What is an annuity contract: A brief overview
Whatever your financial circumstances or career path, it makes sense to put a retirement plan in place — and purchasing an annuity contract means you needn’t worry about outliving your savings.
But what is an annuity contract, and how does it give you a guaranteed income for life?
What exactly is an annuity contract?
An annuity contract is an agreement between you and the insurance company, which sets out the terms of an annuity.
An annuity is an insurance product that provides a predictable lifetime income, with advantages including tax-deferred growth, death benefits for heirs, and favorable tax treatment.
Put simply, it states that you’ll pay the insurer a lump sum, in order to receive regular payments upon retirement (or before).
The contract describes which type of annuity product you’re buying and includes the date on which the payouts will begin.
It will outline any fees you need to pay, such as for contract riders (these include the option to withdraw funds for long-term care).
Types of annuity contracts
There are several types of annuity contracts, which you can choose from according to whether you want a variable or fixed rate of return and the date when you want to start receiving payouts.
Firstly, what is a fixed annuity contract?
1. Fixed annuities
Fixed annuity contracts give you a fixed interest rate, set by the insurance company. It means you’ll earn a guaranteed rate of interest for a set period of time, typically between three and 10 years.
There’s no need to worry about market volatility, and fixed annuities generally have the lowest fees.
It’s also possible to buy a fixed-indexed annuity, which earns interest based on a market index but doesn’t participate directly in the stock market.
There’s a guaranteed minimum rate of return, typically higher than fixed annuities.
2. Variable annuities
A variable annuity contract is so called because it is based on interest rates that can vary throughout the contract’s term.
This type of annuity is dependent on market risk and performance—it offers more growth potential but can’t guarantee a return.
Interest is earned via investment options you select within the annuity, including stocks, bonds, and mutual funds.
3. Deferred annuities
This is the most common type of contract, as it defers the payments until the date you specify (typically retirement).
With deferral, your money accumulates for longer, so you benefit from higher annuity income later on.
Unlike other investments like 401(k)s and IRAs, there are no contribution limits for deferred annuities.
Because you have to wait longer for the annuity payments, this type is not suitable if you have short-term financial needs or want a more aggressive investment strategy.
4. Immediate annuities
Immediate annuities, also called single premium immediate annuities (SPIAs), are those that start paying out within a year of purchase, rather than accumulating money until a specific date, such as retirement.
How does an annuity contract work?
An annuity contract is a legal document proving that both parties have agreed to the terms of the policy.
It outlines the premium you’re going to pay to the insurance company, which may be a lump sum or periodic payment.
It also states the chosen type of annuity, the level of liquidity, and the date on which the income payments are due to begin.
What is included in an annuity contract?
As well as the sections mentioned above, annuity contracts set out certain provisions.
These may include some of those typically found in a life insurance company policy, but they mainly relate to payments and penalties.
Crisis waiver provisions mean the surrender charge can be waived in extreme circumstances and under certain conditions, such as the owner holding the contract for a minimum number of years.
Death benefits provisions depend on whether the annuitant dies before or after the start date.
Tax status provision denotes any IRS tax advantages beyond tax-deferred growth.
What happens at the end of an annuity contract?
There are various options:
- Annuitize your contract, with the current contract value converted into a series of payments for the rest of your life.
- Cash it out in a lump-sum balance, which may incur a surrender penalty.
- Renew the contract.
- Transfer money into a different annuity contract or retirement account.
How to get out of an annuity contract
If you want to exit your contract early, you always have the option of cashing out, but this usually incurs a surrender charge — unless you’ve included a crisis waiver.
The IRS also allows investors to switch to a similar annuity without a tax penalty (called a 1035 exchange).
And if you only recently signed the contract, you should be able to cancel it during the “free-look” period (typically 10 to 30 days).
How do you transfer an annuity contract?
If you’re the contract owner, you have complete authority to transfer the contract.
Transfer a qualified annuity contract
Qualified annuities have been paid for with pre-tax funds. There are two ways to transfer them:
- Cash out and repurchase: Cash out the annuity and use the funds to buy a new one.
- Custodian-to-custodian transfer: The annuity’s custodian (the insurer) transfers it to another custodian without distributing the funds to the owner. It’s still not tax-free, though. Here are some types of tax forms you might want to be aware of.
Transfer a non-qualified annuity contract
Non-qualified annuities are purchased with after-tax funds, which makes transfers simpler.
The owner and the individual receiving the annuity must agree to the transfer, and signatures may need to be notarized.
Achieve financial goals with an annuity contract
So, we’ve learned what an annuity contract is, the different types, and how they work.
Although most annuities are purchased in order to guarantee a regular stream of income at retirement, they help people of all ages to achieve their financial goals.
A contract will ensure you’re protected. When you know exactly what you’ll receive and when you can make plans for the future.