The Investment Series: Annuity Basics

 Annuity Basics  (Go to the Investment Series for other Basics)

This is the seventh article in a series on investment basics. If you are new to investing, it is recommended that the articles be read in order. Prior articles introduce terminology that is used in later articles.

What is an Annuity?

Other Considerations
Income for Life The Worry List
The Types of Annuities Part of a Plan
The Tax Advantage References
Fixed versus Variable Recommended Reading

What is an Annuity? 

An annuity is a series of payments made at regular intervals over a period of time. Annuities are issued by insurance companies. Typically, you pay in an amount of money and receive regular payments in return. 

State lotteries are typically paid as annuities. A 10 million dollar winner does not receive 10 million dollars upon winning. The winner receives a payout of $500,000 per year for 20 years. The state has purchased an annuity at a cost considerably less than 10 million dollars to do so. 

Many company retirement plans are annuities that will pay a regular income to the retiree for his or her lifetime.

Income for Life 

The original driving force behind annuities was an income for life. Insurance companies could statistically predict the life expectancy of a large group of people with a fair degree of accuracy. Their annuity product could then be priced accordingly. With life insurance, you collect if you die. With a life annuity, you collect if you live. It’s the life insurance “bet” in reverse. 

The annuities became popular as a means of growing invested dollars tax deferred. The deferral opportunities coupled with changes in regulations have lead to a huge growth in the sale of annuities.

The Types of Annuities 

Annuities are a complex product. Nonetheless, the product can be classified into several major types.


The terminology used may vary somewhat among publications, but these are the basics. 

A fixed annuity provides a series of regular payments of a specified dollar amount for the specified term. 

A variable annuity will provide regular periodic payments but the dollar value of those payments may vary depending on the performance of the underlying investments. 

An immediate annuity begins the payments immediately after payment for the annuity. 

A deferred annuity will delay starting annuity payments for some period of time. this allows an accumulation period during which time the investment can grow. 

Even the premium may be a single lump sum payment or a periodic payment- and that periodic payment may be fixed or variable. 

Along with a variety of ways to pay for and structure the basic contract, there are variety of payout options. 

Life annuity provides regular payments for the life of the annuitant (the person receiving the payments). Live long and beat the insurance company. Don’t live long and the insurance company keeps the money. 

Life with cash payment provides regular payments for the life of the annuitant. However, if the annuitant dies before the total payments equal the amount paid in, the balance will go to the beneficiary. The beneficiary may receive the leftover as a lump sum or by continuing the payments as an installment refund. 

Life with term certain provides for regular payments for the life of the annuitant. If the annuitant dies before the  specified minimum number of time periods, then the beneficiary will continue to receive payments for the rest of the specified time. 

Joint and survivor provisions provide income for the life of the annuitant and the specified survivor-usually a spouse. The benefit amount typically decreases after the passing of one of the annuitant. 

Fixed period provides payments for a specified number of periods.

Lump sum provides for a single lump sum payout of the annuity.

The Tax Advantage

The contributions made to annuities are not tax deductible, but the taxes on earnings are deferred until the money is withdrawn. There is a 10% penalty for withdrawing the money before age 59 ½ and withdrawals have to start by age 70 ½. When the money is taken out, it is taxed as ordinary income, not as capital gains. And there is no limit on how much money can be put into an annuity. 

By not paying taxes on earnings, more of your money is earning money every year than would be the case if taxes were coming out every year. This substantially improves the rate of growth over time. 

The experts we spoke with recommended that individuals not pursue an annuity for tax deferral benefit until their 401K plans and IRA options were fully funded. Both the 401K plan and traditional IRA are funded with pre-tax dollars, whereas the annuity is funded with post tax dollars. 

Our experts also recommended in general against purchasing an annuity within another tax deferred vehicle such as an IRA or a 401k plan. Both the IRA and 401k are limited in the amount of funds that can be deposited each year. Placing an annuity within one of these vehicles does not gain any additional tax deferral on the earnings of the annuity since annuity earnings are already tax deferred. 

Fixed versus Variable 

With a fixed annuity, the insurance company invests the premiums in fixed-rate investments such as bonds. You earn a guaranteed fixed rate of return for a specified initial period. When the initial period ends, your assets are rolled into a new time period at a new rate. The new rate may be better or worse depending on the state of the economy. In many fixed annuities, there will be a guaranteed minimum rate which is often related to the rate of treasury bills. With a fixed annuity, your insurance company is taking on the investment risk. 

Variable annuities are quite different. With a variable annuity, your premiums are invested in the likes of stocks, bonds, mutual funds, money markets, and even real estate. Many mutual funds are part of a family of funds and the investor can transfer funds among members of the fund family without incurring additional fees. Similarly, the owner of the annuity may have the option to transfer the assets within the annuity between various investments. Thus with a deferred variable annuity, the amount of dollars developed during the accumulation period can vary substantially depending on the performance of the investments. 

The payout of the variable annuity is based on the number of units held by the annuitant. Think of a “unit” as analogous to a “share” in a mutual fund. You own a certain number of shares in a mutual fund but the value of the share fluctuates. Similarly, the annuitant is credited with a number of units, but the value of those units will fluctuate resulting in a variable payout. 

Thus, with the variable annuity, the risk is taken by the holder of the annuity rather than the insurance company. 

The funds for a fixed annuity are held by the insurance company in a general account. The funds for a variable annuity are held in a separate account for the holder of the annuity. Many variable annuity contracts allow a mixture of mixed and variable with some finds held in the general account, and some in the separate account.

Other Considerations 

Annuity contracts offer a host of things to consider. Here are some.

 Contracts carry a surrender charge that should taper of to zero after a number of years, but can be initially as high as 10 percent.

 Contracts may include provisions for partial withdrawals with no penalty imposed by the insurance company. However, tax considerations would still apply.

 Contracts may offer provisions for loans.

 Contracts may guarantee a return of premium or principal upon liquidation or as a death benefit.

 Contracts may include special provisions if the annuitant is admitted to a nursing home or diagnosed with a terminal illness.

 Contracts can include varying fees which the buyer should consider when evaluating the cost of the policy.

The Worry List 

If buying an annuity, here is a short list of some things that should be of particular concern:

 The solvency of the insurance company offering the annuity. There have been failures.

 The expenses, commissions, and surrender charges.

 For deferred fixed annuities, the history of the renewal rate. Less ethical companies may offer a high initial rate guarantee, and then more than make it up through very low renewal rates- to the detriment of the contract holder.

 For variable annuities, who is the fund manager and what is the performance history of the fund or funds being offered. Read the prospectus for any investment.


Part of a Plan 

If one chooses to buy an annuity, it should be done as part of an overall financial plan. Financial planning is complex because it involves many options and considerations. An annuity is also complex and involves many options and considerations. We continue to recommend using professional help in developing a financial plan.


National Insurance Consumer Hotline Info
This is a hotline where questions can be asked and information sent.

SEC on variable annuities
The site by the Securities and Exchange Commission of the U.S. government provides a description of variable annuities and how they work, along with some very specific cautions for the investor. 

SEC quickline on annuities
On this site, do a search on the word "Annuities". This will provide a
brief discussion of annuities. In addition, one can search for information about  a host of other topics dealing with securities.

Recommended Reading 

Clicking on the picture or title will take you to Amazon where the book can be ordered. We get a small commission on books ordered from such click-throughs. It helps support the Us Boomers website at no additional cost to you.

coverGuaranteed Income for Life: How Variable Annuities Can Cut Your Taxes, Pay You Every Year of Your Life, and Bring You Financial Peace of Mind 
This book includes information on annuities and on investing in support of those pursuing variable annuities.
cover The Complete Idiot's Guide to Buying Insurance and Annuities


This books covers annuities and other insurance products.

Certified Financial Planner offering financial, business and personal development services in the Lehigh Valley, PA area. This certified financial planner offers annuity expertise to Eastern PA and NJ

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