date.
Annuity and insurance
On the death of the annuitant or after the fixed annuity period expires for annuity payments, the invested annuity fund is refunded with a small addition calculated at that time. Annuities differ from life insurance in that an annuity does not provide any life insurance cover but offers a guaranteed income either for life or a certain period.
An annuitant can receive guaranteed income throughout life by buying annuity. Also lump sum benefits for the annuitant's estate in addition to the payments during annuitant's life time can be earned.
There are ways and means to obtain higher rate than the standard amount offered by the provider. For instance, the open market option lets one transfer pension funds to a company offering better returns before the benefits are drawn. Similarly, an impaired annuity should suit if the owner or partner is suffering from a serious medical condition as this gives better annuity rate.
A beneficiary can be termed as a person who receives assets on the death of the owner of a contract. The contract owner can pick the beneficiary either at opening the account or later.
Primary beneficiaries: In the event of death, the first person who can claim the assets is the primary beneficiary. There can be multiple primary beneficiaries in some cases. For instance, in case of 3 primary beneficiaries, each of them would receive 33.3% of assets.
Contingent beneficiaries: They are used as a backup. In case there are no living primary beneficiaries, the contingent beneficiary claims the assets. For instance, if the husband has chosen his wife as the primary beneficiary, and she is killed along with him in an accident, the assets will go to a contingent beneficiary. Owners can name more than one person as beneficiary and there are annuity owners who can choose several persons.
By assigning a beneficiary, the owner makes it clear who would receive the proceeds of any asset in the event of his/her death. This eliminates any probable disputes that may arise among family or friends who might contend to receive the assets. Choosing a beneficiary also speeds up things as there is no need to wait for probate processes since a named beneficiary can claim assets as soon as the decedent's death is documented.
Most financial institutions allow an account owner to change beneficiaries. This is because the beneficiary selections are bound to change with marriage, divorce, birth and death. Annuity beneficiaries like other inheritors can be subject to taxes. However, annuities are far less susceptible to these issues than any other forms of inheritance as they are channeled through an insurance company.
Annuity beneficiary should be chosen wisely. If an annuity beneficiary decides to take all the inheritance at once or if the beneficiary is as such wealthy, then higher taxes may be levied when the inheritance takes place and much of the annuity money may have to be paid to the government.
A deferred annuity is not taxable till the right to receive the same arises. All other forms of annuities including those made under a will or granted by life insurance Company, or accruing as a result of a contract come under the head 'Income from other sources' and assessed under income tax act.
Most of the annuities are non qualified and unlimited after tax contributions to them and their earnings grow tax deferred. These tax deferred earnings are alone subject to income tax at a later date. A qualified annuity is regulated under government rules as a retirement plan. All contributions to them are deductible from a working income.
Similar to other qualified plans, any withdrawal made before reaching the stipulated age will have a penalty tax imposed on it in addition to income tax. Income tax is imposed on annuitization, accumulation withdrawals, gifts of an annuity, and beneficiary withdrawals.
Gifting the deferred annuity to any person or trust triggers income tax on the annuity earnings and any 10% penalty tax as well. In case of annuities going to beneficiaries and survivors, it is considered as income in respect of a decedent and not as an investment and hence subject to income tax to the extent that money paid out to them exceeds the annuity basis.
An annuity provides the option to convert a portion of savings into a stream of payments. Annuities are guaranteed income for the rest of one's life. It should be the right choice for someone who proposes a planned and peaceful retired life as well.