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
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
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
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
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.
Income from annuity
- The lump sum used to purchase the annuity
- The age and health when annuity is purchased
- Annuity rates at the time of purchase
- Type of annuity
- Any additional options chosen
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
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
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
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.