If you follow this blog, you know I usually write about senior living and continuing care retirement communities (CCRCs or life plan communities). Choosing a retirement community is a major financial decision, so this week I’ll address a related topic that often causes confusion: annuities.
Before founding myLifeSite, I spent 14 years as a financial planner. I still enjoy explaining retirement finance, and I’m often asked about annuities. This article summarizes the main types of annuities, how they work, and key features to consider when evaluating them.
Annuities in a nutshell
Annuities are insurance contracts issued by insurance companies. Unlike life insurance, which pays upon death, annuities provide income during life. All annuities fall into one of two broad categories: immediate annuities and deferred annuities. Each category includes several variations that affect timing, tax treatment, investment risk, fees, and payout options.
Immediate annuities
An immediate annuity converts a lump sum into a regular income stream that begins almost immediately. A lifetime annuity, for example, pays a set amount each month for as long as the annuitant lives. The annuitant is the person whose life determines payout duration; the owner and annuitant are often the same person but can differ, for instance when someone purchases an annuity to provide income for an elderly parent.
Monthly payouts depend on the annuitant’s age, life expectancy, and prevailing interest rates. If the annuitant lives to or beyond their actuarial life expectancy, total payments typically exceed the original lump sum. If the annuitant dies shortly after purchase, the total received may be less than the original payment unless the contract includes a guaranteed period or other beneficiary protections. Common payout options include:
- Lifetime annuity: Pays income for the annuitant’s lifetime and may be structured as a joint-life annuity to cover a spouse; joint-life payouts are usually lower than single-life payouts.
- Life with period certain: Pays for life but guarantees a minimum payout period; if death occurs within that period, remaining payments go to the beneficiary.
- 10-year certain: Pays income for a fixed 10-year period regardless of whether the annuitant lives the full term; this option typically provides higher monthly payments than lifetime options if the annuitant’s life expectancy exceeds the fixed term.
Ask your insurer about all available payout options and how each affects monthly payment amounts and beneficiary rights.
Tax exclusion ratio
One tax advantage of immediate annuities is the exclusion ratio: part of each payment may be treated as a return of principal and therefore not taxable. For example, if a monthly payment is $1,000 and 60% is classified as return of principal, only $400 is subject to income tax. The exclusion ratio generally increases with the annuitant’s age.
Using immediate annuities for fixed expenses
Immediate annuities can provide guaranteed income to cover fixed, non-discretionary expenses—such as housing or monthly retirement community fees—while discretionary spending comes from other savings. For residents of CCRCs or similar communities, an immediate annuity can be a useful tool to ensure monthly fees are covered.
Deferred annuities
Deferred annuities accumulate funds over time and begin paying out at a future date. Contributions grow tax-deferred, meaning taxes on interest and gains are postponed until withdrawals are made. This distinguishes deferred annuities from taxable vehicles like certificates of deposit, where interest is taxed annually.
When accessing a deferred annuity, owners typically have two options: convert the contract to an immediate annuity to receive guaranteed periodic income, or take periodic withdrawals while leaving the remaining balance invested to continue growing. Some contracts require annuitization at a specified date.
Taxes on withdrawals from deferred annuities
Withdrawals from deferred annuities are taxed using LIFO (last in, first out) accounting: earnings are treated as withdrawn before principal. Withdrawals taken before age 59½ are subject to ordinary income tax on earnings plus an additional 10% penalty tax, unless an exception applies. Principal withdrawals are generally not taxable. For example, if $100,000 was invested and the contract value has grown to $120,000, the first $20,000 withdrawn would be taxed as ordinary income.
Fixed, variable, and equity-indexed annuities
Deferred annuities can be structured in different ways depending on how funds are held or invested:
Fixed annuity: Funds earn a specified interest rate or a rate that resets periodically. Fixed annuities cannot lose principal and usually guarantee a minimum interest rate, making them stable but typically offering lower long-term growth than market-based options.
Variable annuity: Contributions are invested in a separate account that resembles mutual funds. The account value can rise or fall with market performance, so variable annuities carry investment risk and may lose value. They offer potential for higher long-term growth but usually come with higher fees.
Equity-indexed annuity: Returns are linked to a market index’s performance (often the S&P 500) but the funds are not directly invested in the market. These contracts typically credit growth up to a cap or subject to participation rates; in down markets the credited return may be zero, but principal is generally protected from market loss. Indexing methods and crediting formulas vary widely, so contract specifics matter.
Other important details about annuities
Withdrawal penalties (surrender charges)
Deferred annuities often impose surrender charges if you withdraw more than allowed during a surrender period that can range from a few years to a decade or longer. Longer surrender periods typically correspond with higher guaranteed interest rates. Surrender charges are measured from the contract purchase date rather than the annuitant’s age.
10 percent free withdrawals
Most contracts allow penalty-free annual withdrawals up to a set amount—commonly 10% of the current contract value or occasionally 10% of the original purchase amount. Check the contract to confirm which applies.
Death benefit
Annuities usually provide a death benefit to beneficiaries equal to at least the original premium minus withdrawals, regardless of account performance. For variable annuities, many contracts guarantee that the beneficiary will receive at least the principal amount invested, which can be an important legacy protection if market losses occur.
Guaranteed minimum withdrawal benefit (GMWB)
Variable annuities have evolved to include optional guarantees such as a guaranteed minimum withdrawal benefit (GMWB). A GMWB may allow the owner to withdraw a specified percentage of a benefit base each year—say 5%—for life or for a set period without annuitizing the contract. If the account value is depleted, the guarantee can continue payments based on the benefit base. These guarantees often increase the guaranteed withdrawal amount when you defer withdrawals, for example by compounding the benefit base by a set percentage annually. Fees for GMWBs can be substantial, and any guarantees depend on the financial strength of the issuing insurance company.
GMWBs can complement other fixed income sources and may be useful for covering consistent expenses like monthly retirement community fees, while other savings cover discretionary spending.
Annuities held in IRAs
Holding a tax-deferred annuity inside an IRA generally offers no additional tax advantage because IRAs are already tax-deferred. Variable annuities often carry higher fees, so placing them inside an IRA can result in paying unnecessary costs for a benefit you already receive. Advisors have been criticized for recommending variable deferred annuities in IRAs primarily because clients gain no extra tax deferral while potentially incurring higher fees and commissions.
That said, some people choose annuities within IRAs for benefits other than tax deferral—for example, to obtain a GMWB or other guarantees. If considering this route, understand the fees, contract features, and the fact that tax deferral is not an additional benefit within an IRA.
Summary
Annuities come in many forms with distinct trade-offs in timing, tax treatment, investment risk, fees, guarantees, and beneficiary protections. Immediate annuities convert a lump sum to guaranteed income, while deferred annuities allow tax-deferred growth and flexible access later. Fixed annuities offer stability, variable annuities offer market exposure, and equity-indexed annuities offer limited market participation with principal protection features. Optional guarantees like GMWBs provide income protections at a cost and rely on the insurer’s financial strength.
Because annuities can be complex and expensive if chosen without care, consult a trusted financial advisor to determine whether an annuity fits your retirement plan and to compare specific contract terms, fees, and guarantees before purchasing.