How Do Annuities Work? 

In the good old days, retiring was simple. All you needed was a great pension, Social Security benefits, and maybe a soft couch, and you were pretty much set to retire with security and peace of mind.

But these days, things have changed—a lot.

With pensions all but extinct and the future of the Social Security system questionable, you’re probably facing some important questions: Will you save enough to retire the way you want, or will you run out of money in your golden years?

It’s a terrifying thought, sure. But believe it or not, you don’t have to hold the weight of this conundrum. Instead, you can transfer the risk of outliving your retirement savings from you to an insurance company. Yep—it’s called an annuity. Annuities can be tough to understand, but don't worry! We’re going to break down what they are, how they work, and the features they offer.

What Is an Annuity?

An annuity is a contract between you and an insurance company, ensuring you get a steady stream of payments in retirement, often for the rest of your life. Think of it as a pension that’s funded by you. One of the basics of annuities and how they work is you make payments (called premiums) to an insurer, and when you decide to annuitize, you’re guaranteed a series of payments in return.

But it's not just guaranteed income. There are many types of annuities you can choose from and depending on the type you pick, you can increase the value of your annuity as the insurance company pays you interest on your premium. And the best part? Whatever you earn in your annuity grows tax-deferred!

So, unlike other financial products (such as CDs and savings accounts, which require you to pay taxes on your earnings every year), you won’t pay a dime until you withdraw the money.

How Does an Annuity Work?

An annuity works like this: you (the owner) sign a contract with an insurance company.

Then, you make payments into the annuity over a period called the accumulation phase. When you’re ready to withdraw, you enter the payout phase. During payout, the insurance company turns on the flow of money, and boom—you get a steady stream of retirement income.

Sounds simple, right? Well, it gets a little more complicated. Because it's a personalized contract, your annuity may have different terms and restrictions than someone else's. For example, your contract dictates when you receive payouts, how long you receive them, and even how you want your money to grow. So, to figure out how your personal annuity will work, you need to answer these five basic questions.

1. When Do You Want the Annuity To Pay Out?

First things first: You have to decide if you want your annuity to pay out now (immediate annuity) or later (deferred annuity). It is always a good idea to consult a financial professional about your financial strength when looking at your options for income in retirement. 

Immediate Annuity

If you're about to retire or you are already retired, chances are you'll want an immediate annuity. With an immediate annuity, you hand over a lump sum to an insurer, and depending on your payment period (monthly, quarterly, yearly, etc), you'll start to receive payments right away. Why would you want an immediate annuity? Easy—in exchange for your money, you lock into a stable stream of income that’s not dependent on the stock market.

And, as long as you've paid taxes on the contributions you put in, you will only pay taxes on what you earn—when you make withdrawals in the future.

Deferred Annuity

If you're not planning on retiring soon but have a financial goal for retirement, you probably want a deferred annuity. With this type of annuity, you contribute to the annuity—in a lump sum, monthly payments, or some combination of the two—and allow growth for a number of years or even decades. Then, after you turn 59½ (the age you can withdraw without IRS penalties), you have the ability to turn the annuity on (this is called annuitization) and watch the payments hit your bank account.

With a deferred annuity, you have the power of time: Not only can you put money in for a longer period of time, but you give your contributions more time for growth.

Oh yeah—and if you've maxed out other retirement accounts (such as your 401(k) or IRA), a deferred annuity can be your best friend because there are usually no contribution limits. Time is great for allowing deferred annuities to grow, but it also means waiting.

Keep in mind that if you decide to withdraw money before 59½, there's a 10% IRS tax penalty on the gains, plus you'll pay income taxes at your current tax rate. And if you decide to cancel your annuity early, well, the insurance company could impose a  surrender charge for that too. 

2. What Type of Annuities Do You Want?

Once you've figured out when your payouts will start, it's time to decide how you want your money to grow. You have three choices here, and they all come with varying levels of risk: fixed, indexed, and variable annuities.

Fixed Annuity

A fixed annuity is the safest and most straightforward annuity product out there. When you sign your annuity contract, your insurer will lock you into a fixed interest rate for a given period. That means, no matter how volatile the market is during that fixed period, you're always earning at the same rate.

Indexed Annuity

With an indexed annuity, things get a bit more complicated. Instead of getting a fixed rate, you choose one or multiple market indexes, such as the S&P 500 or Russell 2000. Your contributions are invested in these markets, and you earn interest based on their performance.

But there’s a catch (or two): Unlike investing directly in the market, index annuities have a minimum and maximum rate of return. So, if the market tanks, the minimum protects you from losing money. But if the market does really well, the maximum crediting rate on your contract will be a ceiling.

Variable Annuity

Of all the annuity types, variable annuities are the riskiest and the most complicated. With variable annuities, you’re given a list of investment options, and your contributions are invested in whichever option you choose. If these investments (called subaccounts) do well, your balance grows.

If they do poorly, well—your annuity loses value. As you can guess, variable annuities can be a fun ride, or they can be another reason you can't sleep at night.

And though they come with investment options, they come with fees too—including management fees on your subaccounts.\

3. How Do You Want To Contribute?

After you choose the type of annuity you want, it's time to fund it. Now, remember that an annuity is an insurance product. And just like other kinds of insurance, you fund it with a premium. When it comes to annuity premiums, you can pay all at once (single premium) or pay over a period of time (flexible premiums).

Single Premium

A single premium means you make one lump sum payment—and that's it. This is great if you have cash sitting in a savings account or CD. This may also give you the ability to fund your annuity with the money that has accumulated in your 401K or IRA.

Flexible Premiums

Don't have a lump sum lying around? Well, then you can pick a flexible premium annuity. With flexible premiums, you make payments over several years. You can use money from your savings accounts, or you can set up direct deposits from your paycheck.

4. Will You Use After-Tax or Pre-Tax Dollars?

As you know by now, your earnings in an annuity grow tax-deferred, meaning you won't pay taxes on gains until you withdraw that money. But things get tricky when it comes to your principal—that is, the money you put in. How does it get tricky? Well, it all comes down to whether your annuity is non-qualified or qualified.

Non-Qualified Annuity (After-Tax)

Let's start with the easiest one: a non-qualified annuity. When you hear "non-qualified," think after-tax. In other words, the money you use to fund your annuity has already been taxed. So, when it comes time to withdraw your money, you don’t have to pay taxes on the money you put in. Only your earnings are taxed as ordinary income.

Qualified Annuity (Pre-Tax)

A qualified annuity, on the other hand, is funded with pre-tax money.

This is money that hasn't been taxed yet, such as money from a 401(k) or IRA. Because the money in your annuity has yet to be taxed, you'll pay taxes not only on what you earn but also on all initial contributions. On top of that, the IRS requires you to start withdrawing money from a qualified annuity after you turn 72—or face steep penalties.

5. How Long Do You Want To Receive Annuity Payments?

Now comes the fun part: getting paid.

As you probably guessed, you can choose from various payout methods, each one working slightly differently. The four most common ways of getting your annuity payments are: lifetime income, period certain, lifetime with guaranteed term, and joint-life payouts.

Lifetime Income Payouts

The lifetime option is just as it sounds—you get guaranteed income payments for the rest of your life. But the emphasis here is on "you." If you die young, your annuity won't pay your spouse, kids, or other beneficiaries. Instead, the money goes back to the insurance company.

Period Certain Payouts

With a period certain annuity, you don't get payouts for life. Instead, you pick a period—say, ten years—and your annuity pays out during that time. Unlike lifetime income, period certain annuities come with a death benefit (similar to life insurance). So if you die during your payout, your beneficiary collects money until the period ends.

Lifetime With Guaranteed Term Payouts

This option combines the previous two options. Along with a guaranteed source of income for life, you also get a period certain phase.

If you die during the period certain phase, your beneficiary collects your payouts for the remainder of the period. If you die after the period certain phase, the money goes back to the insurance company.

For example, let's say you choose lifetime income with a ten-year period certain phase, and you die two years after your annuity starts. Well, in this case, your beneficiary will get paid for the next eight years.

But, if you choose this same annuity and die after the period certain phase, the money will be returned to the insurance company.

Joint-Life Payouts

Lastly, you can choose a joint annuity, in which you and your spouse receive guaranteed income for the rest of your lives. As long as one of you lives, the annuity continues to pay out.

Want a Simple Annuity That Works For You?

At first glance, a simple annuity can sound like an oxymoron. A simple annuity? Is that even possible?

You bet it is.

At Canvas, our annuities are simple, straightforward, and designed for real people. We offer fixed annuities with highly competitive rates that you fund through a single premium with either qualified or non-qualified funds.

Once you create your annuity, your interest rate is locked into place for the term that you choose, meaning your earnings won’t be affected by the ups and downs of the market. Unlike most annuity products, which are sold through agents, Canvas gives you the power to buy your annuity directly online.

That means you don’t have to pay commission, account fees, or annual fees. And when it comes time for payouts, you decide if you want a lump sum or periodic payments. Ready to get started? Apply today, and become part of the Canvas family.