Annuities combine insurance with investment components, enabling you to create a stream of income from an account that grows tax-free each year. Understanding the various types of annuities and how their payment timetables are structured will help you determine whether they’re an appropriate choice for your financial plan. As you review the different kind of annuities, consider how their features would affect you in the short and long run so that you can avoid being surprised by rates and fees during retirement.
1. Fixed Annuity
A fixed annuity is the simplest type of annuity. Your money accumulates in the annuity with a fixed rate of interest, and after its annuitization — this happens when you convert it into income — you receive a guaranteed stream at a fixed payment rate based on your life expectancy. Fixed annuities offer tax-deferred growth, but if you make a withdrawal before you’re 59.5 you’ll pay a penalty of 10 percent, the same amount you’d pay for an early withdrawal from a 401k.
Fixed annuities come with an annual or monthly fee and their interest rates reflect reductions for expenses and profits. Most annuities also carry surrender charges, which kick in if you sell the annuity before a specified time period.
Fixed annuity rates depend on market interest rates. Two of the best annuity rates — from major insurance annuity companies Midland National and Royal Neighbors of America — range from 2.9 percent for a five-year annuity to 3.25 percent for a 10-year annuity.
If you prefer knowing how much your future income payments will be — which might be of particular interest if you’re a retiree and want to avoid making any retirement mistakes — a fixed annuity might be a good choice. Remember, however, that the return on fixed annuities is not high when low interest rates prevail.
2. Variable Annuity
When you invest in a variable annuity, you select from a variety of market-based investment options similar to mutual funds. Your investment’s value rises and falls based on the performance of the investments you choose.
You can take money out of a variable annuity in a lump sum or over time — the amount you can withdraw depends on the combined value of your contributions and investment gains during the accumulation period. Variable annuities typically offer additional options, such as a death benefit for your heirs if you die before you begin receiving payments.
Most major life insurance and investment companies offer variable annuities. Although their returns vary widely, top funds typically have annual returns from 10 to 19 percent. Fees vary among annuities as well. The Fidelity and Great-West annuities are currently the lowest-fee products on the market with annual rates of 0.25 percent.
Related: How Much Money Do I Need to Retire?
3. Indexed Annuity
An indexed annuity combines fixed and variable annuity features. Like a fixed annuity, it guarantees a minimum payment. That payment, however, is based on the performance of a specified index tied to the annuity such as Standard & Poor’s 500 index. You receive the higher of the guaranteed minimum payment or the larger payment tied to the index performance.
An indexed annuity might appeal to you if you like a sense of security but want higher returns than a traditional fixed annuity provides. Lincoln Financial offers an indexed annuity that provides $20,361 in annual income — starting at age 65 — for a 55-year-old investing $200,000. His total income by age 85 would be $407,220, which could theoretically be higher if the market performed consistently high.
Indexed annuities often have complex fee and payment structures. In addition to paying traditional surrender charges, you don’t receive the full value of underlying index gains. You should thoroughly investigate how index returns are calculated on indexed annuities, according to the Financial Industry Regulation Authority.
4. Immediate Annuity
No accumulation period is associated with an immediate annuity. Instead, you make a single payment to an insurance company and immediately begin receiving monthly income for either the rest of your life or a certain period of time.
The life insurance company Guardian offers an immediate annuity that generates approximately $964.20 in monthly, lifetime income for a 60-year-old male investing $200,000. The total payout could top $289,000 by the time he reaches the age of 85, which represents a 5.79 percent rate of return.
Most immediate annuities allow you to choose riders, which are features you can use to tailor the product to your needs. For example, your choices might include whether your payments continue for your spouse after you die or if you receive cost-of-living adjustments or annual payment increases to help counter inflation.
5. Deferred Annuity
A deferred annuity is a type of fixed annuity that defers payments to a future time. After you make your initial premium payment, you begin receiving guaranteed annuity payments at a specified time.
Because your annuity will be earning interest while you defer payments, the longer you can wait to start withdrawals the larger the payments will be. For instance, Mutual of Omaha’s deferred annuity will generate an annual payment of $19,461 — for a 55-year-old male investing $200,000 — when he turns 65 and provide $389,220 in total income by the time he turns 85.