An annuity is a contract with an insurance company. You pay it a lump sum or a series of payments, and in return the insurer agrees to make periodic payments to you, starting right away or at a later date. Interest in a deferred annuity is tax-deferred until you take money out, and most contracts charge a surrender charge on larger withdrawals in the early years.
What an annuity is: immediate and deferred
An annuity is a contract issued by an insurance company, and you fund it with a lump sum or a series of payments. You can use it to build up money on a tax-deferred basis and to set up a stream of income, now or later. Annuities are meant for long-term goals, so the SEC's Investor.gov points out that they suit only people with a long-term time horizon.
Immediate annuity
You pay a single premium, and income payments typically start within one year. They may come monthly, quarterly or yearly, depending on the contract.
Deferred annuity
You pay a lump sum or a series of payments over time. The money builds up first (the accumulation phase), and payments begin at a future date you choose (the payout phase).
How payments can be set up, depending on the contract
- A lump sum of the account balance.
- Payments for the annuitant's life, with nothing paid after death.
- Payments for life or for a set number of years, whichever is longer.
- Payments to two people, continuing to the survivor.
- Payments for life, with any remaining balance paid to a beneficiary.
An insurer's obligations under an annuity depend on its financial strength and claims-paying ability: if the company has financial difficulties, it may not be able to pay you.
Fixed and indexed annuities
A fixed annuity earns interest at a rate the insurance company sets, never below the minimum rate stated in the contract, and the company may pay more than that minimum. Interest accumulates tax-deferred until income payments begin or the money is taken out.
An indexed annuity, which Florida's regulator treats as a kind of fixed annuity, credits interest based partly on how a market index performs over a set term, often a year. You don't know the rate in advance. When the index falls, a fixed indexed annuity credits no loss, but the interest for that term may be zero.
- What the index gained
- Dividends usually left out
- A participation rate credits only part
- A cap limits the gain
- A spread or margin subtracts from it
The insurer can change some of these features from time to time, such as the cap, and the changes can affect what you earn. Indexed annuities are complex products, so read the contract, and any prospectus, before you decide.
Surrender charges, and what else an early withdrawal costs
Most annuity contracts charge a surrender charge on money withdrawn in the first several years, a stretch called the surrender period. The charge is usually a percentage of the amount withdrawn, and it declines each year until it reaches zero. Your contract holds the year-by-year surrender schedule.
The surrender period typically lasts six to ten years, or even longer. Most contracts do let you withdraw ten percent a year without a surrender charge.
Other costs can come with an early withdrawal. Withdrawals may be taxable, and before age 59½ there may be a federal tax penalty. Some contracts also apply a market value adjustment, often negative, in addition to any surrender charge. A tax professional can explain the tax side.
Exchanging one annuity for another has costs of its own: Investor.gov warns that you may pay a surrender charge to leave the old annuity and start a new surrender period with the new one.
Questions to ask before you sign
Florida's Department of Financial Services suggests asking the licensed agent or the insurance company these questions:
- Does this annuity meet my financial objectives?
- What is the minimum interest rate in the contract?
- Does it include riders? How do they work, and what do they cost each year?
- Are there other fees?
- What are the surrender charges, and for how many years?
- Can I make a partial withdrawal without charges, and how often?
- Are withdrawal charges waived if I am confined to a nursing home or diagnosed with a terminal illness?
- What are my income options when the surrender period ends?
Florida law requires an agent who recommends an annuity to act in your interest without putting the agent's or the insurer's financial interest ahead of yours: to know your financial situation, insurance needs and objectives, and to tell you the reasons for the recommendation, under Florida Statutes 627.4554. The agent must also give you a document explaining how they are paid for the sale.
After a fixed annuity is delivered, you have at least twenty-one days to return it for a refund that includes any contract fees or charges. Indexed annuities have the same twenty-one days, though the refund may be adjusted for market changes during that time.
Don't sign under pressure. Check any agent's license on Florida's Licensee Search first.
Long-term care is a separate kind of coverage. If it's on your mind, here's how long-term care insurance works.
Sources: Florida Department of Financial Services, Annuity Overview and Investor.gov, Annuities.
Questions people ask
What is the downside to an annuity?
It depends on the contract. The main costs to watch for are surrender charges on early withdrawals, often for six to ten years or longer; fees, some of them built into the interest credited; caps and participation rates that limit what an indexed annuity credits; taxes, and a possible federal tax penalty, on withdrawals before age 59½; and the insurer's ability to pay, since its obligations depend on its financial strength. The contract and its surrender schedule show which apply to you. Questions about your own situation? Ask me when you first reach out.
What decides how much an annuity pays?
It depends on the contract: how much you pay in, the interest the insurer credits (a fixed annuity's minimum rate is stated in the contract; an indexed annuity's depends on the index and on the contract's participation rate, cap or spread), any fees and riders, and the payout option you choose, such as a lump sum, payments for a set period, or payments for life with or without a refund to a beneficiary. The insurer's quote and the contract state the figures. If you're wondering about your own situation, bring it up when you first contact me.
Have a Medicare or other coverage question? Look for it on the Answers page.