An annuity is a contract between you, the purchaser or owner, and an insurance company, the annuity issuer. In its simplest form, you pay money to an annuity issuer, and the issuer pays out the principal and earnings back to you or to a named beneficiary. Life insurance companies first developed annuities to provide income to individuals during their retirement years.
One of the attractive aspects of an annuity is that its earnings are tax deferred until you begin to receive payments back from the annuity issuer. In this respect, an annuity is similar to a qualified retirement plan. Over a long period of time, your investment in an annuity can grow substantially larger than if you had invested money in a comparable taxable investment. Like a qualified retirement plan, a 10 percent tax penalty may be imposed if you begin withdrawals from an annuity before age 59½. Unlike a qualified retirement plan, contributions to an annuity are not tax deductible, and taxes are paid only on the earnings when distributed.
Four parties to an annuity contract
There are four parties to an annuity contract: the annuity issuer, the owner, the annuitant, and the beneficiary. The annuity issuer is the company that issues the annuity. The owner is the individual or other entity who buys the annuity from the annuity issuer and makes the contributions to the annuity. The annuitant is the individual whose life will be used as the measuring life for determining the timing and amount of distribution benefits that will be paid out. The owner and the annuitant are usually the same person but do not have to be. Finally, the beneficiary is the person who receives a death benefit from the annuity at the death of the annuitant.
Two distinct phases to an annuity
There are two distinct phases to an annuity: (1) the accumulation (or investment) phase and (2) the distribution phase.
The accumulation (or investment) phase is the time period when you add money to the annuity. When using this option, you’ll have purchased a deferred annuity. You can purchase the annuity in one lump sum, or you make investments periodically, over time.
The distribution phase is when you begin receiving distributions from the annuity. You have two general options for receiving distributions from your annuity. Under the first option, you can withdraw some or all of the money in the annuity in lump sums.
The second option provides you with a guaranteed income stream from the annuity for your entire lifetime or for a specific period of time. Guarantees are based on the claims-paying ability of the issuing insurance company. This option can be elected at any time on your deferred annuity. Or, if you want to invest in an annuity and start receiving payments within the first year, you’ll purchase what is known as an immediate annuity.
Joint and Survivor Annuity
You can also elect to receive the annuity payments over both your lifetime and the lifetime of another person. This option is known as a joint and survivor annuity. Under a joint and survivor annuity, the annuity issuer promises to pay you an amount of money on a periodic basis. The amount you receive for each payment period will depend on how much money you have in the annuity. Also, it depends how earnings are credited to your account, and the age at which you begin the annuitization phase. The length of the distribution period will also affect how much you receive. If you are age 65 and elect to receive annuity distributions over your entire lifetime, the amount you will receive with each payment will be less than if you had elected to receive annuity distributions over five years.
When is an annuity appropriate?
It is important to understand that annuities can be an excellent tool if you use them properly. Annuities are not right for everyone.
Annuity contributions are not tax deductible. That’s why most experts advise funding other retirement plans first. However, if you have already contributed the maximum allowable amount to other available retirement plans, an annuity can be an excellent choice. There is no limit to how much you can invest in an annuity. As with other retirement plans, the funds are allowed to grow tax deferred until you begin taking distributions.
The big picture
Annuities are designed to be very-long-term investment vehicles. In most cases, you’ll pay a penalty for early withdrawals. If you take a lump-sum distribution of your annuity funds within the first few years after purchasing your annuity, you may be subject to surrender charges imposed by the issuer. As long as you’re sure you won’t need the money until at least age 59½, an annuity is worth considering. If your needs are more short term, you should explore other options. Contact us today for your complimentary consultation and let us help you!
Disclosure:The content provided in this publication is for informational purposes only. Nothing stated is to be construed as financial or legal advice. Sterling Group United recommends that you seek the advice of a qualified financial, tax, legal, or other professional if you have questions.