Annuities: Basic Varieties

An annuity is a financial contract with an insurance company and is designed to be a source of retirement income. An annuity can be purchased in two ways. With a single premium, you make one lump-sum payment at a single time. You cannot contribute more money at a later date to this annuity; instead, you will have to purchase another annuity. With a flexible payment, you can make contributions at any time and in any amount.

There are two basic types of annuities that can be purchased: fixed and variable.

Fixed Annuities
A fixed annuity earns a guaranteed rate of interest for a specified amount of time period, for example, one, three or five years. When the guarantee period is over, a new interest rate is set for the next period. A fixed annuity is similar to a Certificate of Deposit (CD) purchased from a bank, but an annuity is not backed by the Federal Deposit Insurance Corporation (FDIC); instead, the security of the annuity depends on the financial health of the insurance company which issues the annuity.

Variable Annuities
A variable annuity usually offers a variety of investment options, including stocks, bonds and money market instruments. Because the return on variable annuities can increase or decrease, the principal and the return are not guaranteed and depend on the performance of the investment options. A variable annuity has a higher risk factor than a fixed annuity. It is possible for earnings to meet or even exceed the inflation rate with a variable annuity; however, it is also possible for not only previously gained earnings but also some of the principal to be lost.

In addition to a range of investment offerings, some variable annuities offer a fixed account option guaranteeing both principal and interest, much like a fixed annuity. You have the option of dividing your money between the low-risk fixed option and higher-risk investments all under the umbrella of just one annuity.

Variable annuities also allow money to be transferred from one account to another without causing a taxable event. This means that if you transfer money to a different option within your variable annuity, you will not incur any taxes on any earnings that have been made.

Expenses
A fixed annuity typically has fewer expenses but fewer features than a variable annuity. In certain fixed annuities, contract expenses, such as maintenance and contract fees, are taken into consideration when the company declares periodic interest rates or determines the payment amount.

Variable annuity fees are more complicated and usually higher than fixed annuities. Variable annuity fees might include an annual contract charge for administrative expenses, surrender fees, and a mortality and expense risk charge. Variable annuities charge this latter fee to guarantee the death benefit, the availability of payout options and the level of expenses.

A variable annuity also has fees for managing and operating the investment options in which your money is invested. These charges cover everything - from the fund manager's salary to the costs of printing the fund prospectus.

The prospectus, which must be given to you when you are solicited to purchase the annuity, will explain all fees that are charged for the annuity. It is essential to read the prospectus carefully before purchasing an annuity to understand what expenses will be incurred and how you will be charged.

When You Can Take Payments: Deferred and Immediate Annuities

Deferred Annuities
With deferred annuities, money grows tax deferred, which means no taxes on are paid on earnings until you begin to withdraw money.

If you feel that the tax-deferred aspect of a deferred annuity is important, the expenses should not outweigh the tax benefits. It can be a difficult decision, but a good guideline is that if the expense charges are more than 1.5% greater than a comparable financial vehicle and your time horizon is less than 10 years, a deferred annuity may not be the option for you. Consult a tax advisor for assistance in making this determination.

Using a deferred annuity for current expenses will be costly. In addition to IRS penalties for withdrawing money before age 59 ½, the insurance company that issues the annuity may impose its own early withdrawal penalty, known as a surrender fee. Often there is a separate surrender fee for each payment. For example, a recent payment may have a 7% fee if you take the new payment out right away, while a 10-year-old payment may have no surrender fee. The surrender fee will usually decrease and be eliminated over time. It is possible to withdraw small amounts (e.g., 10%) annually without any penalty from your insurer, but the IRS penalty may still apply.

If you switch annuities, you may also incur withdrawal charges from your current annuity. If you are thinking about changing from one company's annuity to another, consider the characteristics of the new annuity compared to the one you already have – such as interest rate, investment choices or flexibility and whether these offset the withdrawal charges. If you decide to move from one annuity to another, request and complete the appropriate forms provided by the company to ensure that the transaction will be treated as a tax-free exchange under the federal income tax law.

Withdrawing Money from a Deferred Annuity
Before you start withdrawing money from your deferred annuity, you will need to decide how to receive the money. It can be taken all out in a lump sum; you can take it as you need it; or you may receive it in periodic equal payments, known as "annuitizing." If you annuitize, you can receive a certain amount of income each quarter or year and it is guaranteed to continue for the rest of your life, no matter how long you live, with the tax liability spread out for the remainder of your life as well. There are many options on withdrawing annuity money. To learn about these options, read our article Annuities: Taking Your Money Out. Be sure to consult with your tax or financial adviser before making any decisions.

Immediate Annuities
An immediate annuity is purchased by making a one-time payment; distributions typically begin within a month. An immediate annuity can be fixed or variable. The income payments from a fixed immediate annuity are based on the amount contributed, your age and the interest rate at the time of purchase. The payments you receive will not change. The payments from a variable immediate annuity fluctuate depending on the performance of the investment options chosen. Payments may go up or down. The principal in an immediate annuity is not readily accessible. There also is a chance you may lose some of your principal. If you choose an income for life option with no refund guarantee, and you die before your principal is all paid out, the balance of your principal and any earnings will go to the insurance company, not to your heirs. However, annuities offer several guaranteed payout options. Again, talk to your financial adviser before making any decisions.