How Does an Annuity Work?Apr 30, 2021 | 3 MIN READ
An annuity is a financial product that, in exchange for one or more up-front payments, provides a stream of income to the annuity holder (annuitant) in the future. In addition to the financial security of guaranteed future income, annuities can convey valuable tax benefits. Because annuities come in different forms, it’s important to understand the differences between them before you decide to purchase.
Immediate annuities are purchased with a single lump-sum payment and provide an immediate stream of income. Immediate annuity income can be paid monthly, quarterly, or annually. Depending on the terms of the contract, the income stream can last for a fixed period or for life.
A deferred annuity may be purchased either with a lump-sum payment or a series of payments. The annuity provider then holds the premium payments for a certain amount of time before income payments begin. This time is referred to as the accumulation period because the money has the opportunity to grow in value before it is returned to the annuitant.
Because of this accumulation period, deferred annuities are generally able to provide more income relative to their premium payments than immediate annuities are. Like immediate annuities, the payments from deferred annuities can last either for a set term or for life and can be distributed monthly, annually, or quarterly.
With many annuities, income payment amounts are fixed for the life of the contract. It’s also possible, however, to receive annuity payments that increase with inflation or that vary with the performance of underlying investments. In the latter case, either all or part of the variable annuity payments may be tied to investment performance. If you’re considering an annuity that has variable payments, be sure you understand what your guaranteed minimum return will be, and be prepared to get by with that level of annuity income, if necessary.
Special Benefits of Deferred Annuities
In addition to the luxury of time to grow, deferred annuities offer enhanced growth potential and flexibility through tax deferral, compound interest, and options for withdrawal and additional payments.
While the money in an annuity is growing, federal taxes are deferred. Tax is only due on income as it’s paid out. This is different than how a certificate of deposit (CD) works, as the interest earned on a CD is taxed each year. This is important because when the IRS doesn’t take a cut of the earnings, more is left in the account over time, fueling more potential for growth.
Compound interest on your annuity makes the ability to defer taxes even more valuable. Simple interest is calculated by multiplying the principal amount by an interest rate and again by the period of time over which interest is applied. Compound interest, on the other hand, adds all earnings that have accumulated over the contract period to the principal amount each year, giving the account even more growth potential.
For example, if your $10,000 investment were to earn compound interest at a rate of 5% per year for five years, your gain would be $2,762.82. With compound interest, growth continues to accelerate so that after ten years, earnings would reach $6,288.95.
$10,000 x (1.05)5 – 10,000 = $2,762.82
$10,000 x (1.05)10 – 10,000 = $6,288.95
One more way that you can boost the earning capacity of an annuity is to make additional payments during the accumulation period. This can be a particular advantage when you’re not certain how much you can afford to put into the annuity. With the ability to make additional payments, you can give yourself a financial cushion and then transfer more into your annuity as you’re comfortably able. Contract terms vary, so be sure to understand whether and how you may make additional payments to any deferred annuity you’re considering.
After age 59½, owners of deferred annuities may take withdrawals from them without tax penalty. (Before that time, the IRS charges 10% on funds withdrawn from an annuity, unless the annuitant qualifies for certain exceptions.) This is in contrast to immediate annuities, which do not allow withdrawals. Contract terms vary widely, so it’s important to read your contract carefully to understand what fees may be charged for withdrawals before you purchase a deferred annuity. In many cases, withdrawal fees decline over the first several years of the contract.