What is an Annuity, and How Does it Work?

If you’re considering an annuity as a source of retirement income — or to manage your personal finance picture today — take a few minutes to get familiar with the basics. Equipped with this "nuts and bolts" knowledge, you’ll be better prepared to discuss your options with a financial professional. You’ll learn:

-What an annuity is

-The different types of annuities

-The financial and tax benefits of each

-Whether annuities may be right for you

Annuity definition

An annuity is a contract between you and an annuity provider which states that — in return for your lump-sum investment or premium payments — you are guaranteed to receive a certain amount of income over a specific period or for the rest of your life. Annuities are often used to provide guaranteed income in retirement and, in the case of lifetime annuities, help ensure that you won't outlive your money.

You can typically purchase an annuity at any time after age 18, but most people purchase them as part of their retirement savings strategy. Contributions to annuities are independent of contributions made to retirement accounts such as a 401(k) or an IRA. Unlike these retirement accounts, annuities have no IRS contribution or income limits. Plus, many annuities offer valuable tax advantages, including growing your money on a tax-deferred basis.

Here are some other key facts. There are two phases to a deferred annuity:

• Accumulation phase : This is the period before you start taking payments, when the money you put into the annuity earns interest or, in the case of some annuities, like variable or indexed annuities, gains from positive equity market performance.

• Distribution phase: This is the period when you start receiving income via withdrawals or the annuitization feature, usually at retirement (note there can be tax consequences to withdrawing funds from an annuity before age 59½).

Finally, when you purchase an annuity for yourself, you are considered the annuity owner and the "annuitant" — the person who receives the annuity income. There are other ways to structure the contract — such as having a family member or other third party receive the annuity income — depending on the type of annuity being purchased and what the insurance company allows. A financial professional can explain your options.

How do annuities work?

Annuities are financial instruments typically designed to provide a steady stream of income during retirement (although some annuities allow you to opt for a lump sum payment if you prefer). Essentially, you invest a lump sum or periodic premium payments into an annuity now. In return, the annuity provider agrees to make regular payments back to you, starting either immediately (single payment income annuities) or at a future date (deferred income annuities and deferred annuities).

• Payment period: Annuity payments can last for a fixed period — as determined by you when purchasing the annuity — or over the course of your lifetime. Either way, an annuity can help to ensure financial stability and a steady stream of income in retirement.

• Tax benefits: Besides the security provided by a guaranteed income stream, most annuities offer valuable tax benefits. If you purchase an annuity with pre-tax dollars, your future withdrawals will generally be taxed as ordinary income – which can work to your benefit if you’re retired and in a lower tax bracket. If you purchase the annuity with after-tax dollars, you’ll only owe taxes on interest or market gains earned during the accumulation phase.

• Potential drawbacks: It’s important to note that annuity contracts can be very complex, significantly more complicated than some other investment vehicles. Annuities can also have higher fees and lack of liquidity. Also, early withdrawals from an annuity — withdrawing funds before the predefined payout period — can have some negative financial consequences.

If you choose to make early withdrawals (only available in deferred annuities with a cash value) you can incur significant charges known as surrender fees. These fees are highest in the first years of the payout period and typically decline over time. In addition, if you withdraw annuity funds before the age of 59½, you will probably incur a 10% federal tax penalty in addition to paying taxes on the earnings withdrawn.

Types of Annuities

There are several different types of annuities, each catering to different financial needs, retirement planning needs, and levels of risk tolerance. Choosing between them depends on a few key factors, including your desired payment start date, your need for predictable income, and whether you’re willing to expose yourself to market risk in hopes of a higher return. Here, we’ll simplify the distinctions to help you better understand your options.

Income annuities

Income annuities (also known as payout annuities) usually require a lump sum investment and typically start making regular payments right away – within one or two years of your initial investment. Because there isn’t an extended delay in collecting income, immediate annuities can be a good fit for people who are almost at or already in retirement. The three types of income annuities are:

• Single-premium immediate annuity (SPIA): SPIAs offer a guaranteed income stream almost immediately after you make your initial lump-sum investment. Payments typically begin within a year and continue for a specified period or throughout your lifetime. This makes it an attractive option for retirees (or those near retirement) looking to ensure that they have a consistent income flow to cover their living expenses.

• Deferred-income annuity: With a deferred income annuity, you invest a lump sum, but unlike an immediate annuity, your payments won't start until at least two years have passed. Because of this delay in taking income, it will yield higher income payments than you might receive from an immediate annuity. Deferred income annuities may make sense if you don’t need the annuity payments immediately.

• Qualified Longevity Annuity Contract (QLAC): A QLAC is a special type of deferred income annuity purchased with a portion of your retirement savings (e.g., 401(k) or IRA). QLACs can help increase income in retirement by deferring part of the minimum distribution requirement for your retirement plans beyond the age of 73, allowing for additional growth potential and tax deferrals.

These annuities can be set up as lifetime annuities that pay income for as long as you live), or period-certain annuities that pay income for a specified period (e.g., 10 or 20 years). If desired, they can include a provision to provide payments to a beneficiary (e.g., spouse or child) after your death.

Deferred annuities

Deferred annuities — sometimes called "savings annuities" — are designed to grow your money in a tax-deferred manner before they start to pay income. By accumulating funds for several years before starting payments, deferred annuities can provide a higher rate of return than immediate annuities, which is why they are usually the preferred choice of those who have a number of years to go before needing retirement income.

Deferred annuities can be either fixed, fixed index or variable. Fixed annuities provide the security and stability of a guaranteed interest rate. Fixed index and variable annuities offer the potential for higher returns since they are tied to financial market investments. Which type is appropriate for you depends largely on your risk tolerance since market-based annuities can go up or down depending on market performance.

Upon reaching the annuitization (payment) phase, you can choose to receive a lump-sum payment, begin a stream of income payments, or maintain the account in a deferred status — meaning your money will have more time to grow before you take your payments. Upon reaching the maximum annuity commencement date —typically no later than age 100 — you must choose to receive either a lump sum payment or a stream of income payments. These distributions will then be subject to taxation as required. Here are a few more key details:

• Fixed-rate annuities (also known as a fixed annuity)
  A fixed annuity provides a guaranteed interest rate. This makes it an attractive option for those who prefer a stable, predictable investment with stable, predictable returns.

• Fixed index annuities
  A fixed index annuity is tied to a market index such as the S&P 500, and offers the potential for higher growth than a fixed-rate annuity if the market performs well. In the event of a market downturn, you’ll receive a minimum guaranteed interest rate, so your contract value will not be reduced. One drawback to fixed index annuities is that they put a cap on stock market earnings, so in a year when the market does especially well, you might only enjoy a portion of the index returns.

• Registered index-linked annuity (RILA)
  A Registered Index-Linked Annuity (RILA) is a new type of annuity tied to market-based investments. It lets you proactively manage your risk by selecting from different levels of protection, called buffers. Your investment is protected from losses up to the buffer amount you select, and your gains will be capped at a pre-determined level. RILAs are considered most appropriate for more sophisticated investors.

• Variable annuities
  A variable annuity is also tied to market-based investments, but unlike a fixed index annuity or a RILA, it doesn't provide the level of protection of a floor or buffer. But, in return for the added risk, a variable annuity doesn’t put a cap on your stock market earnings, so there is the potential for higher returns. As are many market-based investments, variable annuities are most appropriate for those with some level of risk tolerance.

Are annuities right for you?

The answer depends on your current financial circumstances and, more importantly, your future financial and retirement needs and goals. Generally, annuities are a good choice for those who have lower risk tolerance and are willing to accept a relatively low rate of return — lower than the potential returns of other investment vehicles such as stocks and mutual funds — in exchange for the security of knowing that their money and their income will be there when they need it.

That said, if your risk tolerance is high — or you need a higher rate of return than that available from most annuities — you might opt for other investment vehicles that may better meet your needs. A financial professional or tax advisor can help you make the best decision.

Annuities vs. life insurance

Life insurance and annuities are both designed to provide financial security, but they serve very different purposes and have distinct features. Life insurance is primarily intended to provide a death benefit to your beneficiaries in the event of your passing. Most life insurance policies pay a tax-free lump sum that can help your beneficiaries handle day-to-day living expenses and other financial responsibilities in the absence of your income. Annuities, on the other hand, are designed to provide you with periodic payments while you are alive, typically in retirement.

While life insurance pays out upon your death – thereby protecting your survivors - annuities offer a predictable income stream during your life, thereby protecting you and reducing the chances that you will outlive your money. Which is more appropriate for you depends on your individual financial needs, concerns, and circumstances.

How Guardian can help

If you're thinking about annuities as part of your retirement savings plan or as a source of lifetime income, we hope that the information above will be helpful in getting you started. However, as you get deeper into the annuity purchase process, there will be issues that require you to consult a financial professional or financial advisor with specialized expertise. That's where Guardian can help.

If you don't currently have someone to speak to, a Guardian Financial Professional will listen to your needs and help you find the annuity that best meets your financial and retirement needs. And can fill you in on Guardian’s annuity offerings, each of which can be customized to meet your specific financial or retirement needs; here's how to find someone near you: