How Do Annuities Work: Your 101 Guide
If you’re someone planning for retirement, you may have heard the term annuity before. But, what are annuities and how do annuities work?
In this guide, we’ll walk you through what you need to know about annuities, including the different annuity types and how people use them to supplement more traditional sources of retirement income, e.g. Social Security and pension plans.
Let’s get started! You can also download our “How Do Annuities Work” infographic or visit our infographic page.
Annuities
An annuity is an investment that is issued by an insurance company. They’re essentially insurance contracts designed to help supplement your retirement income. Whereas Life insurance protects your family when you pass away too early, annuities can help keep you from outliving your retirement assets.
There are three main types of annuities: fixed annuities, variable annuities, and index annuities. Annuities can also have different payout options, lump sum or payments over a specific period of time or lifetime.
Fixed annuities
Fixed annuities offer the least amount of risk and the most predictability, according to annuity.org. Some Fixed annuities also do not charge any fees to purchase them.
A fixed annuity has a guaranteed fixed interest rate and the safety of the principal. In other words, you’re guaranteed to receive your principal investment back after a specific period of time.
A good way to think about this: “you’ll never earn less than the guaranteed interest rate, regardless of how the insurance company’s investments perform,” says annuity.org. Annuities are guaranteed by the insurance company and Insured by the State Guaranty Association (SGA).
The Purpose of a Fixed Annuity
Fixed annuities are aimed to help meet people’s long-term retirement goals. The goal is for the purchaser to make a single contribution to the insurance company which will then at a later date make a lump sum or periodic payments to the purchaser. In return, the purchaser will also enjoy tax-deferred growth. Note: Those withdrawing funds before the age of 59 ½ may be subject to a 10% withdrawal tax.
Remember: Fixed annuities are a low-risk option that has a guaranteed interest rate and safety of principal. They’re considered low-risk since their interest growth isn’t dependent on the stock market or investment portfolio.
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Variable annuities
Variable annuities are considered a higher-risk option. Unlike fixed annuities, variable annuities don’t guarantee a return.
This is because they’re typically “mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three,” says investor.gov. When you take this option, there’s the chance that you could lose on the money you originally invested.
If you want to learn more about variable annuities and their risks, we suggest you visit U.S. Securities and Exchange Commission’s (SEC) variable annuities page.
Index Annuity
Index annuities have the characteristics of both a fixed and a variable annuity. Their performance is based on an underlying index, but they can also have certain protections built in, as well. Because they’re somewhat in between a fixed annuity and a variable annuity, you can get upside growth potential while also getting some downside protection.
How Does an Annuity Work?
As we mentioned earlier, annuities allow you to pay a set amount of money or payments. In exchange, these payments can become a stream of income for the future. You can choose different types of annuities depending on your risk-comfort and what your goals are. There are two stages to any annuity contract:
Stage 1: Accumulation
The first stage is the accumulation stage or the period where you save and potentially grow your retirement funds and build the cash value of your annuity. This can be through either a lump sum or periodic payments, depending on the annuity.
Stage 2: Distribution
The accumulation phase ends at the onset of the distribution stage. This is when you’re ready to begin spending the money to create an income in retirement. With annuities, this is called annuitization – or the process of converting your annuity into regular payments for retirement. If you don’t want to go through annuitization, you can also just take a lump sum, explains Thrivent.
Let’s Put This Together
“Basically, you buy an annuity with a single upfront payment, or by making a series of payments to the insurance company. Then, the insurance company sends you either one lump sum or multiple payments during retirement,” explains Credit Karma.
A major benefit of annuities is that they’re tax-deferred. So, you don’t have to pay for taxes until you start receiving payments. Check the background of investment professionals associated with this site on FINRA’s BrokerCheck.
Should I Consider Getting an Annuity?
This is a good question to think about if you’re older and have some time before retirement. While different insurance companies’ rules vary, people usually start buying annuities around their 40s and 50s. Annuities can be purchased with funds from either qualified (IRAs or retirement accounts) or non-qualified accounts.
Here, are three key reasons why people buy annuities:
- Tax-deferred growth: You pay no taxes on your annuity until you start receiving payments.
- Guaranteed Lifetime Income: Depending on your annuity, you may receive periodic payments over the span of a select time period or lifetime.
- Death benefits: If you die before receiving your payments, you can name a beneficiary to receive your specific payments.
How Can I Get Started Buying an Annuity?
Before you purchase an annuity, it’s key that you source out reputable broker-dealers and investment advisors that are registered through the U.S. Securities and Exchange Commission (SEC). You can use their free and simple Check Your Investment Professional tool to get started.
Plus, you’ll want to ask your broker-dealer or investment advisor about the risks and fees involved. This way you have a better understanding of what you’re agreeing to. One more important item: Before you invest in a variable annuity, another thing the U.S. Securities and Exchange Commission (SEC) says you should look into is the prospectus and regular shareholder reports using their [SEC’s] website.
Have Questions: Contact First New York Retirement & Investment Services
If you need help, First New York Retirement & Investment Services can assist you with annuities. Our investment professionals can help you better understand annuity products and annuity contracts while helping you determine if an annuity would help you accomplish your long-term financial goals.
To schedule an appointment with one of First New York Retirement & Investment Services’ Investment Professionals, please call (518) 393-1326, extension #1302 or visit the First New York FCU Retirement & Investment Services Advisor’s website or sign in here if you currently have an investment account.
Check the background of investment professionals associated with this site on FINRA’s BrokerCheck.
Disclosure
Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a
10% IRA penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.
This material contains only general descriptions and is not a solicitation to sell an insurance product or security, nor is it intended as any financial or tax advice. For information about specific insurance needs or situations, contact your insurance agent. This article is intended to assist in educating you about insurance generally and not provide personal service. They may not take into account your personal characteristics such as budget, assets, risk tolerance, family situation or activities which may affect the type of insurance that would be right for you. In addition, state insurance laws and insurance underwriting rules may affect valuable coverage and its costs. Guarantees are based on the claims paying ability of the issuing company. If you need more information or would like personal advice you should consult and insurance professional. You may also visit your state’s insurance department for more information.
First New York FCU provides referrals to financial professionals of LPL Financial (“LPL”) pursuant to an agreement that allows LPL to pay First New York FCU for these referrals. This creates an incentive for First New York FCU to make these referrals, resulting in a conflict of interest. First New York FCU is not a current client of LPL for advisory services.
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