An annuity account is an account set up by an insurance company to hold and invest funds from individuals purchasing annuities. The purpose of the account is specifically to fund annuity contracts and any benefits related to those annuity agreements.
Annuity accounts are established when a person buys an annuity product from an insurer. The buyer, known as the annuitant, makes either a lump-sum payment or a series of payments into the annuity account. These payments are called premiums.
The insurer invests the premiums in the account with the goal of growing the funds over time. The annuitant can later receive scheduled payments from the annuity, typically during retirement. These payments provide a predictable income stream, usually for the annuitant’s lifetime.
Types of Annuities
There are several different types of annuities available:
- Immediate annuities
Also known as a single premium immediate annuity (SPIA), this type of annuity begins making payments shortly after the initial premium payment. It provides income immediately to the annuity holder.
- Deferred annuities
This type of annuity has an accumulation phase where funds grow tax-deferred. Payouts typically begin years or even decades after the initial investment.
- Fixed annuities
This annuity provides set, guaranteed payments to the annuity holder. The insurance company bears the investment risk.
- Variable annuities
With this type of annuity, payouts fluctuate based on the performance of underlying investments, usually mutual funds. The annuity holder bears the investment risk.
- Indexed annuities
These annuities offer a minimum guaranteed return combined with the potential for higher returns linked to a market index, like the S&P 500. Part of the risk stays with the insurance company.
How Annuities Work
Annuities have two main phases – the accumulation phase and the payout phase.
The accumulation phase is the period during which the account value grows. Contributions made to the annuity are allowed to grow tax-deferred until withdrawals begin. Money invested grows tax-deferred at a fixed interest rate for fixed annuities or based on market performance for variable annuities.
During the payout phase, the accumulated annuity account balance is used to provide a guaranteed stream of income to the annuity holder, usually for life or a set number of years. This phase is called “annuitization.”
The payouts are made from the insurer’s annuity fund, which pools premiums and investment returns from other annuity holders to pay out benefits. The risk is spread across the large pool of annuities.
Benefits of Annuities
There are several benefits that annuities can offer retirees:
- Steady cash flow
Annuities provide a predictable stream of income that lasts for life or a set period of time. This helps hedge against longevity risk or the risk of outliving savings.
- Tax-deferred growth
Earnings in an annuity grow tax-deferred until withdrawals begin. This may result in faster growth compared to taxable accounts.
- Guaranteed income for life
Lifetime annuity payouts offer retirees protection against running out of money regardless of how long they live.
- Death benefits
Most annuities offer beneficiaries payouts through death benefits if the annuity holder passes away early.
- A variety of investment options
Variable annuities allow the account holder to allocate funds across a variety of investment subaccounts, typically invested in stocks and bonds.
Risks and Considerations
While annuities offer several advantages, there are also some drawbacks to consider:
- Fees and charges – Annuities come with fees like administrative fees, mortality and expense risk fees, and surrender charges if money is withdrawn early. These can significantly reduce account value.
- Investment risk – Variable annuities expose the investor to market risk since payouts are not guaranteed. Poor market performance can reduce payouts.
- Lack of liquidity – Annuities come with surrender charges if withdrawn early. And funds converted to lifetime income payments cannot be readily accessed in emergencies.
- Tax implications – Any withdrawal from a deferred annuity before age 59 1⁄2 faces a 10% IRS early withdrawal penalty in addition to ordinary income taxes.
Who Buys Annuities?
Annuities are usually bought by people who want steady retirement income they can’t outlive. Some common annuity buyers include:
- Retirees – They use annuities to create guaranteed lifetime income during retirement. This protects them from possibly running out of money later in life.
- People Nearing Retirement – They buy annuities years before retiring to start building future income. These deferred annuities grow tax-deferred until payouts begin later.
- IRA and 401(k) Owners – They take a part of their retirement account balances and use it to purchase an annuity. This converts savings into lifetime annuity income.
- Pension Holders – Some cashed out their pensions in one lump sum and used that to buy an annuity. This replaces the pension with similar annuity payments.
What Is a Non-Qualified Annuity?
A non-qualified annuity is bought with money from regular savings and accounts, not tax-advantaged retirement accounts. Key points:
- Purchased using after-tax dollars from regular bank accounts or investments.
- Earnings grow tax-deferred, but payouts just return your principal tax-free.
- Withdrawals before age 59.5 avoid the 10% early IRA/401(k) withdrawal penalty.
- Beneficiaries pay taxes on any annuity inheritance over the original purchase amount.
What Is the Surrender Period?
The surrender period is the time you’ll pay fees if you withdraw or cash out your annuity. Important to know:
- This applies when you first purchase a deferred annuity contract.
- Often lasts 5-15 years before ending.
- Discourages withdrawing too soon after buying an annuity.
- Fees are typically a percentage of the amount withdrawn each year.
- Fees decrease annually over the surrender period.
Conclusion
In summary, an annuity account provides retirees with a means of generating a guaranteed lifetime income stream that can supplement other retirement income sources like Social Security and pensions. Annuities help hedge against longevity risk and offer other benefits like death benefits. But annuities are complex products with risks like fees and lack of liquidity that must be evaluated. Seeking advice from a financial planner when considering an annuity purchase can help analyze if it aligns with retirement goals.
