Even if you're a seasoned investor, annuities can be disconcertingly different. Their ancestry lies within the insurance industry rather than the investment world, so in some ways, they resemble life insurance more than a conventional investment such as a mutual fund. This isn't necessarily good or bad, it just means you need to do the necessary research. Some of the annuity world's quirks, such as temporary annuities, can be quite useful in certain circumstances.
When you invest in mutual funds, there's no way to guarantee the outcome. They're likely to give you a profit, but the company could also lose your money. An annuity works differently. When you invest in an annuity, either as a lump sum or by years of payments, the company will contractually guarantee you a minimum income from your capital. Once that rate is set and you've begun drawing an income, the contract usually obligates them to make the same payment for the rest of your life, even if the markets crash. As long as the company remains solvent, you can't outlive your income.
The size of income you derive from an annuity is determined by your age and projected lifespan. If you start drawing an income at 60 years of age, your payments will be much lower than if you started at 78. Temporary annuities can provide even higher incomes by limiting the payout period to a set term. Often called term-certain or period-certain annuities, they can pay either for a given number of years from the start date, or to a specific age. This limits the company's risk, and allows them to be more generous with the payments from a given amount of capital.
Using Temporary Annuities
The most common use of a temporary annuity is to provide a short-term, or "bridge" income. For example, if you retire at 55 you might use one to provide income for a decade, until you draw your company pension or receive Social Security benefits. Alternatively, you might wish to travel for the first few years of your retirement. A temporary annuity could provide the additional income you need to support that ambition. They can also provide short-term income for a former spouse or partner, until the children of the marriage come of age.
Your contributions to the annuity are made with after-tax dollars, so when you withdraw those funds they're not taxed again. However, any growth in the annuity was sheltered from taxation, and becomes taxable at your regular rate when it's withdrawn. If you buy the annuity with a lump sum and draw an income immediately, the effect is minimal. However, if you begin contributing at 25 and draw an income at 55, that's no longer the case. Furthermore, if you're under the age of 59 1/2 when you receive the income, the percentage of your income that came from growth is subject to an additional 10 percent tax penalty.
- Texas Department of Insurance: Understanding Annuities
- California Department of Insurance: What Seniors Need to Know About Annuities
- CNN Money Ultimate Guide to Retirement: Annuities -- What Payout Options Do I Have?
- California Public Employees' Retirement System: A Guide to Your CalPERs Temporary Annuity
Fred Decker is a trained chef and certified food-safety trainer. Decker wrote for the Saint John, New Brunswick Telegraph-Journal, and has been published in Canada's Hospitality and Foodservice magazine. He's held positions selling computers, insurance and mutual funds, and was educated at Memorial University of Newfoundland and the Northern Alberta Institute of Technology.