This is the eighth post in our Retirement Investing 101 series written by Amanda Smith, Client Services Specialist at CESI. Check out Part 1 or continue on to Part 9.

Annuities: these are a complicated species. An annuity is a contract between an investor and the insurance company. There are two different types of annuities, fixed and variable.

Fixed annuities are an agreement to pay a specified amount of interest over a specified period of time. These payments can be paid out monthly, semi-annually, or annually and are guaranteed. Payments can be deferred or immediate depending on the investor’s need. Payments that are deferred will pay out more than if the investor receives immediate payments. Fixed annuities offer a steady stream of income which is great for staying on a budget. Fixed annuities are fairly straightforward and easiest to understand.

Here is an example: At the time of retirement, you have managed to save $500,000 in your retirement account. You are afraid you will go on a shopping spree, spending the entire amount. But because you are so incredibly smart, you choose to invest this $500,000 into a fixed annuity to receive annual payments. After a great deal of research, you find an annuity that offers 4% interest over 25 years, and you’ll receive roughly $32,000 per year for 25 years. (If this isn’t enough money for you to live on after you retire, you will need to save more!)

Variable annuities are an entirely different animal. The payout amount will be determined based on the present value at time of payout. You can purchase a variable annuity based on a single purchase payment or a series of purchase payments. Periodic payments can be made immediately or chosen for a future date. The value of your annuity is based on the investment options you choose which primarily include mutual funds. The variable annuity offers several great benefits:

• Periodic payments, which may be paid:
  • For the rest of your life, or
  • For the rest of your spouse or other beneficiary’s life
• Death Benefit
  • If you die prior to receiving periodic payments, your beneficiary is guaranteed to receive a specified amount (at least equal to purchase payment)
  • Enhanced guaranteed death benefit
    • You may lock in a specific date in time where your beneficiary will receive the value of the annuity based on this date guaranteeing a higher payout at time of distribution
• Tax Deferred
  • You are not required to pay taxes on any income or gains until withdrawal
  • Withdrawals are taxed based on income tax rate, not capital gains rate

During the accumulation phase (the time your money is being invested and no payments are being withdrawn), investment options can be transferred to another investment option without tax penalty. However, your insurance company may charge a transfer fee to process the transaction. In the beginning of your payout phase, you may choose a lump-sum option or periodic payments (usually monthly). The periodic payment option offers two time periods to choose from. You may choose a fixed amount of time, such as 20 years, to receive a fixed amount of payments or the lifetime option, in which payments vary based on performance.

If at some point you need to withdraw from your annuity during the accumulation phase, you will be subject to a “surrender charge” and/or a 10% tax penalty if you are under the age of 59 ½.  Also be aware that a fee is charged for each benefit of the variable annuity so be sure to review this information prior to purchase.

Continue on to Part 9.

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