Single premium annuities are purchased with one, lump-sum premium payment. Some single premium annuities do accept additional premiums during a short, specified time period at the beginning of the contract.
Flexible premium annuities accept several premium payments during the life of the contract. These premiums generally can be of varying amounts as long as an annual minimum is met. This type of annuity would make possible the sort of retirement savings where small monthly payments are added — to an IRA, for example.
A fixed annuity guarantees to pay a specified interest rate that is based on the current rate environment. The initial rate is guaranteed for one or more years and subsequent renewal rates are guaranteed to stay above a specified minimum rate. Because it provides several guarantees, a fixed annuity is viewed as a conservative financial product.
An index annuity is a special type of fixed annuity in which the interest rate is determined in part by reference to an investment-based index, such as a Standard & Poor’s index or a NASDAQ index. As interest is credited, the earnings are locked in to the account value; additionally, the account will not participate in any losses. Because of this reference to an index, the annuity offers the ability to participate in some gains associated with a rising financial market while at the same time providing the security and guarantees similar to those associated with traditional fixed annuities.
A variable annuity offers earnings and income payments that fluctuate with the performance of specific investment funds. While variable annuities have the potential to provide high returns, they differ from fixed products because the policyowner bears investment risk and possible loss of principal. As these products are more complex and have associated with them more risk, the broker who sells this annuity must be licensed to sell securities.
Non-qualified means that there is no tax deduction for the premiums paid. There is, however, the benefit of tax-deferred growth in the annuity. And upon annuitization a portion of the payments will be considered a non-taxable return of premium.
Qualified tax status refers to individual retirement accounts (IRAs) and employer-sponsored savings plans like a 401(k) or a 403(b) Tax-Sheltered Annuity. These receive special IRS tax treatment, including possible tax deduction for premiums or contributions in addition to the benefit of tax-deferred growth.
A deferred annuity grows, tax deferred, until the contract is annuitized (put into a payment stream) or surrendered (paid out as a lump sum).
A deferred annuity contract is chiefly a vehicle for accumulating savings and eventually distributing the value — either as a payment stream or as a one-time, lump-sum payment. All varieties of deferred annuities have one thing in common: the increase in account value is not taxed until those gains are withdrawn (or paid out). This is also known as tax-deferred growth.
The tax-deferred status of deferred annuities has led to their popularity. In the U.S. tax code, the benefits from annuity contracts are not required to be taken as a fixed stream of payments and many contracts are purchased primarily for the tax benefits and not to get a fixed stream of income.
People will often talk of the affect of “triple-compounding” of annuity growth because the account will earn interest on
- Principal (the initial premium payment);
- Interest (the amount credited as account growth based on the contract interest rate); and
- Unpaid Taxes (the amount that, without deferral, is paid annually).
An immediate annuity guarantees payments, which start right away, for a specified time period or for a lifetime.
This contract is generally used as a way to generate income payments. These periodic payments may be either level or increasing and designated for a fixed term or until death, in one of several combinations.
The chief characteristic of an immediate annuity is the contract’s ability to distribute savings with a tax-deferred growth factor. The U.S. tax code dictates that every annuity payment is a combination of return of principal (is not taxed) and payout of income (is taxed at normal-income rates, not capital-gain rates). This has the benefit of stretching the tax payments over a longer time period. A common use for an immediate annuity is converting accumulated savings into an income stream during retirement.