What are Annuities?
An annuity is a financial product designed to provide a guaranteed stream of income. An insurance company provides this income in exchange for one or more premium payments, depending on the terms of the annuity contract. The insurance company collects the premiums, and the value of the annuity grows tax deferred.
Typically, only the earnings portion of annuity income is subject to tax. However, it is possible to purchase an annuity with qualified (pre-tax) funds, such as through a 401(k) or traditional IRA. In this case, the payments would be 100% taxable as income, since taxes would not have been paid on the income used for premium payments.
There are two main types of annuities: immediate and deferred.
When you purchase an immediate annuity, you pay a lump sum to the insurance company up front and begin receiving regular payments soon after. The amount you receive will depend on the premium you paid, your age, the prevailing interest rates, and the number of payments the insurance company expects to make. This is the more popular choice among those who are already retired or plan to retire soon because it provides the security of an immediate, steady stream of income.
Depending on the terms of the annuity contract, payments may be made for the rest of your life or for a specified period of time. Because payments begin almost immediately, there is little risk that you will die before you start receiving an income from an immediate annuity. You may also be able to name a beneficiary, who would receive payments or a return of principal if you were to die before all payments have been made. Such provisions may cost extra, however.
A deferred annuity can be purchased with either a lump sum or a series of premium payments. Unlike immediate annuities, deferred annuities have an accumulation period before the insurance company begins making regular payments. This provides both benefits and risks. On one hand, a deferred annuity has more time to generate interest, providing much more potential for tax-deferred growth. In some cases, you can also choose to make additional payments during the accumulation period. On the other hand, there is a risk that you’ll die during the accumulation period of a deferred annuity. What happens in that event depends on the terms of the annuity contract, so it’s important that you understand these terms before you buy.
Another feature that sets deferred annuities apart is that in many cases, they allow the withdrawal of funds ahead of scheduled income payments. How and when you can do this varies from one annuity contract to another, so be sure you’re clear on these details before making a purchase decision. A variety of costs may accompany withdrawals, including
- Withdrawal charges, which may decrease or disappear over the course of the contract period
- Reduced interest rate
- Market value adjustment
Which type of annuity is best for you depends on factors such as how soon you plan to retire, how prepared you are for financial emergencies, and the amount of additional income you need in retirement. Discuss your needs with a financial professional to determine your best course.
ELCO Mutual offers both immediate and deferred annuities. Our deferred annuities are available with options for single or flexible premium payments. Our deferred annuities provide generous liquidity terms, with free withdrawal of accrued interest and no market value adjustments. Learn more about annuities and whole life insurance on our FAQ page and blog.