How Annuity Payments Work

An annuity is a financial contract between an investor and an insurance company. The investor gives the insurance company a specified amount of money in exchange for guaranteed payments. Annuities can either be deferred, meaning that taxes on the earnings along with the distribution of payments are deferred until a later time, or they can be immediate.

With an immediate annuity, the payments normally begin within 12 months of the start of the contract. Investors who have not yet reached retirement age are more likely to invest in deferred annuities as part of their retirement savings plan, while those who have reached at least age 59 ½ or those who have taken lump-sum distributions from qualified plans will often choose immediate annuities.

Some employers offer the choice of an annuity as part of a defined contribution plan. Money can be deducted each month from the employees pay and placed in the account. An employee can also choose to purchase an annuity on his or her own if the maximum amount allowed by current law has been contributed to a retirement plan.

How Are Deferred Annuity Payments Structured

Because the earnings on a deferred annuity grow tax-deferred until the payouts begin, an annuity can be a good way to increase retirement savings. Following the accumulation phase of the annuity, which is the time payments are being made by the investor, the distribution phase begins. This is referred to as “annuitizing the contract”.

When purchasing the contract, the investor can choose between payouts that are guaranteed for a set number of years or payouts that are guaranteed for life. The length of the payout period, along with the amount of money in the annuity will determine the payout amount. An annuitant can also choose a payout structure that provides income on a monthly, quarterly or annual basis.

The amount of an annuity payout also depends on the type of return the investor needs to achieve and the amount of risk he or she is willing to take. The three most common types of deferred annuities are fixed, variable and indexed. Each has its benefits and its drawbacks. Investors are always advised to match their annuity selection with their risk-tolerance level. It’s also a good idea to discuss an annuity purchase with a tax advisor or other financial professional.

Fixed Deferred Annuity Payouts

The annuity payouts generated by a fixed annuity remain the same annually, but may fluctuate from year to year depending on market conditions. In other words, if the annuitant chooses monthly payouts, the 12 payouts that begin with the anniversary of the contract would be the same, but the next 12 payouts may be higher or lower depending on interest rates in general.

The upside to a fixed annuity is that the payouts, at least for 12 months, are known. The downside occurs if the fixed rate falls significantly. However, most insurance companies will allow an annuitant to surrender the contract without penalty if the rate that is credited drops substantially below the contract rate.

A fixed annuity is a good choice for investors who are risk-averse or who have other sources of cash. Investors in a fixed annuity may also appreciate knowing that they will receive a guaranteed amount of cash each month.

Variable Deferred Annuity Payouts

The annuity payouts paid to an investor who owns a variable annuity change based on the return that is earned on the underlying investments. The premiums that are paid toward a variable annuity are placed in an account that invests in stocks, bonds and possibly other types of financial instruments. The annuitant then directs the insurance company to make the investments on his or her behalf in an attempt to capture market gains.

A variable annuity can provide added diversity to a portfolio. For the investor who wants to ensure that the risk of his or her investments is spread out over a number of different industries that do not move in tandem, a variable annuity can provide the answer. While diversity may reduce the potential for the highest possible gains, it should protect an investor in the event one industry is subjected to a significant market downturn.

The difference between the returns of a fixed annuity and a variable annuity can be significant over time, especially if the underlying investments do very well. If the investor is investing the premiums in areas of high growth over a period of years, the accrued gains can compound very quickly. Tax-deferred accounts generally accrue more quickly as money is more dollars are retained within the account and not removed for taxes. However, investors should also be mindful of the potential losses that can be incurred. During a market downturn, the higher risk factor can result in a loss of principal.

Indexed Annuity Payouts

Indexed annuity payouts are tied to a market index such as the Standard and Poor’s 500. An indexed annuity achieves gains, or losses, with the underlying index. For example, if the S&P 500 increases by 2%, the value of an indexed annuity would increase by 2%, minus the management fees charged by the insurance company for managing the investment.

An indexed annuity can be a good choice for investors looking to increase their market exposure but who feel they do not have the skills necessary to manage their money.

How Are Immediate Annuity Payouts Structured

Because immediate annuities are most often purchased with a lump-sum amount at or after retirement, the most common type of immediate annuity is fixed. The payouts begin immediately and only the amount of interest earned is taxed. The Internal Revenue Service considers annuity payouts to be the return of principal. Therefore, the tax liability of annuity payouts is generally quite favorable.

Immediate annuity investors can also choose payouts that are monthly, quarterly or yearly. Payouts can be guaranteed for life or for a predetermined number of years. Whatever annuity payout structure an investor chooses, knowing that the income is guaranteed goes a long way toward providing financial stability during retirement.