Annuities have become an increasingly popular option for investors looking to build up a nest egg for 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 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 annuities and variable annuities. Because fixed annuities are not tied to any economic indicators or market indexes, they provide a guaranteed rate of return regardless of stock market fluctuations. Variable annuities, which are tied to mutual funds and other market-based securities, often provide a higher growth potential than fixed annuities.
A variable annuity is a tax-deferred retirement account, which means you won’t have to pay taxes on fund earnings until you start receiving payments. With a variable annuity, you pay a lump sum, and the insurer invests that money on your behalf to realize capital gains. Once you are retired, your annuity payment amounts are determined by the performance of the underlying investments of the annuity.
Because there is some level of risk associated with variable annuities, many investors worry the investments are unsafe. Perhaps that’s why variable annuity sales are on the decline – in fact, total sales fell to $137.9 billion in 2014, a 3.4% drop from the year prior, according to the Insured Retirement Institute.
However, many insurance companies have been able to mitigate variable annuity risks in the stock market through hedging. There are also many safeguards built around variable annuities that regulate and protect these investments. (For more on this, read Are Variable Annuities Safe?)
Here is how variable annuities work after retirement when the payout phase begins.
If you withdraw money from a variable deferred annuity before you turn 59½, you may have to cough up a penalty fee. Additionally, the IRS may impose a 10% federal tax penalty on early withdrawals. However, depending on your variable annuity contract, you may be able to withdraw a specified amount during the accumulation phase without paying an insurance company–imposed penalty. If you withdraw more than that specified amount, you’ll probably have to pay surrender charges.
Once you have reached 59½ and are ready to take distributions, you can choose to receive income payments (called annuitization), or you can receive a lump-sum payout or take systematic withdrawals.
If you choose to receive income payments, the amount of each payment will vary depending on the performance of the investments where your money is allocated. Once you start receiving payments, the undistributed portion of your investment can continue to compound, tax-deferred.
Some variable annuities include a provision in which the insurance company guarantees the return of an amount regardless of the actual performance of the underlying investments. However, there is usually an additional fee for these benefits.
Variable annuities usually include a guaranteed death benefit. This means that if you die before you start receiving payments from your annuity, your named beneficiary will receive a death benefit amount guaranteed to equal the amount you invested or the value of the contract on the most recent policy statement – whichever is higher.
When you sign up for a variable annuity, you choose an annuity commencement date, the date when you’ll begin receiving income payouts. It’s important to note that many insurers set an limit on the age when you must start receiving payouts, usually between ages 85 and 95, depending on your contract.
At this age, you are required to select a payout option, which is also called “forced annuitization.” Depending on your contract, forced annuitization can result in the cancelation of the death benefit on your policy.
Because this type of annuity is a tax-deferred account, you will not have to pay taxes on the funds until you start receiving payments. In other words, your contributions and earnings in a variable annuity can grow tax-free until you’re ready to tap into the funds.
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.
If you’ve maxed out your contributions to your 401(k) and IRAs, a variable annuity can be an excellent supplement to your retirement savings. The way your variable annuity works after retirement will vary greatly depending on your contract and the underlying investments. Before you choose to invest in – or withdraw funds from – a variable annuity, talk to a financial advisor or tax professional.