Difference Between Annuities

What is an annuity?

To put it simply, an annuity is a contract with an insurance company in which you would make one or more payments in exchange for a future income stream in retirement. Funds in an annuity accumulate tax deferred regardless of which type is selected. Because you do not have to pay taxes on any growth in your annuity until it is withdrawn, this vehicle is an attractive way to accumulate funds for retirement.

For more information on the basics of annuities, watch this video.

There are a several types of annuities, but for now we will focus on the four most common ones: fixed, immediate fixed, deferred fixed, and deferred variable.

Fixed Annuities

With a fixed annuity, you can fund it either with a lump sum (say, with the proceeds from a large gift) or with regular payments over time. In exchange, the insurance company will pay and income stream that will last a specified period of time.

Fixed annuity contracts are issued with guaranteed interest rates. Although this rate may be adjusted, it will never fall below a minimum rate that has been specified in the contract. This guaranteed rate acts as a “floor” to potentially protect a contract owner from periods of low interest rates.

Additionally, fixed annuities provide an option for an income stream that could last a lifetime. The guarantees of fixed annuity contracts are contingent on the financial strength and claims paying ability of the issuing insurance company.

Immediate Fixed Annuity

Usually, an immediate annuity if funded with a lump sum premium to the insurance and payments begin within 30 days or can be deferred up to 12 months. Payments can be made monthly, quarterly, annually or semiannually for a guaranteed period of time or for life (whichever is specified in the contract). Only the interest portion of each payment is considered taxable income. The rest is considered a return of principal and is free of income taxes.

Deferred Fixed Annuity

With this type of annuity, you can make regular payments to an insurance company over time and allow the funds to build an earn interest during the accumulation phase. During this process, taxes are postponed, and you get to keep more money to work and grow for you. This means that an annuity may help you accumulate more over the long term than a taxable investment. Any earnings are not taxed until they are withdrawn, at which time they are considered ordinary income.

Deferred Variable Annuity

Rather than fixed returns, a variable annuity provides fluctuating returns instead of the usual fixed ones. The key feature is that you get to choose how to control and invest your premiums by the insurance company. Therefore, you decide how much risk you want to take on and you also bear the investment risk.

Most variable annuity contracts offer a variety of professionally managed portfolios called “subaccounts” (or investment options) that invest in stocks, bonds, and other vehicles. A part of your contributions can be placed in an account that offers a fixed rate of return. Your premiums will be allocated with the subaccounts you select.

Unlike a fixed annuity, with pays a fixed rate of return, the value of a variable annuity contract is based on the performance of the investment subaccounts you choose. These subaccounts will fluctuate according to market conditions, in fact, the principle may be worth less than you the original cost of the annuity when surrendered.

Another great thing about variable annuities is that they have the double benefits of investment flexibility and potential for tax deferral. The taxes on all interest, dividends, and capital gains are deferred until withdrawals are made.

When you reach a point where you want to receive income from your annuity, you can choose a lump sum, a fixed payout, or a variable payout. The earnings portion of the annuity will be subject to ordinary income taxes when you begin to receive income. Annuity withdrawals are taxed as ordinary income and may be subject to surrender charges plus a 10% federal income tax penalty if made prior to age 59½. Surrender charges may also apply during the contract’s early years.

Annuities have contract limitations, fees, and charges, which can include mortality and expense risk charges, sales and surrender charges, investment management fees, administrative fees, and charges for optional benefits. Annuities are not guaranteed by the FDIC or any other government agency; they are not deposits of, nor are they guaranteed or endorsed by, any bank or savings association. Any guarantees are contingent on the financial strength and claims-paying ability of the issuing insurance company.

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