Fixed Annuity Frequently Asked Questions
What is an annuity?
Answer: An annuity is a contract between you (the purchaser or owner) and an insurance company. In its simplest form, you pay money to an annuity issuer, and the issuer then pays an income stream back to you or to a named beneficiary. Annuities are generally used to provide income in retirement.
In an annuity, your money is tax deferred until you withdraw it. The trade off is that if you take your money out before age 59½, you’ll usually have to pay a 10 percent early withdrawal penalty to the IRS, unless an exception applies.
Most life insurance companies sell annuities. You pay the insurance company a sum of money, either all at once or
incrementally. The type of annuity you own determines whether your money earns a fixed amount or an amount that depends on the equities in which the annuity is invested. At a designated time chosen by you, the insurance company generally begins to send you regular distributions from the annuity’s account. Or, you may be able to withdraw the money over time or in one lump sum.
There are many different kinds of annuities. Four of the most common are the following:
- Single premium immediate annuity: You pay the insurance company a lump sum now and begin to receive withdrawal
distributions for a period of time you specify. The amount you receive will vary according to the length of time the
payments are to last and whether anyone will receive the remaining balance at your death.
- Single premium deferred annuity: You pay the insurance company a lump sum now and defer receiving withdrawals until
later. The amount of those distributions will depend on the value of your account at the time your payments begin, the
length of time the payments are to last, and whether anyone will receive the remaining balance at your death.
- Additional premium deferred annuity: You send money to the insurance company usually monthly, quarterly, or annually.
You defer your withdrawals to a later date.
- Variable annuity: This type of contract is a vehicle for equity investments. You can do a one-time deposit or contribute
throughout the life of the contract. You have choices as to how your money is invested in an offering of investment
portfolios, and you may invest conservatively or aggressively. The growth of your account value will vary, depending on
your choice of investments.
Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk including the possibility of loss of principal. Variable annuities contain fees and charges including, but not limited to mortality and expense risk charges, sales and surrender (early withdrawal) charges, administrative fees and charges for optional benefits and riders. Variable annuities are sold by prospectus. You should consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity, or from your financial professional. You should read the prospectus carefully before you invest.
Can I change my annuity for one with a better interest rate?
Answer: Yes. However, to receive favorable tax treatment, the exchange must satisfy the requirements of a Section 1035 exchange. According to Section 1035 of the Internal Revenue Code, you can exchange one annuity for another without the immediate recognition of any gain or loss, as long as the following requirements are met:
- The annuity cannot be cashed in and the proceeds then used to purchase a new annuity contract. Rather, the value of
the old annuity must be transferred to the new annuity, usually by assigning rights to the old annuity to the company
issuing the new annuity.
- The exchange must involve like-kind property (i.e., property that is similar in nature or class and of equal value). If the
annuitant receives cash or a payment in kind of cash or property, then that part of the exchange involves property that
is not like-kind and may be taxable.
- Under the new contract, the owner, along with the annuitant, must be the same as under the old contract. Both contracts
must also be payable to the same person(s) (the beneficiary).
Also, be aware that surrender charges may reduce the value of the annuity you transfer. In addition, the new annuity likely will impose a new set of surrender charges.
I’m confused–is an annuity an investment vehicle or an insurance policy?
Answer: An annuity is a distinctive financial product. Although it’s not an insurance policy per SE, it is a contract with an insurance company. Many different types of annuities exist, with many different features. A deferred annuity is a savings vehicle that accumulates earnings on a tax-deferred basis. An immediate annuity is a financial instrument that converts a lump- sum premium into a stream of payments over a certain period of time or for as long as the annuitant lives.
Here’s how it works. You (the annuitant) pay cash to an annuity issuer (the insurance company) for either a deferred or an immediate annuity, which will accumulate earnings at a fixed interest rate (a fixed annuity) or a variable rate determined by the growth (or losses) in investment options known as subaccounts (a variable annuity). With a deferred annuity, you (or the beneficiary you chose) can receive the principal and earnings in one lump sum when the contract is surrendered (i.e., cashed in). With an immediate annuity, you (or your beneficiary) receive the principal and earnings over a predetermined period of time.
An annuity may have certain guaranteed or insurance-like characteristics. (Guarantees are based on the claims-paying ability of the issuing insurance company.) For example, a deferred variable annuity may guarantee that your beneficiary will receive at least the amount of your original principal if you die, even if the value of the annuity has declined due to poor performance of the subaccounts you selected. And whether you purchase a fixed or variable immediate annuity (or if you’ve chosen to annuitize a deferred annuity), you’re guaranteed to receive payments for life if you elected that payout option, no matter how long you live.
Deferred annuities are most commonly used to help save for retirement. Immediate annuities are generally used to provide a guaranteed income during retirement.
I bought an annuity a few years ago, but I don’t want it anymore. Is there a way to get rid of it?
Answer: You can cancel your annuity at any time. However, you may have to pay an early cancellation fee known as a surrender charge. The federal government will also penalize you if you cancel your annuity before you reach age 59½.
Your annuity contract should have its surrender charges explained in the contract itself. If you cancel the annuity before the date stipulated in the contract, you will be charged a fee that is a percentage of the withdrawn amount. The surrender charge is usually reduced as the annuity gets older and typically ends after the first 10 years. For example, if you wish to cancel a contract that has been in effect for 5 years, the surrender charge will typically be a lower percentage than it would be if your contract has been in effect for only 3 years. Insurance companies will usually allow you to withdraw a certain percentage, typically 10 percent, of your account annually without having to pay any surrender charge.
Besides the surrender charges that the insurance company imposes, the federal government may penalize you 10 percent of the earnings portion of the withdrawn amount if you cancel your annuity before you reach age 59½. In fact, the government will charge the same percentage on any amount you withdraw from your annuity before age 59½, to the extent the withdrawal represents untaxed earnings, even if you don’t cancel the contract.
So, before you cancel your annuity, speak to a trusted financial advisor to make sure you understand any surrender charges or governmental penalties you may incur.