Annuities in Plain English: How They Work and Questions to Ask

Annuities come up a lot when people around Lake Norman start planning for retirement. Some people love them, and some people are wary of them. The truth is that an annuity is a tool: helpful in some situations and a poor fit in others. Here's a balanced look at how they work and what to ask before you buy.

This is general information, not financial, tax or investment advice. Features, fees and rules vary by contract and by insurance company.

What an annuity is

An annuity is a contract with an insurance company. You pay money in, either all at once or over time, and in return the insurer agrees to certain terms, such as crediting interest or paying you income later. Many people use annuities to grow money on a tax-deferred basis or to create a stream of income in retirement.

For an overview of the types we help with, see our annuities page.

The two phases

Most annuities have two stages:

• Accumulation: the money in the contract has the chance to grow. With most annuities, taxes on that growth are deferred until you take money out.
• Payout: you can take withdrawals, or turn the value into a stream of income (called annuitizing), sometimes for a set number of years and sometimes for life.

Common types

• Fixed annuities credit a set interest rate for a period of time.
• Fixed indexed annuities credit interest based partly on the performance of a market index, within limits set by the contract, such as caps or participation rates. Your money isn't invested directly in the market.
• Immediate income annuities start paying income soon after you buy them, in exchange for a lump sum.
• Variable annuities are invested in market subaccounts and can lose value. They're securities, sold only by representatives with the appropriate securities license.

Any guarantees in an annuity are backed by the claims-paying ability of the insurer that issues it. Past index performance doesn't predict future crediting, and no one can promise a particular return.

The trade-offs to understand

• Liquidity. Most annuities have a surrender period, often several years, when taking out more than a set amount triggers a surrender charge. Money you may need soon may not belong in an annuity.
• Taxes. Withdrawals of earnings are generally taxed as ordinary income, and withdrawals before age 59½ may face an additional federal tax penalty. A tax professional can tell you how this applies to you.
• Fees and riders. Optional riders, such as income or death benefit riders, usually come with an annual cost. Make sure you understand what you're paying for.
• Complexity. Crediting methods, caps and rider rules can be hard to compare. If something isn't clear, ask until it is.

Questions to ask before you buy

1. What problem is this annuity solving for me: growth, income or something else?
2. How long is the surrender period, and what are the charges each year?
3. How much can I withdraw each year without a surrender charge?
4. How is interest credited, and can the caps or rates change after the first year?
5. Which riders are included, and what does each one cost?
6. What happens to the money if I pass away?
7. How strong is the insurance company issuing the contract?
8. How does this fit with my Social Security, retirement accounts and other income?

When an annuity may not fit

An annuity may not make sense if you need the money in the next few years, if you don't have a separate emergency fund, or if it would tie up most of what you've saved. Replacing an existing annuity can also restart a surrender period, so look carefully before making a switch.

Talk it through with a local broker

Matt MacMillan is an independent insurance broker in Mooresville. He can explain how different annuity contracts work, compare options from the companies he represents and walk through the trade-offs in plain English, with no pressure to buy. You can meet in person, by phone or by video, and there's no fee for his help. If you work with a financial advisor or tax professional, he's happy to coordinate with them.

This article is general information, not legal, tax or financial advice. Coverage, rules, features and availability may vary by insurance company and state, and every policy is subject to the insurer's underwriting and eligibility rules.