There is much confusion regarding life insurance annuities so let’s see if I can clear the air. First of all, a life insurance annuity is always offered through a life insurance company. Life insurance companies follow a unique set of tax laws allowing annuities to be “tax deferred”. Tax deferral means that you do not pay taxes on the growth of your investment each year (unlike most other investments). Instead, you pay taxes on the taxable portion when you withdrawal the money (usually upon retirement). In exchange for tax deferral you may be penalized 10% by the IRS on monies you withdrawal prior to age 59 ½. Since annuities are offered via life insurance companies, they guarantee at least the principal (often times with interest) to be paid to your beneficiary upon your death regardless of actual investment performance.
A life insurance annuity falls into one of two categories, immediate or deferred, depending on when they are “annuitized”. “Annuitizing” your annuity means giving up control of your money in exchange for a guaranteed periodic payment (often for the remainder of your life). Immediate annuities are annuitized when the contract is purchased, whereas deferred annuities are annuitized at a later date. Many investors choose to never annuitize and simply use a deferred annuity to defer taxes.
There are two basic types of annuities, fixed and variable. A fixed life insurance annuity has a fixed interest rate, whereas a variable life insurance annuity allows you the freedom to choose between various “mutual fund like” sub accounts. A popular variation of the fixed annuity is called an “indexed” annuity. For many people the fixed annuity can offer the best of both worlds. The indexed annuity allows you to partially participate in the upside performance of an index (such as the S&P 500) without risk of losing money if the index is negative for a particular time period. The type of annuity you choose should be determined by your risk tolerance, time horizon, and objectives. Often times you can change from one type of annuity to another without taxes or penalties.
Annuities have many optional features (for an additional charge) that can get expensive if not used sparingly. Since they have various options, restrictions, and possible penalties for early distributions, you should review your needs carefully with your financial adviser or insurance agent before purchasing an annuity. In addition, it is advisable to periodically review old annuities. In summary, annuities aren’t for everyone, but they can be a wonderful tool for the right situation. Enjoy Life!