You're not alone. Many people have difficulty understanding them. The main reason for all the confusion: Annuities may be single or flexible-payment; fixed or variable; deferred or immediate. No matter the type, annuities are financial contracts with an insurance company that are designed to be a source of retirement income. This page is designed to inform you about annuities in general. 

Single vs. Flexible-Payment Annuities

You can purchase an annuity in two ways:

Fixed vs. Variable Annuities

There are two basic types of annuities you can buy-fixed and variable.

Fixed Annuities

Fixed annuities earn a guaranteed rate of interest for a specific time period, such as one, three or five years. Once the guarantee period is over, a new interest rate is set for the next period. This guarantee of both interest and principal makes fixed annuities somewhat similar to Certificates of Deposit (CDs) purchased from a bank. Unlike a typical CD, however, an annuity is not backed by the Federal Deposit Insurance Corporation (FDIC); its security is directly related to the financial health of the insurance company that issues the annuity.

Variable Annuities

Variable annuities typically offer a range of investment or funding options. These funding options may include stocks, bonds and money market instruments. The return on variable annuities can go up or down. Your principal and the return you earn are not guaranteed; they depend on the performance of the underlying investment options. If the funding options you choose for your annuity perform well, they may exceed the inflation rate or fixed annuity returns. If they don't, you may lose not only prior earnings, but even some of your principal.

Variable annuities usually have more features and higher fees than fixed annuities. With some fixed annuities, contract expenses – such as maintenance and contract fees – are taken into consideration when the company declares periodic interest rates or determines the payment amount. Surrender changes may also apply.

Variable annuity fees are more complicated. They may include an annual contract charge that covers administrative expenses and surrender fees, as well as a mortality and expense risk charge. Variable annuities charge this latter fee to guarantee the death benefit, the availability of payout options and the level of expenses.

In addition, a variable annuity has fees for the management and operating expenses of the funding options in which your money is invested. These charges pay for everything from the fund manager's salary to the costs of printing the fund prospectus.

Deferred annuities can be a great way to accumulate money for retirement, if you want retirement income beyond what you will receive from Social Security or your pension plan. They are particularly effective if you have many years before retirement. Your money grows tax deferred, which means you pay no taxes on earnings until you begin to withdraw your money.*

*Note: Unlike a nonqualified deferred annuity purchased with after-tax-dollars, an IRA receives tax deferral under the provisions of the Internal Revenue Code. Therefore, there is no additional tax benefit in purchasing a deferred annuity.

If the tax-deferred aspect of a deferred annuity is important to you, make sure the expenses do not outweigh the tax benefits. This can be a tough judgment call, but a good guideline is that if the expense charges are more than 1.5% greater than a comparable financial vehicle and your time horizon is less than 10 years, a deferred annuity may not be the option for you. Consult a tax advisor for assistance in making this determination.

A deferred annuity is not a vehicle for money you may need for current expenses. If you withdraw income before age 59½, the IRS will usually apply a 10% penalty in addition to ordinary income tax, similar to the penalty for early IRA withdrawals. What's more, your insurer may impose its own early withdrawal penalty, also known as surrender fees, if you cash in your deferred annuity within a specified period. These fees, similar to withdrawal penalties on a CD, usually cease seven years after your date of purchase. Often there is a separate surrender fee for each payment. So, a new payment may have a 7% fee if you take the new payment out right away, while a 10-year-old payment may have no surrender fee. The fee will usually decrease and be eliminated over time. Keep in mind, however, you can often withdraw small amounts (e.g., 10%) annually without any penalty from your insurer, but the IRS penalty may still apply. The IRS views all withdrawals as income, which are taxable, until all income has been paid out.

If you switch annuities, you may also incur withdrawal charges from your current annuity. If a salesperson advises you to change annuities despite the fact that you will be penalized, make sure you know the reason. Do the benefits of the new annuity – such as a higher interest rate, better investment choices or greater flexibility – offset the withdrawal charges? Be sure the salesperson isn't benefiting from the switch at your expense. If you decide to exchange one annuity for another, be sure to request and complete the appropriate forms provided by your insurance company to ensure that the transaction will be treated as a tax-free exchange under the federal income tax law (Section 1035 of the Internal Revenue Code).

Withdrawing Money from a Deferred Annuity

There are a number of good reasons to consider a deferred annuity as part of your financial retirement plan:

You can provide death benefits to your heirs. If you die prematurely, your annuity can offer a death benefit to your beneficiaries without the costs and delays of probate. Your beneficiaries will never receive less than what you have contributed (less any withdrawals). In addition, a spouse who inherits an annuity before distribution has begun can step in as the new owner of the annuity and the tax deferral continues until amounts are withdrawn. If distribution payments had begun, the benefits would generally have to be distributed to the beneficiary at least as rapidly as through the method in effect at the time of the annuitant's death. Taxation will continue to apply to those proceeds. Generally, a beneficiary who inherits an annuity before distribution begins can request a lump sum distribution without penalty but will be subject to full taxation on the accrued interest or gain on the contract.

Immediate Annuities

Immediate annuities can provide dependable financial security: a stream of income payments guaranteed to continue for the rest of your life or for a period you select. If you are about to retire, an immediate annuity may be a good place to put a large lump sum of money accumulated for retirement through another savings or investment vehicle. You also can convert your deferred annuity into an immediate annuity to start receiving income.

To purchase an immediate annuity, you make a one-time payment, and distributions typically begin within a month. Immediate annuities can be fixed or variable, just like deferred annuities. The income payments you receive from fixed immediate annuities are based on the amount you contribute, your age and the interest rate environment at the time of purchase. The payments to you will not change. The payments from variable immediate annuities fluctuate based on the performance of the investment options you choose. Although payments may go up or down, variable annuities are designed to provide income that can rise over time to help you keep pace with inflation.

The principal in an immediate annuity is not readily accessible. If you need more money than the income provided by the immediate annuity, you can minimize this drawback by keeping some of your retirement funds in a liquid account, such as a savings account or money market fund. There also is a chance you may lose some of your principal. If you choose an income for life option with no refund guarantee, and you should die before your principal is all paid out, the balance of your principal and any earnings will go to the insurance company rather than to your heirs. Fortunately, annuities offer several guaranteed payout options. For more information see Options with Guarantees.

Among the reasons to consider an immediate annuity are the following:

The money contributed to an annuity may be in post-tax dollars. When you contribute after-tax savings to an annuity, you can put in as much money as you like. Before you put after-tax savings into an annuity, it may be advisable for you to put the maximum pre-tax amount into a retirement plan such as your IRA, SEP, 401(k) or 403(b). Also note that annuities may fund an IRA, SEP, 401(k), 403(b). When an annuity is used to fund these vehicles there are contribution limits that apply, and federal tax laws generally require that you begin taking minimum distributions by April 1 of the calendar year following the year in which you reach age 70½. Failure to do so will result in a tax penalty of 50% of the amount of the shortfall. Additionally, once money is in your 401(k) or 403(b) plan, you generally cannot make withdrawals before age 59½ except for special circumstances, such as severance from employment, death or disability. If you meet an exception, withdrawals are generally subject to a 20% federal income tax withholding in addition to regular income tax and a 10% early withdrawal penalty for pre-59½ withdrawals.

Expenses can vary. Make sure that the annuity contracts you consider have competitive fees. Independent rating services such as Morningstar and Lipper Analytical Services both publish reports that compare variable annuity fees. Your local library may have copies. While cheaper doesn't necessarily mean better, if a contract is too expensive it could offset gains from the tax-deferred status.

All earnings from annuities are taxed as ordinary income.* If your ordinary income rate at retirement is higher than the current capital gains rate for other investments, you would actually pay higher taxes. You do, however, have a tax deferral on any earnings. With some other investments, you could be subject to ordinary income as well as capital gains taxes annually, even if you have not cashed in the investment, which can reduce the value of your earnings.

If you've decided that an annuity makes sense for you, here are a few key questions to ask yourself before signing up:

1. Have you done some comparison shopping and considered all of your options? Because annuities are long-term savings vehicles, you'll want to make sure the company you pick will be around at least as long as you will. And, as you learned in the previous discussion, different annuities offer a wide range of choices, prices, features and flexibility.

2. Does the rate on a fixed annuity look too good to be true? You want a competitive interest rate at renewal time. If the company is offering bonus rates (a higher interest rate for a set period of time) make sure the underlying interest rate and the company selling the annuity are financially viable. Once the bonus rate term expires, there is no guarantee going forward that renewal rates will be competitive. Be especially careful if you are exchanging annuities.

3. What are the annuity's surrender fees and how long are they in place? If the surrender fee is high (typical fees are around 6-7% and decline over a period of approximately five-to-seven years), you could feel locked into a contract from which it will be costly to escape.

4. What is the track record of the funding options offered in a variable annuity? Don't be swayed by last month's top performer. Look for strong returns over a three-to-five-year period or more. Newspapers such as Barron's and the Wall Street Journal – available in your local public library - publish rankings of various funding options on a regular basis. The history of various funding options also can be found in Morningstar and Lipper Analytical Services publications, available in larger libraries. Remember, past performance is not a guarantee of future results.

5. Does a variable annuity offer multiple funding options in case you change your investment strategy a few years down the road? Look for a range of funds to diversify your retirement savings as your needs change.

6. Will your ordinary income tax rate be greater than the current capital gains rate when you begin to take distributions (possibly at retirement)? If so, you may pay more in taxes by choosing annuities over another investment that would be taxed at the capital gains rate. Keep in mind, however, that your money in an annuity is accumulating on a tax-deferred basis. By selecting an annuity, you avoid paying yearly ordinary income tax on the earnings while your money compounds and grows.

Getting Started in Annuities
(ISBN# 0471-283037)
Gordon Williamson, John Wiley & Sons $19.95

Creating Retirement Income
Virginia B. Morris, Lightbulb Press Inc. and the National Association for Variable Annuities $14.95

Pamphlets from the Federal Government

Life Office Management Association (LOMA)
2300 Windy Ridge Parkway
Suite 600
Atlanta, GA 30339
1-800-ASK-LOMA (275-5662)
www.loma.org

National Association for Variable Annuities (NAVA)
11710 Plaza America Drive
Suite 100
Reston, VA 20190
www.navanet.org