What is an annuity?
Editorial staff, J.P. Morgan Wealth Management
- An annuity is a financial contract between you and an insurance company in which you make a lump sum or series of payments in exchange for certain guarantees related to income, death benefits, accumulation and tax deferral, to name a few.
- There are different types of annuities, many of which are designed to meet specific needs and help people achieve their retirement goals.
- There are two main categories of annuities: fixed annuities and variable annuities. Within each there are sub-types of annuity products. The level of risk and the potential for growth and income can vary amongst the options.
- All annuities can potentially provide guaranteed lifetime income through annuitization. However, not all annuities need to be annuitized to provide guaranteed lifetime income.
Overview of annuities
An annuity is a financial contract between you and an insurance company in which you make a lump sum or series of payments in exchange for certain guarantees related to income, death benefits, accumulation and tax deferral, to name a few. There are different types of annuities, many of which are designed to meet specific needs and help people achieve specific retirement goals. These guarantees are backed by the financial strength and claims-paying ability of the issuing company.
How annuities work
Different annuities may be designed to help solve for different needs. All annuities can potentially provide guaranteed lifetime income through annuitization, however certain annuities may be geared more toward accumulation and protection rather than generating a lifetime income stream or wealth transfer. Please be sure to consult the prospectus or discuss with a financial advisor whether an annuity is an appropriate strategy for your investment goals.
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Is an annuity a retirement account?
An annuity is a retirement product that may be used as part of your overall investment portfolio. Annuities can be leveraged for a variety of purposes and are most commonly used to protect assets or to generate an income stream throughout retirement. With an annuity, funds accrue on a tax-deferred basis, but there are certain rules and guidelines for the different types of annuity products. For example, people who purchase an annuity must generally wait to withdraw funds until they are at least 59½ years old to avoid an additional tax penalty.
How annuities are taxed
An annuity may accumulate funds on a tax-deferred basis. However, taxable distributions received from an annuity are generally taxed at ordinary income rates. Also, in contrast to 401(k) contributions, the money people put into annuities does not reduce their taxable income. For this reason, some people wait to buy an annuity until after they have maxed out their pre-tax retirement accounts.
Types of annuities
There are two main varieties of annuities – fixed annuities and variable annuities. The level of risk, along with the types of features and benefits, can vary among these types of annuities.
Fixed annuity
A fixed annuity can accumulate funds or distribute income at guaranteed rates and in guaranteed amounts.
- Fixed rate annuities earn interest at a set rate for a specified period of time.
- Fixed indexed annuities are designed to provide a return based on the performance of an underlying index such as the S&P 500. Regardless of the type of fixed annuity, these products provide guaranteed principal protection from market loss.
Variable annuity
Variable annuities accumulate funds or distribute income based on the performance of the underlying investment options chosen by the policyholder. Some of the features variable annuities may provide include:
- Guaranteed lifetime income
- Standard or enhanced guaranteed minimum death benefits
- Tax deferral
- Principal protection
A variable annuity is a contract between you and an insurance company and is sold by prospectus. A variable annuity offers a range of investment options. The value of the investment as a variable annuity owner will vary depending on the performance of the investment options chosen. The investment options for a variable annuity are typically investment subaccounts or funds that invest in stocks, bonds, money market instruments or some combination of the three.
Potential disadvantages of annuities
While annuities can be a great investment option for many, there are some potential disadvantages to consider. For one, when compared to other retirement accounts, like an IRA, contributions to annuities are not tax-deductible. Also, distributions from an annuity are taxed as ordinary income, so any benefit from lower tax rates (such as on long-term capital gains or qualified dividends) is sacrificed. There are also penalties on early withdrawals from annuities, and there may be limited investment options in a variable annuity, specifically.
Regardless, an annuity may be the best option for you. Please consult with an advisor to see if an annuity fits in your long-term financial plan.
The bottom line
Because there are so many different types of annuities, it is possible for people to find an annuity structure that is tailored to their specific needs if they do some research about their options. Consider connecting with a J.P. Morgan advisor to see which annuity might be the right fit for you.
Frequently asked questions about annuities
All annuities can potentially provide guaranteed lifetime income through annuitization. An income annuity, also known as a Single Premium Immediate Annuity (SPIA) is a type of fixed annuity that is designed to provide an immediate income stream through annuitization of the purchase payment. SPIAs typically require the income benefit to commence within 13 months of purchase and are often purchased by individuals who are in, or very close to, retirement so that they receive periodic guaranteed income for as long they live. A person will lose access to their premium in exchange for a guaranteed lifetime income payment.
An index annuity could refer to either a fixed indexed annuity or a buffered annuity/registered index-linked annuity (RILA). These products are designed to provide a return based on the performance of an underlying index such as the S&P 500. While the benchmark index does track to the market, the annuity owner is not directly exposed to the market. A person’s return is either a percentage of the underlying index’s performance or a capped percentage of the index’s performance. Fixed indexed annuities provide complete principal protection from market loss while buffered/RILAs typically provide partial downside protection in the form of a buffer or floor. A fixed rate annuity accumulates funds or distributes income at guaranteed rates and in guaranteed amounts. Fixed rate annuities earn interest at a set rate for a specified period of time. A fixed rate annuity provides predictable returns, tax-deferred growth and principal protection from market loss.
Annuity contracts usually allow for single or multiple purchase payments. A person may be able to fund their annuity by either making a one-time lump sum payment or with periodic payments over time. Income payments generated by an annuity may last until a certain value is depleted or can be guaranteed for life. When the client is making contributions and there is no need to begin taking income, it is known as the “accumulation phase” and when they begin receiving payments it is known as the “distribution phase.”
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Editorial staff, J.P. Morgan Wealth Management
