Annuity Options Explained — A Fast Guide to Deciphering Annuity Choices
Are you considering different annuity options for your retirement portfolio? An annuity is a type of insurance product, purchased from a life insurance company and/or an annuity company. Annuities are popular retirement options due to the safety they offer for your money, the potential for tax-deferred growth, and their reliability for giving permanent, lifelong income.
That being said, sometimes it can be confusing when you try to make sense of different annuity types, contract features, benefits, and downsides. Since you would commit a sum of your money to an annuity contract for a period of time, it’s prudent to do research and develop an understanding of your annuity options before committing to any financial decision. Here is a short guide to help you get started on understanding the different annuity options.
Fixed Annuities
There are a number of annuity options of the “fixed” variety. These types of contracts come with a guaranteed, fixed interest rate. The insurance company also guarantees your principal, or original sum of money put into the contract. A fixed insurance contract tends to offer a high degree of safety and lower risk for retirement money.
Annuity contracts of the fixed variety include: a fixed annuity, a fixed index annuity, and a multi-year guarantee annuity – also known as a fixed-rate annuity. Within these fixed-type contracts, the insurance company will guarantee the principal that you put into the contract and provide you with a guaranteed interest rate over time. This is a low-risk instrument with terms that can range between 3-12 years.
Generally speaking, when purchasing other fixed-type annuities, an investor can opt for a multi-year guaranteed rate with a higher rate during the first year and slightly lower rates over the upcoming years. This gives retirement savers a fixed blended rate over the duration of the contract. Alternatively, you can also choose a banded interest rate, which guarantees a very high interest rate the first year, and a fluctuating interest rate in the coming years, with a guaranteed minimum rate of interest.
Fixed Index Annuities
As mentioned earlier, fixed index annuities are one type of overall fixed insurance contracts. They are a low-risk instrument, but interest gains are tied to an index, like the S&P 500 price index. In this case, the insurance company might credit your contract the higher of the two interest rates – a minimum guaranteed interest rate, which can range between 0-2%, or an interest rate based on the values of the linked index.
Why potentially 0%? It’s because the insurance company protects your money when the index experiences negative changes in value. When the index “goes down,” the insurance carrier keeps your principal and earned interest intact, so your fixed index annuity doesn’t lose value due to negative index changes.
Market Value Adjusted Annuities
Another option when it comes to fixed annuities is to opt for an annuity with a market value adjustment (MVA). Contracts with an MVA are called market value adjusted annuities. The interest rates on market value adjusted annuities are typically slightly higher than regular fixed annuities. This is because the insurance company shares some of its risk with the annuity contract owner.
While your principal and interest rates are fully guaranteed if you carry the annuity to term, if you choose to withdraw before the term is up, there may be higher surrender charges depending on whether interest rates rise or fall.
Variable Annuities
Unlike fixed annuities, variable annuities are securities products. The insurance company will create a portfolio of investments on your behalf, sort of like you would with mutual funds. Of course, this means that you have the potential for much higher returns on investment. But the trade-off is you hold much more market risk, or the potential to lose money when in-contract investments fall in value.
You can have your principal guaranteed within some variable annuity products. However, it can be expensive. You will most likely pay hefty insurance and administrative fees for that benefit.
When purchasing a variable annuity, you will have to pay annual fees on the core annuity, surrender charges if you choose to withdraw your money early, and optional rider fees, depending on the additional features you may want.
As with all annuity contracts, you will pay a 10% penalty to the IRS if you make withdrawals before you are 59.5. Income tax will apply to your withdrawal sums, as well. While surrender charges and IRS penalties are similar to those of other annuity options explained in this post, annual fees and optional rider fees might be especially costly with variable annuity contracts.
All told, variable annuity costs can range from 2-7% per year, depending on a number of factors, including contract riders and the fees you might be paying for them. These costs put additional weight on the need for the investments within the contract to perform well.
Qualified vs. Non-Qualified Annuities
The terminology “qualified annuities” and “non-qualified annuities” applies to both fixed and variable annuities. The difference between the two is the type of money you are putting in the contract.
In the case of a qualified annuity, you are putting in pre-tax money, or funds that have not yet been taxed by the IRS. This money will grow tax-deferred. Then it will be taxed once you begin taking withdrawals from your annuity at a rate determined by your tax bracket at that moment.
A non-qualified annuity is designated by the IRS as when you have already paid taxes on the money that you are putting into the annuity. That means that when you withdraw it later on, only the earned interest will be subject to income taxes.
Deferred vs. Immediate Annuities
Once again, the annuity options explained earlier in this article can be deferred or immediate contracts. Deferred annuities are long-term instruments, which can be left alone for years before you begin to withdraw money from them.
If you want to avoid unnecessary penalties, it makes sense to avoid making withdrawals before you turn 59.5. So anything you put into an annuity before that will typically be deferred to a time when you expect to need income, which is often after retirement.
On the other hand, an immediate annuity starts paying income benefits almost right away. Your income payments may begin anywhere from one month to a year later. More information about immediate and deferred annuities, and other definitive contract features, can be found on our Annuity Types page.
Lifetime vs. Fixed Period Annuities
Another thing to consider when purchasing an annuity is the payout terms you want to establish. One option is to have the annuity paid over a fixed period of time, for example during 10 years. In this case, the amount to be paid will be calculated based on the principal and the interest rate.
The other option is to have the payments spread out over a lifetime, or until the recipient, also referred to as the annuitant, dies. In this case, the insurance company will use actuarial variables, including the person’s age, the contract amount, and an interest rate to determine monthly or annual payments. You can also add a guaranteed period in case the person dies very soon after the annuity starts paying out. This contractual guarantee can ensure that the policyholder’s heirs will continue receiving payments for a specific period of time. If you would like to learn more about the lifetime income benefits of annuities, including more about income riders, check out this article on Guaranteed Lifetime Income.
Some Final Thoughts on Different Annuity Options
There are many conditions to consider when exploring your annuity options. A retirement investor needs to consider the contract term and conditions, contractual features and benefits, what types of guarantees they get, and how strong those guarantees will be, depending on the insurance carrier’s financial strength and claims-paying ability.
You will want to consider other variables, including potential payout terms, how long it might be before you need your money, and what type of money you will want to pay into the contract. Additionally, be sure to assess how much risk you would like to have within the annuity. If financial safety is important, contracts of the fixed variety may be more appropriate.
Finally, be sure to look out for the best guarantees from the insurance company, including interest rates that can benefit you. It’s also important for you to understand all the terms and conditions of any annuity contract you may be exploring. Working with a financial professional who understand these contracts is a prudent course of action.
You may want to create a comparative analysis of different annuity options and have a financial professional explain them to you. Here at SafeMoney.com, insurance and financial professionals stand ready to help you.
Use our “Find a Financial Professional” section to connect with someone directly and schedule a no-obligation initial consultation. And should you need a personal referral, call us at 877.476.9723.
