An annuity is a financial instrument that pays as long as you live. It is basically insurance against living too long. Typically annuities are paid once a month, but they can pay for almost any frequency from annually down to weekly.
Annuities have their good and bad points:
On the good side
On the bad side
Generally, if you don't want to spend your days worrying about your investments and if leaving a legacy is a lower priority than having income for retirement an annuity is right for you.
Frequently Asked Questions
I have an annuity and it doesn't pay me money.
Chances are you have a deferred annuity. It can be annuitized to begin paying money, but until that happens it is basically just a way to defer taxes on the interest.
Why doesn't it run out of money?
Because it's insurance. People who die before the average life expectancy effectively pay for those who live longer (just as people whose house doesn't burn down pay for those who put in a fire insurance claim).
Why don't my heirs get my money back if I die?
For the same reason the annuity doesn't run out of money if you live: it's insurance. The purpose of insurance is to spread the risk. That's why you can't cash it out before you die either; cashing out a life annuity when you have a terminal illness would be like buying insurance after the house started burning.
How are annuity payments taxed?
This is an incredibly complex question. The simple answer is that money from an annuity that hasn't already been taxed is treated as ordinary income and is reported to the IRS on a 1099 by the insurance company. The complexity arises from the question of what has already been taxed. If you buy the annuity using a direct rollover from a qualified retirement account like an IRA, TSA, or 401(k) then the entire payment is taxed. If, however, the annuity is purchased with cash or if its value builds up in a deferred state over time then every payment has a portion that recovers the cost basis. The Cost Basis is the amount of the purchase price that has already been taxed. The portion excluded from tax is called the exclusion ratio. As each payment is made the excluded amount is accumulated. When the accumulated exclusion catches up to the cost basis the exclusion stops and the payments become fully taxable (Note that there is one payment that "crosses over" that has only a partial exclusion). This is important to the retiree; remember to budget a decrease in the net payments from your annuity since the withholding will increase when the exclusion ends. Click here to read a reasoned opinion of why this is unfair. There are special rules for variable annuities and refund features.
What's a variable annuity?
A normal fixed annuity is a contract to pay a set number of dollars. A variable annuity pays "units" from a mutual fund, selling the shares of the underlying investments when payments are due. It can move up and down with the market, but there is an M&E basis charge. Generally a variable annuity is a good way to protect against inflation, but it can be painful if stocks go down. Some variable annuities include a guaranteed floor. These typically have a very high M&E basis charge, often in excess of 100 points, so when the stocks are moving up rapidly these annuities move up much slower.
What's an M&E basis charge?
A Mortality and Expense charge is a way for the insurance company to pay for the expenses of the variable annuity. On a fixed annuity the company makes a profit on the spread between its investments and the relatively low interest rate paid on the annuity. A variable annuity has the money invested directly in mutual funds, so the M&E basis charge is a way to get some back. It acts like an anchor, dragging back the performance of the funds. One basis point is 1/10,000th of the value (annually). In other words if the underlying fund didn't change in value for a year the funds inside the annuity would lose 1/10,000th of their value over the course of the year for every basis point charged.
What is different about taxing variable annuities?
Variable annuities also have an exclusion, but instead of applying the exclusion equally to all payments the exclusion is calculated for an entire year. Every year the payments at the beginning of the year are completely excluded from tax. After the amount for the year has been excluded the remaining payments are fully taxed. Remember to budget for the resulting reduction in net payments.
What is a Refund feature, or
My annuity DOES pay money to my heirs when I die. Why is that?
Because you have a either a refund or "certain" feature. A refund feature can return the difference between the purchase price and payment made in either a lump-sum or in continuing payments. A certain feature means the payments will be made for a certain amount of time (typically 10 years)
even if the annuitant dies. These features all expire if you live long enough, and the longer they last the more they cost.
How is the refund taxed?
If the cost basis has been recovered (or, in the case of a qualified annuity, there was no cost basis) the refund is fully taxed as income to the beneficiary. That's one reason it is generally better to buy a life insurance policy than to include a refund feature in your annuity. If the cost basis hasn't been recovered the un-recovered portion will be subtracted from the tax liability of a lump-sum refund. If the refund feature is a continuation of payments (like a 10 year certain period) then the initial payments will be completely excluded from tax until the cost is recovered. If there are two or more beneficiaries and one chooses a lump sum and the other a continuation of benefits the unrecovered cost basis is allocated pro-rata to the beneficiaries before making the above calculations.
Arntcha glad you asked?
Whoa! What if I DON'T have a refund feature and my cost basis isn't recovered?
Tough. Don't expect a refund. The IRS sheds no tears. Your estate can use the un-recovered cost basis to offset other tax liabilities though.
What if I want the annuity to pay while either my spouse or I are alive?
A joint annuity will pay for as long as two people are alive. Often the joint annuity will reduce payments (typically to 2/3rds of the original) upon the death of one of the annuitants. Most pensions use a joint and 2/3rds form of annuity. The greater the reduction the cheaper the annuity. If the reduction is 50% for either death the cost is theoretically the same as buying two individual annuities. Note: if the reductions are not the same and the source of the money for the annuity is a qualified investment (IRA, 401(k), TSA, etc) you are required to get a notarized signature from your spouse acknowledging that the benefits are unequal.
I care for an invalid spouse. Can the payments INCREASE if I die and decrease if my spouse dies?
Yes. Almost any type of payment stream that you can think of can be structured in an annuity. This includes lump sums, periodic increases (e.g. 5% per year), odd frequencies (like every 4 months), skipped payments (for people with seasonal income), and more. Of course if the insurance company doesn't have the product "off the shelf" there will probably be a charge for the actuarial services involved. Also not all companies are willing to sell such products. Finally the tax treatments for non-level payments can be quite complex. The IRS regulations allow the exclusion to apply to "essentially equal" payments. The tax calculations are simply too complicated to discuss here.
What is a "Period Certain" annuity?
A Period Certain annuity pays for a period of time, then ceases. In effect when you take out a loan the bank has purchased a period certain annuity from you. The one good reason to use a period certain annuity is to stretch out the taxation from a large deferred annuity without risking the loss of any of the money. It does nothing to insure against outliving your money.
What is a "Temporary" annuity?
This product pays for a set period of time (like a "period certain" annuity) but only if the annuitant is alive. The most common use of a temporary annuity is for disability or workman's compensation payments that cease at retirement age. In rare circumstances it might make sense for an early retiree who will begin to receive a pension at retirement age. A Temporary annuity is cheaper than a period certain annuity because there is a discount based on the probability of the annuitant dying.
Would it make sense to buy a Temporary annuity to pay for college?
Generally, No. Although a Temporary annuity is cheaper than a period certain annuity, the difference in price is negligible for young annuitants. It's a gamble with a tiny payoff and a huge loss that (though unlikely) would be suffered along with the untimely loss of a loved one. It might make sense, however, if the student were of relatively advanced age and there was no heir in need of the money. An 18 year old would save approximately $70 on a 4 year, $25,000 tuition, while a 50 year old would save approximately $350, a 60 year old approximately $650, and a 70 year old $1,250.
What else should I look for?
Hopefully this has informed you sufficiently about the features of an annuity to make your own decision about what features are right for you. There are two other things to think about.
First price. Shop around. The difference in the benefit paid will astonish you. If you have a deferred annuity there is a good chance the mortality table in effect when you started making contributions will be the table used when you annuitize. Since people are living longer all the time older mortality tables pay a better annuity.
Second, look at the stability of the company. Annuities are a contract to pay you. If the company goes bankrupt you will probably be severely impacted. Ask your agent to tell you the AM Best rating of the insurance company. These grades aren't like your high school grades. C isn't average; it's a company that is very much in danger of going under. As a matter of opinion I generally tell my friends to avoid anything lower than an A rating. A++ is the top. The top ratings often have very competitive prices.