Annuity

The term Annuity refers to an insurance contract issued and distributed by financial institutions with the intention of paying out invested funds in a fixed income stream in the future. Since some assets along with Social Security may not be enough to sustain their standard of living, some investors may turn to an insurance company or other financial institution to purchase an Annuity contract.

Annuities are designed to provide a steady cash flow for people during their retirement years and to alleviate the fears of outliving their assets. 

Investors invest in or purchase annuities with monthly premiums or lump-sum payments. They begin paying out almost immediately or at some point in the future. Therefore, the holding institution (Insurance Company) issues a stream of payments in the future for a specified period of time or for the remainder of the annuitant's life. 

Annuities are often used as a way to fund retirement; they are mainly used for retirement purposes and help individuals address the risk of outliving their savings. Lastly, Annuities are designed for long- range retirement planning needs. There are many advantages to an annuity: Lifetime Income Stream, Tax Deferral, & Guarantees.

An indexed annuity is a type of fixed annuity in which the interest rate is based on the performance of a financial index, such as the S&P 500, NASDAQ or any other indexes the insurance company utilizes. The interest paid is calculated based on changes in the index.

Indexed annuities offer the potential to outperform traditional fixed annuities when there are gains in the index. However, unlike variable annuities, Indexed annuities offer downside protection. This means even if the index declines, the annuity will not lose value. Also, once earnings are calculated they are locked in for life - they never change as a result of poor market conditions.

As such, these financial products are appropriate for investors, who are referred to as annuitants, who want stable, guaranteed retirement income. Because invested cash is illiquid and subject to withdrawal penalties, it is not recommended for younger individuals or for those with liquidity needs to use this financial product.

There are generally two different types of annuities:

IMMEDIATE:

Provides income payments that normally begin within a year after the premium is paid.

DEFERRED:

Provide income payments that begin later, often after many years. Deferred annuities are designed for long-term savings purposes.

• Available to purchase using a single lump sum, or with flexible premiums over time.

• When it comes time to take income from your deferred annuity, you will have many options available to meet your needs.

An annuity goes through several different phases and periods. These are called:

• The Accumulation Phase, which is the period of time when an annuity is being funded and before payouts begin. Any money invested in the annuity grows on a tax-deferred basis during this stage.

• The Annuitization Phase, which kicks in once payments commence.

These financial products can be immediate or deferred. Immediate annuities are often purchased by people of any age who have received a large lump sum of money, such as a settlement or lottery win, and who prefer to exchange it for cash flows into the future. Deferred annuities are structured to grow on a tax-deferred basis and provide annuitants with guaranteed income that begins on a date they specify.

Annuity products are regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Agents or brokers selling annuities need to hold a state-issued life insurance license, and also a securities license in the case of variable annuities. These agents or brokers typically earn a commission based on the notional value of the annuity contract.

Annuities usually have a surrender period. Annuitants cannot make withdrawals during this time, which may span several years, without paying a surrender charge or fee (Some are typically 5 years, but most are 10 years). Investors must consider their financial requirements during this time period. For example, if a major event requires significant amounts of cash, such as a wedding, then it might be a good idea to evaluate whether the investor can afford to make requisite annuity payments.

Annuities Explained:

Free-Look Period:

Most states require insurance companies to include a free-look period that allows a buyer to cancel the contract without incurring a surrender charge.

Riders:

Riders are addendums that allow the customization of basic annuity contracts. It’s important that you understand the riders you select and are aware of their additional costs.

Beneficiaries:

You can add a death benefit rider to your contract to ensure that your beneficiary receives a portion of the contract value.

Fees and Commissions:

The fees and commissions for annuities vary by the type of annuity. Fixed annuities generally have the lowest fees.

Taxation:

One of the most attractive features of annuities is their favorable tax treatment from the IRS. If your annuity was purchased with money that you've already paid taxes on, then only your earnings will be taxed when the money is withdrawn to live off. Annuities are tax deferred. But that doesn’t mean they’re a way to avoid taxes completely. What this means is taxes are not due until you receive income payments from your annuity. Withdrawals and lump sum distributions from an annuity are taxed as ordinary income. They do not receive the benefit of being taxed as capital gains.

How is an Annuity Taxed?

All annuities grow tax-deferred, meaning that you don’t have to pay any taxes until you take a distribution either through a regular payment or a withdrawal from an accumulation annuity. Unlike non-qualified investment accounts or savings accounts that are subject to annual taxation, the growth in an annuity can compound undisturbed and thus may grow more over time.

While the money in an annuity will grow tax-deferred, once you start withdrawing your money, that growth will be taxed as ordinary income.

But what about the money you paid into your annuity? The way this money is taxed depends on how you fund the annuity. There are two types of annuity accounts, qualified and non-qualified.

* Qualified Annuities are those purchased through a qualified plan like a 401(k) or SIMPLE IRA, and are normally paid for with Pre-Tax dollars. In this case, the tax rules governing qualified plans and IRAs essentially trump the annuity tax rules, which generally means that the full annuity payout is taxed as ordinary income.

* Non-Qualified Annuities are funded with After-Tax money that has already been taxed. And because the money you put in was already taxed, only the growth portion of your annuity is subject to taxation. The principal (or basis) — the money you put in — will be returned to you tax-free, while the earnings growth will be taxed as ordinary income.

The IRS considers annuities retirement vehicles, and as a result an early withdrawal or distribution could trigger a tax penalty. If the owner of the account or contract is younger than 59½ years old and withdraws funds from an annuity, the taxable portion of the payout could be hit by a 10 percent tax penalty.

How Does an Annuity Work? In order to establish an annuity contract, a client must make a cash payment or rollover of cash value from an existing policy (IRA or 401(k)) to an insurance company. 

- The payment may be made as a single lump-sum payment of cash (single premium) or made through a series of payments (flexible premium). 

- The money earns interest as it remains on deposit with the insurance company during what is called the “accumulation phase.” 

- Early withdrawal (before the age of 59½), can result in serious tax consequences. Once the accumulation phase is over, the “distribution (payout) phase” begins and the money is distributed systematically or by lump sum to the annuitant. Annuities offer a variety of accumulation periods and distribution methods.

If your annuity was purchased with money that you've already paid taxes on, then only your earnings will be taxed when the money is withdrawn. Annuities are tax deferred. But that doesn’t mean they’re a way to avoid taxes completely. What this means is taxes are not due until you receive income payments from your annuity. Withdrawals and lump sum distributions from an annuity are taxed as ordinary income.

In short Summary, People typically purchase annuities to provide or supplement retirement income they will receive from Social Security, pension benefits, investments and other sources.

Annuities can begin immediately upon deposit of a lump sum, or they can be structured as deferred benefits. The immediate payment annuity begins paying immediately after the annuitant deposits a lump sum. Deferred income annuities, on the other hand, don't begin paying out after the initial investment. Instead, the client specifies an age at which they would like to begin receiving payments from the insurance company.

Ideal age of Policy holders: 21-70 years old.