How do annuity payments work?
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How do annuity payments work?

 

An annuity is a contract between an insurance company and an annuity holder that defines how and when payments will be made. Depending on the type of annuity and the clauses in the contract different annuities will have different costs to obtain guaranteed payments by an insurance company. Annuities can either be immediate or deferred, or a hybrid, and this will define when the annuity payments begin. The rate the annuity pays will depend on if it is a fixed-rate, a variable rate or an indexed annuity.

 

Immediate annuities will typically begin payments within 12 months from the start date as defined in the annuity contract. Immediate annuities are popular with investors who wish to begin obtaining payments in the near future.

 

Deferred annuities will begin payments typically beyond one year in the future. Some deferred annuities can have payment start dates defined decades into the future. Deferred annuities are popular with investors who do not want to begin drawing down payments in the near future. Younger investors find deferred annuities popular since the earnings can accumulate without taxation until the age of retirement. It is always good to discuss any annuity purchase with a registered tax professional who can discuss the details of how annuities are taxed and how it would affect you in your own personal situation.

 

How do deferred annuity payments work?

Deferred annuity payouts usually begin well into the future. This is beneficial since the earnings on deferred annuities can grow on a tax-deferred basis until the contractually agreed payout date begins. Many long-term investors see this as a great way to increase the value of their investment over a longer time horizon. During the accumulation phase of a deferred annuity, the buyer will make payments into the annuity contract and the growth of the investment takes place. Following the accumulation phase, the annuity contract will enter the distribution phase. It is in the distribution phase that payments from the insurance company to the annuity holder begins.

 

When the financial contract for the annuity is created it will include the definition of how long the payouts will be for. Payouts can either be for a set number of years for can continue in perpetuity for the life of the annuity holder. The amount of money put into the annuity when it is created will determine the payout amounts. Annuitants can decide on the payout structure based on monthly, quarterly or annual disbursements.

 

The dollar value of the payout of the annuity will also depend on the rate of return versus the amount of risk the annuity holder is willing to tolerate. Deferred annuities are usually either fixed, variable or indexed. Each of these methods for determining the rate of return has its own benefits and drawbacks as well as its own risks. Depending on your risk tolerance level you should investigate which of these three methods for determining a rate of return will best match your long-term goals.

 

How do fixed deferred annuity payouts work?

When I fixed deferred annuity contract is created the rate of return will be specified as part of the contract. This means that the annuity payments will remain constant for the life of the contract. This means for example that if you have a quarterly payment option then your rate of return over the four quarters of the year will remain constant according to the rate specified in the annuity contract. Many investors prefer deferred fixed annuity contracts since the payouts are known well in advance. However, there is a risk that market interest rates will rise significantly over the life of the annuity. If this were to occur and the payout interest rate of the annuity falls significantly below the market interest rate investors might no longer wish to hold their annuity contract. Most insurance companies will allow annuitants to surrender the contract if the market interest rate rises significantly above the contractual rate of the annuity. This type of annuity is well-suited for investors who are risk-averse. Since the rate of return is fixed, the guaranteed payments become a desired part of the overall portfolio.

 

How do variable deferred annuity payouts work?

The rate paid out by a variable deferred annuity will be tied to the change in the rate of return of the underlying investment that the deferred variable annuity is tied to. When you purchase a variable deferred annuity the funds will go into a group investment account that holds a variety of stocks, bonds and other types of financial assets. The insurance company will invest in these different types of assets for the annuitant. You can determine the distribution of how your money is invested among a wide variety of funds such as large-cap stocks, foreign stocks, bonds and money market instruments. These annuities will provide you with the whole rate of return on the amount of funds based on how you invested your money. For example, if you place all of your funds into foreign stocks and your foreign stocks appreciate by 20% then your account value will grow by 20%. Although the higher the rate of your guaranteed return that you select as part of your annuity will result in a lower participation level. For example, if you choose a 50% participation level with the guaranteed return of 6% you’d only make a 10% return any year in which the fund returned 20%. Investors find variable deferred annuities attractive when they are combined with a guaranteed minimum interest. This is because the annuity will provide a guaranteed minimum return but has upside potential based on a growing market.

 

How do indexed annuity payouts work?

Indexed annuities, as the name implies, are tied to an underlying market index like the Dow Jones industrial average or the Standard & Poor’s 500. An indexed annuity will appreciate or depreciate based on the movement in the underlying index. For example, if the Dow Jones industrial average increased by 5% then the value of an indexed annuity would also increase by 5% (minus management fees charged by the insurance company if applicable). One of the most common riders for an indexed annuity is a protection against falling market value. You can write into the annuity contract that the lowest rate of return is 0%. This would mean that if the underlying index were to suddenly crash and decrease in value your annuity would not shrink. Payouts can be made monthly, quarterly or yearly. Based on how you set up your contract payments can be guaranteed for a predetermined number of years or can be guaranteed for the rest of your life. Indexed annuities are a great choice for people who wants to have market participation but do not want to have to worry about market crashes or declines an underlying index.

 

How do immediate annuity payments work?

Immediate annuities are usually purchased with a lump sum payment. As the name implies the payouts of immediate annuities begin normally within 12 months following the purchase of the annuity contract. Most immediate annuities are purchased with a fixed rate of return. Immediate annuities do not grow on a tax-deferred basis and the Internal Revenue Service considers the interest earned as taxable income. Although part of the payments from immediate annuities are considered a return of principal. The IRS does not consider repayment of principal as taxable income. If you are looking for a safe place to put your money for only a few years’ time immediate annuities hold some favorable tax advantages. Speaking with your tax advisor you can learn specifically how you can benefit from immediate annuity payments with regard to your taxes.

When you purchase your immediate annuity you will choose payout options that are either monthly, quarterly or yearly. Depending on how your contract is structured payments will continue for either a predetermined number of years or will continue in perpetuity for the rest of your life. When searching for a secured guaranteed regular income, immediate annuities are a great option and providing financial stability in the time that you most want.