What is an annuity?
Updated June 18, 2021
An annuity is a financial product that provides a stable, predictable stream of cash flow for a buyer of the product over a set period of time. This product is designed to increase retirement income for those who need more than investment income and Social Security to cover regular expenses and is therefore not a short-term investment strategy. The annuity transfers the risk of a borrower running out of their retirement savings onto the insurance company.
Annuities are most commonly a contract between an insurance company and a buyer. The annuity owner makes either a one-time payment or a series of payments to the insurance company in exchange for regular disbursements of money. These disbursements can begin immediately—an immediate annuity—or in the future, which is known as a deferred annuity.
Annuities can be fixed, variable or indexed. Fixed annuities earn buyers a guaranteed regular payment without any variability. The benefit of this predictability is countered by the fact that this option results in a more modest annual return that is only a little more than a certificate of deposit (CD).
Annuities can be fixed, variable or indexed. Credit: Andre Taissin/Unsplash
The disbursements of variable annuities rise and fall based upon the performance of the underlying investment portfolio. Buyers choose from a selection of mutual funds that become part of a subaccount. This type of annuity offers the potential for a higher return, but it comes with greater risk as retirement payments are based upon the subaccount performance.
One example of a variable annuity is a real estate annuity, which is an account with returns generated typically by commercial real estate. This product invests in a diversified portfolio of commercial real estate assets.
Payments of indexed annuities are based upon the performance of a stock index, such as the S&P 500, yet they are secured by a guaranteed minimum return. Annuities based upon the success of investment portfolios tend to have higher fees and more complexity than some other investments.
A buyer can also choose a real estate annuity, which is an account with returns generated typically by commercial real estate.
Similar to a 401(k) account, the income accrued from an annuity is not taxed and it cannot be withdrawn before the buyer is 59 ½ without a penalty. However, any funds contributed to an annuity does not lower an individual’s total taxable income. Due to this, it is recommended that before buying an annuity, individuals should first contribute the maximum amount allowed to their retirement accounts for the year.
Annuity cash disbursements paid to the buyer are subject to regular income tax based upon the individual’s tax bracket. Comparatively, this product would be taxed higher than mutual funds, for example, which when held for over a year, are subject to the lower capital-gains tax. The capital-gains tax rate for most taxpayers is typically 15%.
Annuities can be custom built to meet the individual buyer’s needs, including the payment size, when to begin receiving payments and the duration of disbursements. Durations can be chosen to last through to the end of the buyer’s life. Buyers can also customize their annuity with options to cover the payment of long-term care or provide money for beneficiaries. The longer the duration of the annuity the lower the amount of the regular payment.