There's a widely known joke that describes a camel as "a horse designed by a committee." You could describe an annuity in similar terms, because of its unusual heritage. Annuities are an ungainly hybrid of life insurance policy and investment product, and they're rather odd to the unpracticed eye. It helps to have an understanding of how they're structured.
An annuity's life cycle has two phases, the accumulation phase and the payout phase. The accumulation phase can consist of a single lump-sum payment, for example if you have a chunk of cash or if you're rolling over funds from another investment. More often you'll pay into it for years, like a mutual fund or life insurance policy, until you're ready to retire and start taking an income. That's when the payout phase begins. It can last for a set time or the rest of your life, depending how you set up the contract.
An annuity is a financial contract between four parties. One is the insurance company, which takes your money and invests it for your retirement. The second is the owner of the annuity, the person who buys it and makes the payments. The third is called the "annuitant," which means the person who's going to receive the payments eventually. Usually the owner and annuitant are the same, but not always. For example, the higher-paid spouse can purchase an annuity to benefit a lower-paid spouse, or parents can buy one to provide for a disabled child. The fourth parties are beneficiaries, one or more people or organizations who receive the annuity's funds if the annuitant dies before collecting them.
Three Investment Options
You can choose how the funds in your annuity are invested, based on your financial goals. If you choose a fixed annuity, your money is invested conservatively and you'll get a guaranteed minimum return. If your insurer does really well in the markets, you'll usually get more than the guaranteed rate. If you're looking for better returns, you can choose a variable annuity instead. They're invested in mainstream securities such as mutual funds, so they combine the possibility of a bigger retirement income with the potential for loss if the markets go bad. Index funds are similar, except your returns are pegged to an index such as the S&P 500. Index and variable annuities often have a minimum-return guarantee to cushion you during market downturns.
Life Income ... or Not
At some point you'll start taking money from your annuity, a process called annuitization. How you set up the payout phase determines the size of your payments. For example if you're using your annuity to provide an income between retiring at 60 and getting your pension at 65, you can take pretty large payments for five years. If you want that same amount to last until you die, payments will be smaller. The insurer has to guess your likely lifespan, and provide that guaranteed amount for the duration. You can even set it up so your annuity provides income for two of you, until the second person's death. That's comforting, but it makes the payments smaller.
The Taxman Cometh
One of the perks annuities offer is tax-free growth for your investment, without the contribution limits you'd face with an IRA or 401(k). Of course, that means the tax man has an interest in what happens with that money when you start taking it out. Basically, your annuity contains two kinds of money. The amount you invest comes from your after-tax income, so it's not taxable when you take it out. But the growth in your investment is taxable at your normal rate. If you withdraw from the annuity before you reach age 59 1/2, the IRS also will hit you with a 10 percent surcharge on the taxable portion.
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