Understanding every type of annuity can help you select the one that suits your needs. Annuities allow seniors to establish a steady income stream in retirement, but not all annuities are the same. Those planning for their retirement may consider purchasing an annuity to have a reliable cash flow stream once they are no longer working. An annuity is a form of insurance that buys the beneficiary a lifetime of income in retirement. Buyers can pay premiums in a lump sum or multiple smaller payments over time.
Annuities are broken into two stages: the accumulation and distribution stages. The accumulation stage of an annuity is when you are paying your premiums into your annuity. The distribution stage is when you’re receiving your payouts from the annuity you have purchased.
But what are the various types of annuities? There are immediate annuities, deferred annuities, fixed annuities, and variable annuities and each of these different types of retirement annuities have their advantages and disadvantages. When you’re planning for your future, it’s best to know the difference between each type of annuity so you can choose one that works best for your specific situation.
In this guide, you’ll find the different types of annuities explained so that you can better understand which of the four types of annuities that are most common best suits your individual needs. Let’s get started learning about the various types of annuities.
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What are the different types of annuities? While there are numerous different annuities, just four are most common. We will get into some of the less common varieties of annuities later in this guide, but for now, let’s take a look at the four most common types of annuity payouts and how they differ. An annuity can be either fixed or variable, and each of these types can be either immediate or deferred. That makes the four most common types of annuities immediate fixed, immediate variable, deferred fixed, and deferred variable. The difference between these types of annuities depends on how your investment grows and when you start to receive your annuity payments.
Let’s get into more detail about the specific differences between all four of the most common types of annuities.
As we’ve already discussed, there are two types of fixed annuities. But what is a fixed annuity, and how does it differ from a variable annuity? Fixed annuities are the least complicated. A fixed annuity has a guaranteed interest rate on your investment. It is this guarantee that makes a fixed annuity very low risk. Fixed annuities are also predictable and make planning for your future easy. Think of a high-interest savings account compared to an investment in the stock market. While you may not see the gains that are possible with stocks, you also don’t risk the losses. A fixed annuity is more like a reliable, steady savings account with the same interest month after month, no matter how the market performs. You may have to agree to a new interest rate after a certain number of years with a fixed annuity, but you will always see gains. It’s also possible to find an annuity with a guaranteed interest rate for the duration of your contract.
Fixed annuities offer reliability and predictability. When you retire with a fixed annuity, you’ll see the same payouts each month. This perk makes budgeting and planning in retirement a lot easier. There are no unknowns, almost no risk, and there is never a rollercoaster ride of ups and downs when the market is fluctuating. Fixed annuities are a solid choice for those who value stability and predictability.
Fixed annuities can be broken down into two main types: immediate fixed and deferred fixed. Let’s go over what each type of annuity is all about and how they differ.
Immediate annuities, which can also be known as income annuities, are a sort of annuity that pays out right away. With an immediate annuity, you’ll begin to see your payouts within a year of purchase. This sort of annuity comes in handy when someone receives some kind of windfall, such as a large inheritance or insurance payout. You can invest any large sum of money you have received in an immediate fixed annuity, so you can create a fixed income from it while also ensuring your money grows. You’ll protect that sum of money from frivolous spending, and at the same time, you can live off of it. When a person wins the lottery, they have the opportunity to have their winnings paid out as a fixed immediate annuity.
A deferred annuity is a type of annuity that you will pay into, often for many years, so that you can accumulate enough for a steady income at a later date. While immediate annuities are purchased with a lump sum, with a deferred annuity, you can choose to either pay your premiums in a lump sum or over several payments, often monthly. Your deferred fixed annuity will have a guaranteed interest rate on the money you pay into it and a steady, predictable payout when you reach the distribution phase of the contract.
Working people who plan to supplement their retirement income often choose a deferred annuity. Like life, home, or car insurance, they will pay a premium each month for years, and those payments will accumulate and grow at the guaranteed interest rate. When it comes time to retire, the money is used to pay out a steady income so that the beneficiary has reliable cash flow after they are no longer employed.
Variable annuities are a little bit more complex than fixed annuities. They come with higher risks, but they also have the potential to deliver much higher rewards. A variable annuity will have an interest rate related to an investment portfolio. That means that the better the performance of the investments in the portfolio, the higher the payouts will be. It also means that your investment is susceptible to poor market performance. This type of annuity can be more challenging to work with when you’re budgeting because you don’t always know how much your payouts will be.
It is possible, with a variable annuity, to purchase a rider that guarantees your income stream despite poor market performance, which means more predictability and less risk with your variable annuity.
Variable annuities can be broken down into two main types: immediate variable and deferred variable. Let’s take a closer look at what these mean.
An immediate variable annuity is when the annuitant uses a lump sum to purchase a variable annuity to begin prompt payouts. Like an immediate fixed annuity, an immediate variable annuity is an excellent choice for someone who suddenly comes into a large sum of money. Life insurance beneficiaries, for example, may choose to put their payout into an immediate annuity to protect them from excessive spending and ensure that the money will last and provide a steady income. When an immediate annuity is also a variable annuity, the interest rate can fluctuate with the market and the specific investments tied to the annuity.
An immediate variable annuity pays out right away, and presents higher risk and less predictability than an immediate fixed annuity.
Deferred variable annuities provide a steady source of income at a later date. At the same time, payouts and growth are both determined by the portfolio's performance of investments tied to the annuity. A consumer who purchases a deferred annuity will pay premiums into the fund over some time, often years. The money that has been paid into the fund is then invested into mutual funds. The annuity’s growth will depend on how well that mutual fund performs. As with any mutual fund, there will be peaks and valleys that can affect your payout when you enter the distribution phase of your deferred variable annuity.
A deferred variable annuity pays out in the future and is riskier and less predictable than a deferred fixed annuity.
Now that we’ve explored the main four types of annuities, we can look at other forms that annuities come in and how they might benefit you. All of these different variations of annuities differ from each other in many ways, and they come with their own set of pros and cons. The other types of annuities are:
Let’s explore each different type of annuity in more detail.
Indexed annuities are sometimes referred to as equity-indexed annuities or fixed-indexed annuities, and they fall somewhere between fixed and variable annuities. Indexed annuities offer a solution with much less risk than a variable annuity, but they do have the same potential for increased gains as the variable annuity. In essence, you get the security of a fixed annuity with the potential for growth of a variable annuity. Your interest rate is dependent on how well investments perform, but it is guaranteed to stay above a specific amount detailed in your contract. That means that the annuitant is guaranteed a minimum return. It’s kind of like the best of both worlds. However, indexed annuities do come at a higher cost than fixed annuities, and the interest rate can be challenging to figure out. For some, the potential for higher returns is worth the investment.
Long-term care annuities are a type of long-term care insurance that aims to cover the costs of any long-term care you might need while also protecting your retirement income. Essentially, it is an annuity with a long-term care rider, which is insurance jargon for “add-on.” Insurance policy riders offer added benefits to the insured. In the case of long-term care riders on annuities, you are adding coverage for care to your annuity. That means that in the event you find yourself requiring nursing home care, assisted living, in-home care, or adult daycare, your long-term care annuity will cover the costs up until a previously agreed-upon amount. A long-term care rider is a type of deferred fixed annuity, which means your policy will pay out a steady and predictable income in retirement while also covering the costs of long-term care. A long-term care rider with your annuity provides a significant increase in benefits, which means the overall cost will be higher, and your premiums will be more significant. However, this is a highly cost-effective way of protecting your retirement income from the unknown.
Deferred income annuities are a type of deferred annuity that will, during the distribution phase, pay out a steady income once you hit retirement. Think of it as a personal pension plan, where you invest over time so that, once you are no longer working, your annuity will pay out a reliable income. Your premiums accumulate over time, but they also grow with a guaranteed interest rate. Consumers can purchase an annuity with a lump sum or multiple premiums paid out during the accumulation phase. In return, the insurance company pays out a paycheck each month beginning at a later date. You can start paying into a deferred income annuity for as much as 30 or 40 years, ensuring a great deal of stability in retirement. As a rule, the more time you spend accumulating or paying into your annuity, the greater the amount you’ll be paid out in retirement. A deferred income annuity pays out for life.
A two-tiered annuity is a variety of fixed annuity. Two-tiered annuities offer different interest rates depending on how you choose to receive your payout. You can choose to maintain ownership of the money in the annuity and receive a lump sum payout later, or you can choose to have your annuity distribution occur in payments. If you choose the lump-sum distribution option, your interest rate will be lower, and your annuity won’t have as much growth. Conversely, if you decide to annuitize and receive payments over time, you will be eligible for the higher interest rate. The higher interest rate is an incentive to choose multiple smaller payouts over time rather than a lump-sum distribution. It is in the best interest of both the annuity issuer and the annuitant to select multiple payments over time. For the beneficiary, it means steady income and financial stability in retirement. For the issuer, it means they will earn more returns off the investments they make with your money.
A qualified longevity annuity contract is a variety of deferred fixed annuity. What makes a QLAC slightly different is that this type of annuity is purchased using the money from retirement accounts. For instance, you can use your 401(k) or individual retirement account (IRA) to purchase this type of annuity. There are specific requirements set out by the federal government that must be met for an annuity to be qualified. When you buy a QLAC with your retirement funds, you can defer income tax on up to $135,000 of funds in your IRA or 401(k). Without the annuity, you are required to make withdrawals from your personal retirement accounts by the age of 72, and these withdrawals are subject to income tax. When your annuity begins to distribute, you’ll have to pay tax on those payouts. There are contribution limits when it comes to a QLAC. You can only put in up to $135,000 from your retirement account.
Medicaid annuities or Medicaid-compliant annuities have strict rules that must be adhered to. To be eligible for Medicaid, there is an asset limit, and it’s very low. If you have more assets to your name than the allowed amount, you cannot qualify for Medicaid. When someone needs long-term care, this can be a sticky situation. Medicare does not cover long-term care, and unless you bought private coverage elsewhere, you would have to cover all of the costs yourself. But what if you can’t afford to pay for long-term care? It’s expensive and can deplete your savings quickly. For those who don’t have enough money to afford to cover long-term care themselves but who also have too much money to qualify for Medicaid, sometimes it’s worthwhile to unload some assets to allow for that coverage. A Medicaid-compliant annuity enables applicants to reduce the size of their assets and qualify for Medicaid. At the same time, this type of annuity can offer a steady income stream for the spouse who does not require long-term care, while Medicaid covers costs for the spouse who does. Medicaid annuities are fixed immediate annuities purchased as soon as the need arises.
Charitable gift annuities are available through many different charitable organizations in the United States. It offers a way to benefit a charity of your choosing while also ensuring a steady income for life. First, you’ll give a gift to the charity you’ve chosen. That charity will then invest the money, guaranteeing growth over time. You will then receive regular payouts from that investment account for the rest of your life. Whatever is left over once you have passed on becomes the charity's property. As an added incentive, the annuitant is eligible for tax deductions.
All annuities are tax-deferred, but there is a difference between qualified and non-qualified annuities that affect taxes. Qualified annuities are funded with pre-tax money, which means you have not yet paid tax on it. Non-qualified annuities are funded by after-tax money or money you have paid taxes on. Therefore, only the interest that non-qualified annuities earn will be taxed, whereas both the principal and earnings from a qualified annuity will be taxed as regular income. There are limits on how much you may be able to invest in a qualified annuity, but with a non-qualified annuity, there is no limit.
Now that we’ve gone through the types of annuities explained, you might be closer to choosing one that works for you. Choosing the annuity that is right for you will depend on several things. The types of annuity payouts you’re seeking and the risk you’re willing to take on will be the two main determining factors. If you have income coming from other sources during retirement and you won’t be relying on a specific amount from your annuity to keep your bills paid, taking more risk can pay off in the long run. That would make a variable annuity an excellent option for you. Conversely, if you rely on your annuity payout to fund your retirement, a fixed annuity might be a better choice because it offers predictable payouts you can depend on. If retirement is a few years off, you’ll want a deferred annuity, but if you’ve already retired or are near retirement and you need that income now, an immediate annuity would be the best choice for you. A deferred annuity is best when you have a longer duration of payments before you hit the distribution phase. In contrast, an immediate annuity is better when the accumulation phase is much shorter, or you have a lump sum to invest.
When purchasing an annuity, there are several additional factors to consider. For instance, if you want your spouse to continue to receive the benefits after you are gone, you’ll want to look into survivor or joint annuities. Familiarizing yourself with the fees associated with the annuities you’re choosing between is also an excellent way to narrow down your decision. You may also wish to leave room for the possibility of selling your annuity in the future.
Our content is created for educational purposes only. This material is not intended to provide, and should not be relied on for tax, legal, or investment advice. Everdays encourages individuals to seek advice from their own investment or tax advisor or legal counsel.