What you need to know about annuities
An annuity is a financial contract issued by a life insurance company that offers tax-deferred savings and a choice of payout options (income for life, income for a certain period of time or lump sum) to meet your needs in retirement. Credit: iStock
Guaranteed income for life, especially in the aftermath of a deep recession and financial crisis, sounds wonderful. That must be why insurance companies are ramping up their marketing of annuities, which are a complex subject. This week, I'll cover the basics. Next week, I'll address the upsides and downsides of annuities.
An annuity is a financial contract issued by a life insurance company that offers tax-deferred savings and a choice of payout options (income for life, income for a certain period of time or lump sum) to meet your needs in retirement. Because the contract enjoys tax-deferred treatment, the IRS may impose a 10 percent early withdrawal penalty for some distributions if they are taken before age 591/2.
The concept of trading a lump sum of money for a stream of income is easy to understand, but annuities come in lots of flavors, which can make them confusing. The two big categories of annuities are "immediate" and "deferred."
In an immediate annuity, payments begin immediately or within one year of the policy's issue. These contracts are also referred to as "single premium immediate annuities" or SPIAs because they are usually purchased with a single deposit. SPIAs can help you manage the risk of outliving your money, which is known as "longevity risk."
A deferred annuity has two phases: the accumulation phase, during which your money grows on a tax-deferred basis; and the payout phase, during which you begin to receive scheduled payments. There are several types of deferred annuities to consider:
When an insurance salesman, a financial adviser or a broker broaches the topic of annuities with you, get answers to these six questions:
Annuities are notoriously expensive (more on the fees in next week's column), so you will want to understand the total costs, which include mortality and expense charges, commonly known as "M&E" fees, administrative fees, underlying fund expenses, charges for special features and the salesperson's commission.
Before the financial crisis, this question seemed silly, but now we know that insurance companies can go broke. Since the success of an annuity is predicated on the survival of the insurance company, it's important that the company be highly rated.
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