Annuities can help you before and after you retire, providing tax-deferred growth during your saving years and income during retirement.
An annuity is an insurance contract issued by an insurance company and is designed to provide guaranteed or fixed income during retirement. The annuity transfers your risk of outliving your savings to the insurance company. You pay into the annuity before you retire, so you can then withdraw from this built-up value as a source of income after you retire.
Annuities can help you plan ahead for retirement. They offer tax-deferred savings as you pay premiums before you retire and then maintain a reliable income stream during retirement. An annuity can be the foundation for a retirement plan. It can provide “income insurance” with a lifetime payment not tied to fluctuations in the market performance or based on how long you live.
Annuity contract phases
There are two phases of an annuity contract – an accumulation phase and a distribution phase.
During the accumulation phase, you make one single payment or multiple scheduled payments over a period of time in exchange for either a fixed or variable rate of return without having to pay taxes until you begin withdrawing funds. Being tax-deferred helps ensure the steady accumulation of your annuity investment.
In the distribution phase, the value of the annuity contract may be converted into a guaranteed income stream. For example, during retirement, you may need additional income for living expenses. An annuity distribution can provide that income for either a specific period of time or for the rest of your life.
Qualified annuities vs. non-qualified annuities
In addition to annuity contract phases, how an annuity is funded is another important aspect of how an annuity works as an investment strategy for retirement. Qualified annuities are funded using pre-tax dollars, and non-qualified annuities are retirement savings. Qualified annuities are funded using pre-tax dollars and distribution payments are treated as taxable income. Non-qualified annuities are funded using after-tax dollars, so only the earnings on the investment are taxed as income.
Qualified and non-qualified annuities both provide opportunities for tax-deferred accumulation. The differences between the funding may seem simple, but there are some key details to keep in mind.
Qualified annuity contracts:
- During accumulation phase: Will need to remain funded under the retirement savings plan to avoid being taxed
- During distribution phase: Are subject to income taxes once you start taking withdrawals.
- Will provide income guarantees and death benefits
Non-qualified annuity contracts:
- Do not fall under any IRS retirement plan
- During accumulation phase: Money invested serves as the cost basis, which is the total original purchase price
- During distribution phase: Only the gain earned above your cost basis is subject to income taxes once you start taking withdrawals
- Do provide tax deferral advantages
An annuity contract funded with pre-tax dollars is a qualified annuity. Qualified annuity contracts are available through IRAs, and some employer 401(k)s, 403(b)s and pension plans. To avoid annuity taxation, qualified annuity funding must remain under the retirement savings plan
Types of annuities
There are three types of annuities:
- Fixed annuities
- Variable annuities
- Income annuities
Fixed and variable annuities are the two most popular types. Fixed annuities have a guaranteed interest rate, and variable annuities provide a return based on the performance of investments or subaccounts.
Fixed annuities are designed to help you reach your long-term goals by providing a guaranteed interest rate for a set period of time. When you invest in a fixed annuity, you make a payment or a series of payments to an insurance company. The company guarantees a stated rate of interest over a specific time period. The interest on the annuity accumulates on a tax-deferred basis until you withdraw it or begin taking income.
Variable annuities are designed to accumulate tax-deferred retirement savings before you retire, while also giving you an income stream during retirement. When you invest in a variable annuity, the insurance company will offer a selection of underlying investments called sub-accounts. You have the option of several professionally managed and diversified variable annuity sub-accounts or portfolios. You can choose from these accounts based on your investment objectives, risk threshold and the determined length of time until you retire.
Here is a comparison of fixed annuity and variable annuity features:
|Fixed Annuity||Variable Annuity|
|Tax-deferred accumulation||Purchased with a single payment and accumulates tax-deferred at a guaranteed rate. Any earnings or basis not previously taxed are taxed as ordinary income||Purchased with a single payment or a series of payments and any growth is tax-deferred based on subaccount performance; Any earnings or basis not previously taxed are taxed as ordinary income|
|Tax-deferred growth||Any increases in the account value are not taxable until withdrawn||Any increases in the account value are not taxable until withdrawn|
|Choice of guarantee periods||Specific investment time fixed rates for 3-10 years, based on investment time horizon||N/A|
|Guarantee* of interest and principal||Value increases when interest is added to annuity contract. *Guaranteed rate by the issuing insurance company||N/A|
|Guarantee of death benefit||If the annuity owner passes away, the beneficiary is usually guaranteed the amount originally invested, minus previous withdrawals; additional death benefit options may be available||If the annuity owner passes away, the beneficiary is usually guaranteed the amount originally invested, minus previous withdrawals; additional death benefit options may be available|
|Flexible income options||There are three options for income:||There are three options for income:|
|Avoid probate||All annuity proceeds, paid to the beneficiary upon death, are excluded from the probate process; any earnings not previously taxed are still subject to ordinary income tax, and estate taxes would apply to the total value of the contract exceeds the current limit.||All annuity proceeds, paid to the beneficiary upon death, are excluded from the probate process; any earnings not previously taxed are still subject to ordinary income tax, and estate taxes would apply to the total value of the contract exceeds the current limit.|
Fixed annuity fees and expenses
Most fees and expenses of a fixed annuity are factored into the stated annual percentage rate in the original quote, so the rate quoted is the rate paid. Fixed-annuity fees and expenses generally cover the insurance company’s administrative expenses, the cost of offering the annuitization guarantee and profits to the insurance company and agent. Some fixed annuities may assess a nominal annual contract fee, typically around $30.
Should I consider a fixed annuity?
When deciding if a fixed annuity is a good option for you, here are three important considerations:
- Have a guaranteed rate of return for a specific period of time from 3-10 years
- Making withdrawals prior to the end of a guarantee period may have tax implications and cause you to pay surrender charges
- Over time, renewal rates and fixed-income payments may not keep up with the pace with inflation
- The guarantees provided by any type of insurance contract are based on the claims-paying ability of the insurance company
Variable annuity fees and expenses
Most variable annuities have two types of asset-based expenses: an insurance fee and an investment management fee. Annuities also can include optional insurance fees and an annual contract fee. The sum of these fees may be higher than fees charged on other types of investments.
- Insurance fee – the annual insurance fee, also known as a mortality and expense charge, typically ranges from 0.65% to more than 1.75%. The difference in fees may depend on the pricing option the investor chooses.
- Investment management fee
- Additional insurance fees – some variable annuities offer optional insurance benefits such as enhanced death benefits or living benefits. The cost of these benefits vary by contract. These types of benefits should be selected only if they will be used, since the additional cost will reduce the investment return.
- Annual contract fee – this can range between $30 and $50. This fee may be waived if the policy value is above a certain amount, typically $50,000.
In addition to these fees, variable annuities can also have sales charges. A portion of the sales charge is paid to the financial advisor selling the annuity contract.
Should I consider a variable annuity?
When taking a closer look at a variable annuity, it is important that you understand these aspects of this type of annuity:
- Variable annuities are invested in the market and have the potential to increase in value and keep pace with inflation. Because they are subject to market fluctuations, they may also decrease in value.
- There are multiple money managers and investment options that have expenses associated with them similar to other types of investments with market exposure.
- Withdrawals may have tax implications and surrender charges.
- The guarantees provided by any type of annuity contract are based on the claims-paying ability of the insurance company.
Income annuities are also referred to as "immediate annuities" or "deferred income annuities," depending on when income payments begin. They offer a predictable guaranteed stream of income that you can't outlive.
You may pay a single payment of money to the insurance company in exchange for a guaranteed lifetime income. Income annuities can be a good choice for maximizing income.
Income annuity features
Before deciding to invest in an income annuity, here are key features you should know:
- Income payments remain level over time. You can start withdrawing funds immediately or wait up to no more than 10 years.
- Flexibility is limited once payments begin.
- Non-qualified, immediate annuities may offer tax-advantaged payments when payments are considered part return of principal and part interest earned.
- Income payment options can be set up throughout a lifetime or for a set period of time. Depending on the income payment option you choose, your beneficiary may be eligible to receive a death benefit when you pass away.
Income annuity fees and expenses
No specific fees or expenses are deducted from the income payments you receive. The insurance company, however, does factor fees and expenses into the income payment. These cover the insurance company's administrative expenses, the cost of offering income payments for life or the set payment period and profits to the insurance company and agent.
Should I consider an income annuity?
Keep in mind these important considerations:
- Contracts generally cannot be surrendered and should not be considered as a source of liquidity.
- Policyholders are subject to inflation risk. Fixed income payments may not keep up with the pace of inflation.
- The income payment option selected may determine whether or not you receive any or all of your premium.
- The guarantees provided by any type of insurance contract are based on the claims-paying ability of the insurance company.
How are annuities taxed?
Qualified annuity distributions are taxed according to the policyholder's marginal income tax bracket. Non-qualified income annuities will be taxed as part interest and part return on principle. For lump sum or partial non-qualified annuity distributions, any withdrawal from the contract is interest first and taxed as ordinary income. Once the interest is fully withdrawn, the principle is withdrawn and is not taxable income.
Should I consider an annuity?
Fixed annuities can be a good investment choice if you want a reliable income source during retirement. It’s important to keep in mind that since a fixed annuity is an insurance product, it is not intended to have high growth like a traditional equity investment. A variable annuity is an equity investment and may be a good alternative to other equity investments when investing for retirement because of the additional tax deferral on non-qualified investments and the ability to generate guaranteed income in the future.
If you are considering an annuity, we encourage you to take a few moments and complete our quiz. It will help you begin the process of thinking about your long-term financial goals, so you can start building your retirement strategy.
How can I get started with choosing an annuity?
If you’re considering investing in an annuity as part of your retirement financial goals, we encourage you to contact a financial advisor to help you get started. Our financial advisors will work with you to determine what’s important to you now and for the future. We can work together to review your options and design a personalized investment strategy based on your long-term goals.
Edward Jones annuity fees and compensation
Edward Jones receives various payments in connection with the purchase, sale and holding of annuities by its clients. Those payments include commissions, annual service fees and expense reimbursements. The firm also receives revenue sharing from some of its preferred annuities. Here is some information about revenue sharing. Edward Jones financial advisors and equity owners benefit financially from the firm’s receipt of these fees and payments.
Variable annuities are offered and sold by prospectus. You should consider the investment objective, risks, and charges and expenses carefully before investing. The prospectus contains this and other information. Your Edward Jones financial advisor can provide a prospectus, which should be read carefully before investing.
Guarantees are subject to the claims-paying ability of the issuing company.
Edward Jones is a licensed insurance producer in all states and Washington, D.C., through Edward D. Jones & Co., L.P., and in California, New Mexico and Massachusetts through Edward Jones Insurance Agency of California, L.L.C.; Edward Jones Insurance Agency of New Mexico, L.L.C.; and Edward Jones Insurance Agency of Massachusetts, L.L.C.
Edward Jones receives payments known as revenue sharing from certain mutual fund companies, 529 plan program managers and insurance companies (collectively referred to as “product partners”). For more information see Revenue Sharing Disclosure.