An annuity is a financial product that provides a stream of income, typically for retirement purposes. There are many different types of annuities, but all have the same core mechanism; you purchase the product, either through regular premiums or a lump sum, and then at some point in the future benefits are triggered.
For many individuals, annuities can be a great resource for income during retirement. Some annuities include a cash value component that allows the annuity account to grow tax-deferred before benefits are triggered, which helps to increase the benefit payout amounts.
There are two general categories of annuities: immediate and deferred.
Purchased with a lump sum, benefit payments from immediate annuities are usually triggered within a year of purchase, if not earlier. Immediate annuities are commonly known as “Single Premium Immediate Annuities” and do not have an accumulated cash value component.
Deferred annuities are “deferred” in two ways. First, benefits are delayed for a period of time, during which the contract gathers cash value. Second, gains within the annuity account are tax-deferred until distribution, meaning that a consumer doesn’t face a tax liability until they trigger benefits. This helps to accumulate more income that can then be used in retirement.
Several kinds of deferred annuities exist in the marketplace. Typically, they are identified by the means in which they gather cash value.
Types of Deferred Annuities
In a traditional fixed annuity (FA), the interest rate may change year to year as set by the insurance company, but usually, there will be an ongoing minimum guaranteed rate. Traditional fixed annuities may be a good fit for individuals wanting steady, regular growth.
In a fixed indexed annuity (FIA), the interest rate is tied to the performance of a specific stock market index, such as the Dow Jones Industrial or the Standard and Poors 500. While the rate is based on index movement, a fixed indexed annuity has no direct involvement with the stock market. Fixed indexed annuities may be appropriate for individuals desiring a safe product for their money with upside potential.
A deferred income annuity (DIA) works in much the same way as other deferred annuities, with benefit amounts tied to the purchase amount (usually paid in a lump sum). Deferred income annuities involve a period of deferral and are typically structured to last the rest of an annuitant’s life. The longer the period of deferral, the more the benefits grow before distribution.
Among these categories, there may be other levels of customization and variation. One common and useful enhancement is the lifetime income rider. Typically available for additional fees, a lifetime income rider provides the annuitant a source of income that cannot be outlived.
Ultimately the right annuity and options for you will depend on your unique situation, objectives, and needs. This is why it is helpful to involve a knowledgeable financial professional when you begin retirement planning.