What is an annuity and how does it work?
Editorial staff, J.P. Morgan Wealth Management
- An annuity is a contract with an insurance company in which you make a lump sum or series of payments in exchange for contract features that may include income options, death benefits and tax-deferred growth.
- 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 subtypes of annuity products. The level of risk and the potential for growth and income can vary among the options.
- Many annuities can provide guaranteed lifetime income through annuitization. However, not all annuities need to be annuitized to provide guaranteed lifetime income.
An annuity is a contract with an insurance company in which you make a lump sum or series of payments in exchange for contract features that may include income options, death benefits and tax-deferred growth. Different annuities are designed to meet different needs and retirement goals. These features and any guarantees are backed by the financial strength and claims-paying ability of the issuing company.
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How do annuities work?
Different annuities may be designed to meet different needs. Many annuities can provide lifetime income through annuitization, while others may be geared more toward accumulation and protection. For product details, review the relevant disclosure documents (including a prospectus for variable annuities) or discuss with a financial professional whether an annuity is appropriate for your goals.
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 may owe an additional tax if they withdraw taxable earnings before age 59½. Depending on the contract, withdrawals may also be subject to surrender charges.
How are annuities 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 (typically on the earnings portion). Also, in contrast to 401(k) contributions, annuity contributions do not reduce your taxable income. For this reason, some people wait to buy an annuity until after they have reached the contribution limit on their pre-tax retirement accounts.
Types of annuities
There are two main categories 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 annuities
A fixed annuity can accumulate funds or distribute income based on terms set by the contract.
- Fixed rate annuities earn interest at a set rate for a specified period of time.
- Fixed indexed annuities are generally designed to help protect principal from market losses, subject to contract terms, withdrawals, fees and the claims-paying ability of the insurer.
Variable annuities
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
- Optional guaranteed benefits (for a fee)
A variable annuity is a contract between you and an insurance company and is sold with a prospectus. A variable annuity offers a range of investment options. Your contract value 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 securities or some combination of the three.
Potential disadvantages of annuities
While annuities can be a useful 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 tax penalties or surrender charges on early withdrawals from annuities, and there may be limited investment options in a variable annuity.
That said, an annuity may still 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 many types of annuities, people may be able to find an annuity product tailored to their needs by researching their options. Consider connecting with a J.P. Morgan Advisor to see which annuity might be a good fit for you.
Frequently asked questions about annuities
Many annuities can provide 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. With a SPIA, income payments generally begin within 13 months of purchase. In exchange, you generally give up access to the lump sum purchase payment for guaranteed income payments, often for life.
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 tracks the market, the annuity owner is not directly exposed to the market. Your return is either a percentage of the underlying index’s performance or a capped percentage of the index’s performance.
Fixed indexed annuities are generally designed to help protect principal from market losses, subject to contract terms, withdrawals and the insurer’s claims-paying ability. 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 and they provide predictable returns and tax-deferred growth, with principal protection features that depend on the contract.
Annuity contracts usually allow for single or multiple purchase payments. You may be able to fund your 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 you are making contributions and there is no need to begin taking income, it is known as the “accumulation phase.” When you begin receiving payments, it is known as the “distribution phase.”
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