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Strengthening Your Financial Toolbox Series: What is an Annuity?


Many people are looking for ways to increase their financial literacy, but it can be overwhelming knowing where to start. You may find yourself asking, what are the most important things I need to know? Honestly, there is no set answer to that question. Every aspect of financial planning is essential, and they all play their role. However, we believe there are five major topics that everyone should have a firm understanding of to strengthen their financial toolbox, and in this series, we will be covering each. The last tool we will be covering in this five-part series is annuities, so let’s jump right in.


What is an Annuity?

Annuities are probably the most misunderstood financial tool we have discussed in our toolbox series. A quick internet search will yield articles either praising their virtues or warning to avoid them at all costs. The reality is that there are too many unique annuity contracts to make such blanket statements. Annuities have both positive and negative attributes, like any investment tool, and understanding the annuity contract and how it works within your financial plan are key before purchasing an annuity.

Broadly, annuities are insurance contracts that guarantee a set amount of money for the rest of a person's life or a specified period. An annuity can be acquired with a single payment or a series of payments, and it can start paying off right away or at a later date. They are primarily used for retirement planning and to mitigate the danger of outliving one's savings.


Understanding Annuities

Annuities were created to provide a stable source of consistent income flow for people in their retirement years and relieve concerns about outliving one's assets. The purchaser of an annuity is known as an annuitant.

The accumulation phase regarding an annuity refers to the time between when an annuity is purchased and when payouts commence. The accumulation phase is the period in which contributions to the investment are regularly made. Once the payments begin, the contract enters the annuitization phase. The annuitization phase of an annuity refers to the period when the owner of an annuity begins to receive payments from the annuity investment.

The majority of annuities also have a surrender term. This is the time frame during which an investor cannot withdraw cash from an annuity without incurring a surrender charge or fee. If the invested money is removed before the end of this term, it will be subject to a substantial penalty.

Annuities can be a reasonable financial solution for people who want a steady, guaranteed retirement income. Longevity risk is mitigated by the fact that annuity holders cannot outlive their income stream. The product is suitable as long as the buyer realizes they are exchanging a liquid lump amount for a guaranteed series of cash flows. Some buyers aim to cash out an annuity at a profit in the future. However, this is not the product's intended usage. This product is often not recommended for younger investors or those who require liquidity because the lump sum invested in the annuity is illiquid and susceptible to withdrawal penalties


Tailoring An Annuity

Many features of an annuity can be customized to meet the buyer's unique requirements. You may select when you want to annuitize your contributions. That is when you want to start receiving payments. For example, you may choose an immediate annuity that pays out right away. Conversely, you may go with a deferred annuity which starts payments at a predetermined date in the future.

Other aspects of an annuity that can be tailored include the payment to the insurer. Sometimes you can decide whether you want to make a lump-sum payment or a series of payments to the insurer. Furthermore, the duration of the disbursements to be made might also vary. For example, you may have the option of receiving payments for a specified period, such as 25 years or the remainder of your life.


5 Types of Annuities

Annuities can be structured into different kinds of instruments, which gives investors flexibility. In this article, we are going to discuss 5 of the most common types of annuities that you will likely come across as an investor. Those types are:

  1. Immediate Annuities: In exchange for a lump-sum investment, an immediate annuity is meant to provide you with income distributions for a predetermined length of time. They're called term immediate annuities because you start receiving annuity income payments practically immediately after your investment. The insurer determines the number of such payments based on the annuitant's age, current interest rates, and the length of time the payments will be made. Payments usually begin a month after the purchase. Annuitants can also choose how frequently they wish to be paid, which is referred to as a "mode." The most popular payment choice is monthly, although quarterly or annual options are also available.

  2. Deferred Annuities: A deferred annuity is a contract that guarantees the customer a regular income or a lump sum payment at a later period. The three main classes of deferred annuities: fixed, indexed, or variable. What category a deferred annuity falls into affects how its rate of return is calculated. Tax-deferred growth is available with all three forms of deferred annuities. Owners of these insurance contracts pay taxes only when they make a withdrawal, take out a lump sum amount, or start receiving income from it. The money they get is then taxed at their regular income tax rate.

  3. Fixed Annuities: A fixed annuity is a long-term savings vehicle that allows interest to grow tax-free. You and the annuities provider will agree to a set interest rate or dollar amount. Then the insurer will pay the purchaser a fixed interest rate on their contributions to the annuity for a specific period. Fixed annuities often appeal to investors looking for low-risk options as they are the most predictable type of annuities.

  4. Variable Annuities: Variable annuities are annuity contracts whose value varies depending on the performance of an underlying portfolio of sub-accounts. Variable annuities can provide better returns and income than fixed annuities, but they also carry the risk of losing value. A variable annuity's value is determined by two factors: the principal, which is the amount of money you put into the annuity, and the returns that your annuity's underlying assets provide on that principal over time.

  5. Indexed Annuities: An indexed annuity is a type of annuity that pays interest depending on the performance of a market index, such as the S&P 500. The rate on an indexed annuity is often calculated based on the year-over-year gain in the index or its average monthly gain over 12 months. When the financial markets perform well, indexed annuities provide their owners with the chance to earn more significant returns. Conversely, there can be some risks involved with this type of annuity as there is always the chance that the markets will perform poorly. However, they sometimes offer some protection against market losses.


Taxation of Annuities

The tax treatment of an annuity is an essential factor to consider. An annuity provides tax-deferred growth which can be valuable for long-term investment purposes. While the amount grows tax-deferred and your initial investment is not taxable at distribution, for tax purposes the earnings are distributed first and are taxed at your usual income tax rate. By contrast, mutual funds are not tax-deferred and may distribute taxable income each year the investment is held. Mutual funds held for more than a year are taxed at the long-term capital gains rate, which is typically lower than ordinary income tax rates. Additionally, unlike a traditional 401(k) account or IRA, the money you contribute to an annuity doesn't reduce your taxable income.


How to Purchase Annuities

The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) oversee annuity products. Agents and brokers selling annuities must have a state-issued life insurance license and, in the case of variable annuities, a securities license. When venturing into the world of annuities, it is recommended that you find an agent or broker that understands your financial goal and works with you to determine if and which annuity might be the right fit.


Schedule A Consultation with an Experienced Financial Advisor

Here at Fourth Avenue Financial, our first priority is your overall financial success. We want to help you develop, implement, and monitor a strategy that's designed to address your individual situation. If you are ready to start planning for your financial future, we are here to help. Contact us today at (304) 746 7977 to schedule a meeting with one of our experienced financial advisors or schedule online: https://calendly.com/fourthavenuefinancial/introductory-zoom.



Securities offered through JW Cole Financial, Inc. (JWC) Member FINRA/SIPC. Advisory services offered through JW Cole Advisors, Inc. (JWCA). Fourth Avenue Financial, LLC and JWC/JWCA are unaffiliated entities. Non-security products not offered by JW Cole.

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