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An annuity is a contract between you and your insurance company that allows your earnings to grow and compound tax deferred. Tax deferral is a powerful benefit that you can use to help accumulate wealth for your retirement or meet other long-term financial goals.
The word "annuity" means "payments annually or at other regular intervals." An annuity has an accumulation phase and a payout phase. When you buy an annuity, the insurance company agrees to pay you an income for a specified period of time - either beginning immediately (an immediate annuity) or after an accumulation period ends (a deferred annuity).
There are two parties to an annuity (plus the insurance company): the owner, and the annuitant. The owner controls incidents of ownership in an annuity and has the right to the cash surrender value. The owner also can name the beneficiary, assign the policy, and make withdrawals. Often, the owner is also the annuitant. Most importantly, the owner is the party who receives the tax benefit of the annuity during the accumulation phase of the contract, and is responsible for payment of taxes on withdrawals or distributions. The owner does not pay income taxes as the income is earned (the tax deferral), however, the owner does pay taxes on withdrawals and distributions. The owner is typically the person who receives the payments during the income phase.
The annuitant is the person on whose life the terms of the annuity are measured. Again, the annuitant may also be the owner.
There are two main annuity types: deferred and immediate.
With an immediate annuity, your income payments start right away (or within one year). You choose whether you want income guaranteed for a specific number of years or over your lifetime. The insurance company calculates the amount of each income payment based on your purchase amount and your life expectancy. An immediate annuity is a permanent, irrevocable conversion of cash to an income stream.
A deferred annuity has two phases: the accumulation phase, where you let your money grow, and the payout phase, where you begin to receive scheduled payments. During accumulation, earnings grow tax-deferred until a withdrawal is taken. You decide when to take income from your annuity, and therefore, when to pay the taxes.
The payout phase begins when you withdraw income from your annuity. For most people, this is during retirement. As your needs dictate, you can take partial withdrawals, completely surrender your annuity, or convert your annuity into a stream of income payments (known as annuitization). This last option is essentially the same as buying an immediate annuity.
Withdrawals made prior to age 59 ½ are generally subject to a 10% IRS penalty tax and may be subject to charges
Annuities differ in the way they generate earnings and also in the amount of risk involved.
When you buy a traditional fixed annuity, the insurance company guarantees you an interest rate for a certain period of time. At the end of this period, the insurance company will declare a renewal interest rate and another guarantee period. In addition, most fixed annuities have a minimum interest rate that is guaranteed for the life of the contract. In other words, you will never receive less than your guaranteed interest. Traditional fixed annuities typically appeal to people who feel more comfortable knowing exactly how much their money is earning.
With a variable annuity, you allocate your funds among a variety of investment options with objectives ranging from aggressive to conservative (insurance companies call these sub-accounts). Your investment returns are tied to the performance of the underlying investments of the sub-accounts. Variable annuities typically appeal to people who are willing to accept a higher rate of risk in return for higher growth potential. The Lafayette Life Insurance Company does not offer variable annuities.
Indexed annuities are fixed annuities and have the potential to earn interest based, in part, on the positive movement of a market index, and may offer a fixed option that provides a guaranteed interest rate. Because you are not invested in the market, like variable annuities, you cannot lose your principal because of market performance. You are guaranteed a value of no less than the guaranteed minimum surrender value stated in your contract, minus any previous withdrawals.
Index interest credited to the policy is determined, in part, by the percentage of change in the specified market index.
The index interest credited to a policy is generally limited by an interest rate cap, which is the maximum interest rate than can be credited to the account value in a given indexed interest option. There is generally also a participation rate, which is the percentage of any index increase or decrease that is applied to the formula for determining the interest rate credited to the account value in a given indexed interest option. There is no guarantee the index interest rate credited under any of the indexing interest options will be equal to its cap rate or even greater than 0%.
The principal amount and investment earnings in a variable annuity are not guaranteed and will fluctuate with the performance of the underlying investments such that when redeemed, an investor's units may be worth more or less than their original cost.
All annuities offer you tax deferral. When your earnings are not eroding by taxes each year, they compound faster. Faster growth of your money can mean more spendable income for you in retirement.
Whether you're buying an immediate annuity or converting a deferred annuity into income payments, your options are essentially the same. You can choose to receive payments monthly, quarterly, semiannually or annually. You can elect a specific period of time in which to receive payments. You can choose an option that will guarantee income payments for as long as you live. All options, once elected, are permanent and irrevocable.
When you buy an immediate annuity or "annuitize" a deferred annuity, a portion of each payment is considered earnings and a portion is a tax-free return of your principal. You are only subject to taxes on the portion of each payment that represents earnings. Once enough payments have been made that you recover your entire tax-free principal, each additional payment will be fully taxable. There are other ways you can access the accumulated value in your annuity. For example, instead of annuitizing, you may want to take withdrawals. In that case, distributions represent taxable earnings first. After all earnings are distributed, tax-free return of principal remains.
If your annuity is inside an IRA, 401(k) or other qualified retirement plan, 100% of each payment will be subject to taxes. You should consult your attorney or tax advisor regarding your particular situation.
Most annuities allow withdrawals at least once a year (usually 10% of the accumulated value in your annuity, but sometimes less) without a company charge. Another way to receive income from your annuity is through systematic withdrawals. A systematic withdrawal program allows you to enjoy a steady stream of income on a monthly, quarterly, semi-annual, or annual basis. Unlike annuitization, which is a permanent decision, systematic withdrawals allow you to start and/or stop your income payments as your needs dictate. You can have the amount of your payments increased or decreased–it's up to you. However, the withdrawals can never be more than the surrender value, usually not more than 10% of the accumulated value of your annuity. Systematic withdrawals give you added flexibility without giving up control of your money or your taxes. Systematic withdrawals tax your earnings first. So when all of your earnings have been exhausted, tax-free return of principal remains.
Withdrawals made prior to age 59 ½ are generally subject to a 10% IRS penalty tax and may be subject to charges.