An annuity is a financial contract purchased from an insurance company, where an individual pays a lump sum or a series of payments (premiums) in exchange for guaranteed income payments at a future date.
Annuities can provide a reliable stream of payments for a fixed period or for life, helping to address longevity risk. Unlike insurance policies that pay on death, annuities focus on income generation.
Key Takeaways
- Annuities provide a guaranteed, steady income stream for life, ensuring financial stability during retirement
- Earnings in annuities grow tax-deferred, offering potential for higher growth until withdrawal, when taxed as ordinary income.
- They offer flexibility with various payout options and can include death benefits to secure income for beneficiaries.
- Annuities help protect against market volatility and the risk of outliving savings by providing a predictable, stable income.
Understand Annuity
An annuity is a financial product where you invest a lump sum or make a series of payments over time. In exchange, you receive regular payouts, either immediately or starting at a later date. These payouts can serve as a steady income stream, often used during retirement.
How Do Annuities Work?
Annuities work through two main phases:
- Accumulation Phase: The investor pays premiums (either lump sum or installments to the insurance company. The invested money grows tax-deferred during this phase.
- Distribution (Annuitisation) Phase: At a specified date (immediate or deferred), the insurance company begins paying regular income to the investor. Payouts may be monthly, quarterly, annually, or as a lump sum, depending on the annuity contract terms.
Different Types of Annuities
- Immediate Annuities: Purchased with a lump sum and start paying income immediately or within a short period. Suitable for retirees needing instant income.
- Deferred Annuities: Payments start after an accumulation period during which the investment grows. Useful for those planning retirement over the long term.
- Fixed Annuities: Pay a guaranteed fixed amount over the payout period, unaffected by market fluctuations. They are low risk with predictable income.
- Variable Annuities: Payments vary based on the performance of investments chosen by the annuitant (typically mutual funds or equities), so income can fluctuate.
- Indexed Annuities: Returns linked to a stock market index, offering potential for higher returns than fixed annuities but with some insurance protection.
Taxation on Annuities
The lump sum payments and the interest or investment gains within an annuity grow on a tax-deferred basis, meaning taxes are not paid until money is withdrawn. However, annuity distributions are taxed as ordinary income rather than at the lower capital gains rates that apply to many other investments.
Also, contributions to annuities do not typically reduce taxable income, unlike contributions to traditional retirement accounts such as 401(k)s or EPF.
Benefits of Annuities
- Regular Income: Provides a predictable and guaranteed income stream, often for life.
- Longevity Protection: Protects against outliving savings by providing lifetime payments.
- Tax Deferral: Earnings inside the annuity accumulate tax-free until withdrawal.
- Flexibility: Various payout options and premium payment structures to suit individual needs.
- Financial Security: Helps maintain financial independence during retirement years.
- Death Benefits: Some annuities include provisions for beneficiaries if the annuitant dies early.