U.S. annuity sales reached an astonishing $229.4 billion in 2014, a 3.8% increase from the previous year, according to the Insured Retirement Institute (IRI). These investments are skyrocketing in popularity with risk-averse investors who are looking to receive a steady stream of income after retirement.
An annuity is a contract between the investor, or annuitant, and an insurance company. You contribute funds to the annuity in exchange for a guaranteed income stream of your choosing later in life. The period of time when you are funding the annuity and before payouts begin is known as the accumulation phase. Once you start receiving payments from the annuity, you are in the annuitization phase.
There are two different types of annuities: fixed and variable. Fixed annuities are not tied to any economic indicators or market indexes so they provide a guaranteed rate of return regardless of stock market fluctuations. Variable annuities, on the other hand, are tied to mutual funds and other market-based securities. This is why many risk-adverse investors choose fixed annuities. With a fixed annuity, you are accepting slower growth in exchange for the security of a fixed interest rate. For more, see Why Are Annuities Important for Retirement?
Here is how a fixed annuity works after retirement, when you’re ready to start receiving a stream of income.
When can you start taking payouts from a fixed annuity? That depends on whether it’s a deferred or an immediate annuity.
An immediate annuity must be purchased with a single, lump-sum payment. You can immediately begin receiving regular payments, which usually last for the rest of your life. The size of your monthly payment depends on the amount you use to buy the annuity, the payout option you choose and personal factors, such as your age. Immediate annuities are popular with retirees or soon-to-be retirees who are worried about potentially outliving their resources. An immediate annuity is also a great option if you just received a large one-time payment, such as an inheritance, profits from selling a business or lottery winnings. By converting this capital into an immediate annuity, you can guarantee a steady source of retirement income.
On the other hand, a deferred annuity allows you to build your account value over time and convert it to income in the future. With a deferred annuity, you either contribute a lump sum, make a series of contributions over time or do some combination of both. These annuities are popular with younger investors who are looking to build up retirement savings while they’re still working.
Once you’re retired and ready to start receiving an income stream from your annuity, simply notify the insurance company. The insurance company’s actuaries will use a special calculation to determine your periodic payment amount. This calculation includes factors such as the dollar value of the account, your current age, expected future returns from the account's assets and your life expectancy based on standard life-expectancy tables. Any spousal provisions included in your annuity contract are also factored into the equation. It’s important to note that the longer you wait before taking annuity payouts, the larger your payments will be.
Most annuitants choose to receive monthly payments for the rest of their life and their spouse's life. If this provision is built into your annuity, you and your spouse will continue to receive payments for the remainder of your lifetime. Once both of you are deceased, the insurer stops making payments. Therefore, if you live a long life after retirement, the total value you receive from your annuity contract could be significantly more than what you paid into it. However, if you pass away relatively early, you may actually receive less than what you paid into the annuity. Either way, the point of an annuity is to provide peace of mind that you will receive income for the rest of your life.
However, some annuities may include additional provisions, such as a guaranteed number of payment years. With this option, if you and your spouse die before the guaranteed payment period is over, the insurer pays the remaining funds to your estate. For the most part, the more provisions included in your annuity contract, the smaller your monthly payments will be.
With many deferred annuities, you may have to pay a penalty fee if you withdraw funds before accumulating for a minimum number of years. Early distributions may also be subject to taxes before you reach a certain minimum age. However, most annuities have provisions that allow you to withdraw 10-15% of the account for emergency purposes without penalty. It’s important to carefully read through your annuity contract and consult a tax professional before you withdraw any funds from your annuity.
Most annuities offer tax sheltering, which means your contributions to an annuity reduce your taxable earnings for the current year, and your investment earnings grow tax-free until you begin to draw an income from them. Over a long period of time, your tax savings can compound and result in substantially boosted returns.
Once you start receiving payments from the annuity, you will have to pay taxes on that income. However, because you will probably fall into a lower tax bracket after retirement, you will likely pay significantly lower taxes on the payments than if you had claimed the income when you earned it. In the end, this provides you with an even higher after-tax return on your investment.
The way your annuity works after retirement will vary greatly depending on a number of factors, including whether you have an immediate or a deferred annuity, what provisions are included in the contract, your current age and how much money is in the account. However, one thing is certain: All annuities offer post-retirement peace of mind because they provide a guaranteed stream of income throughout your lifetime. For more, see An Overview of Annuities and Introduction to Annuities: Advantages and Disadvantages.