An annuity is a contract in which an insurance company makes a series of income payments at regular intervals in return for a premium or premiums you have paid. Annuities are often bought for future retirement income. Only an annuity can pay an income that can be guaranteed to last as long as you live. Your money grows tax-deferred as long as you leave it in the annuity.
The most common types of annuities are: single or multiple premiums, immediate or deferred and fixed or variable. For a single premium contract, you pay the insurance company only one payment, where as you make a series of payments for a multiple premium. With an immediate annuity, income payments start no later than one year after you pay the premium. The income payments from a deferred annuity often start many years later. Deferred annuities have an accumulation period, which is the time between when you start paying premiums and when income payments start. During the accumulation period of a fixed deferred annuity, your money, less any applicable charges, earns interest at rates set by the insurance company or in a way spelled out in the annuity contract. During the payout period, the amount of each income payment to you is generally set when the payments start and will not change. During the accumulation period of a variable annuity, the insurance company puts your premiums, less any applicable charges, into a separate account. You decide how the company will invest those premiums, depending on how much risk you want to take. During the payout period of a variable annuity, the amount of each income payment to you may be fixed (set at the beginning) or variable (changing with the value of the investments in the separate account.
During the accumulation period, your money, less any applicable charges, earns interest at rates that change from time to time. Usually, what these rates will be is entirely up to the insurance company. The current rate is the rate the company decides to credit to your contract at a particular time. The company will guarantee it will not change rates for a certain time period. The minimum guaranteed interest rate is the lowest rate your annuity will earn. This rate is stated in the contract. Some annuity contracts apply different interest rates to each premium you pay or to premiums you pay during different time periods. Other annuity contracts may have two or more accumulated values that fund different benefit options. These accumulated values may use different interest rates. You get only one of the accumulated values depending on which benefit you choose.
Most annuities have charges related to the cost of selling or servicing it. These charges may be subtracted directly from the contract value. Ask your agent or company to describe the charges that apply to your annuity. Some examples of charges, fees and taxes are surrender or withdrawal charges, free withdrawal, contract fee, transaction fee, percentage of premium charge and premium tax.
Companies may offer various income payment options. You or another person that you name may choose the option. If you choose Life Only, the company pays income for your lifetime. Life Annuity with Period Certain pays income for as long as you live and guarantees to make payments for a set number of years even if you die. If you choose Joint and Survivor, the company pays income as long as either you or your beneficiary lives. In some annuity contracts, the company may pay a death benefit to your beneficiary if you die before the income payments start.
Under current federal law, annuities receive special tax treatment. Income tax on annuities is deferred, which means you are not taxed on the interest your money earns while it stays in the annuity. Tax-deferred accumulation is not the same as tax-free accumulation. An advantage of tax deferral is that the tax bracket you are in when you receive annuity income payments may be lower than the one you are in during the accumulation period. You will also be earning interest on the amount you would have paid in taxes during the accumulation period. Most states’ tax laws on annuities follow the federal law. You should consult a professional tax advisor to discuss your individual tax situation.
Many states have laws that give you a set number of days to look at the annuity contract after you buy it. If you decide during that time that you do not want the annuity, you can return the contract and get all your money back. This is often referred to as a free look or right to return period. The free look period should be prominently stated in your contract. Be sure to read your contract carefully during the free look period.
You should think about what your goals are for the money you may put into the annuity. You need to think about how much risk you are willing to take with the money as well. Ask yourself the following questions: How much retirement income will you need in addition to what you will get from Social Security and pension, will you need that additional income only for yourself or yourself and others, How long can you leave money in the annuity and does the annuity let you get money when you need it.
A few questions that you should ask your agent are: Is this a single premium or multiple premium contract, what is the initial interest rate and how long is it guaranteed, what is the guaranteed minimum interest rate, can I get a partial withdrawal without paying surrender or other charges and is there a death benefit.
Before you decide to buy an annuity, you should review the contract. Terms and conditions of each annuity contract will vary. Ask the agent and company for an explanation of anything you do not understand. Do this before any free look period ends. Compare information for similar contracts from several companies. Comparing products may help you make a better decision. If you have a specific question or cannot get answers you need from the agent or company, the Iowa Insurance Division.
Source: National Association of Insurance Commissioners, May 28, 2008.