What Is an Annuity?
An annuity is a long-term contract with an insurance company that guarantees the employee (or "annuitant") a steady stream of income at a future date. Most frequently, annuities are used to save additional money for retirement as part of an overall financial plan.
How Does an Annuity Work?
A person may purchase an annuity contract independently or receive one through their employer. Annuity contracts require you to make a series of payments or submit a lump sum in exchange for income paid out on a regular basis. You won’t pay taxes on annuity investment gains until you hit the distribution phase. If you pass away before this time, your beneficiaries will receive the payments. This is called a "death benefit."
One example is a fixed annuity, which offers financial protection much like a life insurance policy. In this plan, you pay a fixed monthly amount in exchange for a fixed monthly payout when you retire.
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What Are the Common Types of Annuities?
Annuity contracts can serve short-term or long-term needs. Common types of annuities include:
An immediate annuity is usually ideal if you're going to retire soon. Under this program, you pay a lump sum or a series of smaller payments in exchange for a stream of income that begins right away. For example, you might pay $265,000 to purchase an annuity and immediately start receiving a $6,500 monthly payout that lasts over a specified period.
Deferred annuities provide payments at a predetermined date in the future, coinciding with different disbursement timelines. For example, you could choose a plan that starts paying 15 or 25 years from now (depending on when you want to retire) and continues for the rest of your life.
What Is a Qualified Employee Annuity?
A qualified employee annuity is a retirement savings plan purchased by an employer for their employee. Qualified annuities are funded with pre-tax dollars (gross pay), meaning neither your contributions nor the investment gains are taxed until you begin receiving payouts in the distribution phase.
If you withdraw money from your retirement annuities before age 59 ½, you'll owe the IRS a 10% penalty plus income tax levied on the funds. However, this penalty is waived if the money is withdrawn if an annuitant dies or becomes permanently disabled and needs long-term care.
What Are the IRS Requirements for an Employee Annuity?
Qualified and non-qualified employee annuities are regulated differently. The IRS requirements for these programs are as follows:
- Qualified employee annuities are funded with pre-tax dollars, while non-qualified annuities are funded with post-tax dollars.
- If an employee receives annuity payments with no investment in the contract, those payments are fully taxable.
- If an employee withdraws funds before their annuity start date (the day of the first period in which an employee receives a payment) and their annuity is under a qualified plan, part of the amount is taxable.
- If an employee withdraws funds on or after their annuity start date, the entire amount is taxable.
For more information about the rules on qualified and non-qualified annuities, review IRS Publication 575.
Annuity vs. 401(k) Retirement Options
Annuities and 401(k) plans are two popular retirement savings options. Though they share similarities (like tax-deferred growth), they also hold key differences you should know to ensure you're providing the right benefits to your employees.
Here are the main differences between an annuity and a 401(k):
- Access: While anybody can purchase an annuity from a life insurance company, people can only have and contribute to a 401(k) if their employer offers one (unless they're self-employed).
- Financial security: Annuities offer guaranteed payments throughout your lifetime to help ensure you won't run out of money during retirement. A 401(k) doesn’t carry as much security—you basically get what you give, plus any investment earnings accrued in the account.
- Limits: 401(k) plans carry limits on the amount you can contribute each year. For example, in 2023, the contribution limit was $22,500 for those aged 50 and under. Annuities have no maximum, allowing you to put away more money for retirement.
- Borrowing: You can borrow money from a 401(k) or an annuity, but annuity loans often come with heavier fees and penalties.
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Buying and Selling Annuities: What to Know
You can buy annuities from life insurance companies and some brokerage firms, mutual fund companies, and banks. Make sure to investigate all annuity types and choose the best option based on when you expect to retire, how you want your earnings to be calculated, and how you want to be paid.
To purchase the annuity, you’ll submit an application to the firm and receive a quote. Then, you'll sign a contract and begin paying for your annuity through a funding source, such as cash, a brokerage account transfer, or funds from another retirement account.
6 Common Fees for Annuities
It's important to familiarize yourself with additional costs associated with your program to avoid any surprises. For instance, variable annuities carry several common fees, including:
- Surrender charges: These charges apply if you withdraw from or sell the annuity before the surrender period expires.
- Mortality and Expense (M&E) risk charge: A percentage of your account value is charged (typically around 1.25%) to pay the issuer for the risk they assume in selling you the annuity.
- Underlying fund expenses: These fees are for managing underlying mutual funds within the account.
- Administrative fees: These cover the administration of your account, including recordkeeping and investment-transfer costs.
- Charges for additional features: These fees are for features outside the basic contract that help annuitants tailor their plans to better meet their needs.
- Withdrawal penalties: This is the income tax and 10% penalty you'll owe for withdrawing money before age 59 ½.
How to Withdraw Money From an Annuity
The easiest way to withdraw money from an annuity is to wait until the eligibility age. Then, call your annuity issuer and follow their instructions to set up a structured withdrawal schedule.
You can also opt for a partial or lump-sum sale in which you sell a particular dollar amount of your annuity or a number of future payments.
Alternatively, you can simply withdraw what you need from your annuity. Each insurance company, bank, or investment firm will have a different process for this, so it’s best to call your account manager or financial advisor and ask them to walk you through it. Be aware that income tax and IRS penalties apply to early withdrawals.
Finally, you can consider closing out the annuity contract. However, you'll incur the same fees, which will significantly reduce the amount of cash available from the transaction.
Before a premature withdrawal or closure, it’s important to ask yourself, “What is an annuity account’s purpose in my larger financial picture?” If you truly desire to have an annuity as a retirement account, you may want to steer clear of costly withdrawals and consider other options.
Choosing Whether to Offer Qualified Employee Annuities
Although annuities offer a guaranteed stream of retirement income, not many organizations offer them among traditional investment options.
Research shows they're not very popular among retirees, with only 5% relying on them for income and 9% of non-retirees expecting to rely on them. Some employers are also hesitant to offer annuities because of the hurdles and complexities commonly associated with this benefit, such as:
- Finding an annuity provider that will be around for the long haul. If you do find one, they can pay an employee over the course of their lifetime.
- Finding a provider that offers substantial liability protection.
- Managing costs related to moving participants’ investments from one employer to another. This generally entails fees that differ across providers/plans.
While some employers do offer annuities as a central part of their retirement benefits (and automatically enroll new employees unless they choose to opt out), many businesses are not yet ready.
It’s crucial to research how to navigate and negotiate lower investment fees and provide the best possible annuity benefits to your team. If a company’s workforce is large enough, negotiations may be much easier to initiate.
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