Understanding Annuities Part # 3

March 22, 2012 in annuities, annuities in pennsylvania, annuity, deferred annuity, disbursement phase, immediate annuity, joint and life annuity, lifetime annuities, withdrawing funds before age 59 1/2

Annuities Continued…

To continue our discussion about annuities, we should take a moment to talk about the safety of this type of investment. When an annuity buyer puts up a substantial amount of savings as an investment, the holder is expecting that investment to provide regular annuity payments for the rest of his/her life. Therefore, the security of that investment and of the insurance company providing the annuity is of primary importance. The insurance company is contractually obligated to provide those lifelong payments, and consequently must invest those funds very carefully. The interest rates of an annuity are determined by the insurance company and the type of investment results that have been obtained by the insurer. There are, however, guaranteed minimum rates for annuities in Pennsylvania. The typical minimum rate is 3%, but it can be higher for a limited time, depending on the holder’s contract. For instance, a guaranteed 6% interest rate may be in effect for the first 6 years of a deferred annuity contract. After that time period is over, then the interest rate will drop to 3% or a new guaranteed rate may be put in effect by the insurance company.

In addition to the immediate annuity that we discussed previously, a second type of annuity available to investors is the deferred annuity.

Deferred Annuity

Investment in this type of annuity consists of regular payments that take place over a period of years. These regular payments are received and invested by the insurance company, in order to earn interest. The specific payment amounts and schedule are determined by the annuity contract. Deferred annuities are purchased by people of working age who want to begin accumulating retirement money during their working years. The time period between the insured’s payments and the annuity’s payout is called the accumulation period. During this accumulation phase, no taxes are owed on the credited interest. This tax deferral is a significant advantage of annuity investment. Withdrawal provisions during this phase are extremely limited and can result in significant penalties. The annuity holder will incur a 10% tax penalty from the IRS for withdrawing funds before age 59 ½, as well as penalties imposed by the insurance company. Once the holder reaches retirement age and payout begins, then the regular distributions are taxed as ordinary income by the IRS.

Once the disbursement phase begins, the annuity holder will receive regular payouts according to the terms stipulated in the contract. As a lifetime annuity, the classic payout design for a deferred annuity is the same as that described in the discussion of immediate annuities; distribution payments continue for the life of the holder. The contract then terminates with the death of the holder and any remaining funds revert to the insurance company upon the death of the annuity purchaser.

Most lifetime annuities also provide for a beneficiary variation. In this variation, the holder can designate one or more beneficiaries that will continue to receive payouts until all of the annuity funds have been disbursed or a designated time period has been reached. Beneficiary provisions usually come at a higher initial annuity cost. Another possible variation involves multiple annuitants (annuity purchasers/holders). A joint-and-life annuity pays regular payments until the first annuitant dies; a joint-and-survivors annuity pays until both holders die.

Deferred annuities can be fashioned as fixed deferred, variable deferred, or indexed deferred.  We will discuss the particulars of fixed, variable, and indexed annuities in upcoming articles.



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