# of Forgotten 401K Accounts
0
M
Asset Value of Forgotten 401Ks
$
0
Trillion
of all Retirees have Annuities
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%
A Comprehensive Guide to Annuities: What They Are, How They Work, and Different Types
Written by Michael Henry C.R.C. & Matthew Wu C.R.C, 6 minute read
What is an annuity?
An annuity is a financial contract issued and distributed by an insurance company, purchased by you. In exchange for the premiums paid, the insurance company provides a fixed or variable income stream to you, starting either immediately or at a future date. This differs from a life insurance policy, which pays benefits upon your death or, if available, other qualifying conditions (i.e.: cancer, heart attack, stroke, chronic illness, etc).
You can fund annuities through monthly premium payments or a lump-sum payment. The issuing institution then provides a stream of payments for a specified period, ad-hoc, or for the annuitant’s lifetime.
The primary purposes of annuities are used for retirement income purposes and principal protection by helping you mitigate the risk of outliving their savings and the downturns of the market.
There are two main types of annuities — Variable Annuities and Fixed Income Annuities (FIA). Variable annuities allows you to purchase actual market securities such as mutual funds. These annuities have their benefits and risks, which can lose value due to market downturn. FIAs have their benefits (protection from market downturns) and disadvantages as well. For this purpose of this page, we will focus on FIXED INCOME ANNUITIES.
key takeaways
Generally, there are 3 key types of FIAs:
- MYGA
- Lifetime Income Annuity
- Growth Annuity
Choosing the appropriate annuity for your portfolio can be a difficult task. Having the right financial professional to help you identify which annuity works best for you is key for a successful retirement strategy.
What is a myga?
A multi-year guaranteed annuity (MYGA) is a type of fixed deferred annuity crafted to shield investors from market volatility, deliver tax-deferred growth, and ensure a stable income stream during retirement. MYGAs offer a fixed, guaranteed rate of return for the duration of the chosen term, which typically ranges from three to nine years.
- Guaranteed rates of return: MYGAs are not tied to the market and are not subject to any market losses. Example, if a major market index like the S&P500 drops by 12%, your MYGA will continue providing the agreed APY at the beginning of your contract.
- MYGAs typically produce greater returns than typical bank Certificate of Deposits (CDs) and High Yield Savings Accounts (HYSAs). Example, the highest CD/HYSA rate from a typical bank is 4.05% APY while MYGAs offers upwards of 5.5% APY for the same time period and market conditions.
- Featured returns of MYGAs do not have a significant variance of APY based on the term of the contract compared to CDs. Example, there may be a promotion for a CD with a 4% APY for 7 months, however selecting a term of 36 months will only have a 0.11% APY. Conversely, the difference between a 3 year MYGA has a 5% APY and a 5 year MYGA is a 5.5% APY.
- MYGAs have less reinvestment risk compared to CDs. Due to the nature of CDs being more short term vehicles, after the featured term of a CD is complete, the promoted rates may not be as incentivizing to continue on. Whereas MYGAs will experience higher rates of return for multiple years longer.
- Longer contract duration than typical bank CDs. CDs typically have contract periods of 6-36 months, investors will experience reinvestment risks in rates for longer period.
- Tax Advantages. MYGAs offer tax deferred growth allowing greater potential gains and only paying taxes when withdrawing funds similarly to a 401k or IRA.
- Lower returns: MYGAs may yield lower returns compared to stocks or mutual funds, which often provide higher returns over the long term.
- Restricted liquidity: there are penalties for early withdrawal or surrender. During the initial years, withdrawing funds typically incurs high surrender charges, which decrease over time. Many annuities may allow you allow to withdrawl up to 10% of your account balance without the carrier’s penalty or surrender fees. However, you will still be subject to the IRS 10% early withdrawal penalties if withdrawn before age 59½.
- Not insured: The security of an annuity is instead backed by the issuing insurance company. This means that the safety of your investment largely depends on the financial strength and stability of the insurance company issuing the annuity.
- Conservative investors. Those who prioritize safety and stability over high returns may find MYGAs appealing because they offer a fixed interest rate without exposure to market volatility.
- Individuals nearing retirement or already retired. MYGAs provide a stable, guaranteed income stream, which is ideal for those who need to ensure their savings last throughout their retirement years.
- People looking for tax-deferred growth. MYGAs allow the investment to grow without immediate tax obligations, which can be beneficial for long-term financial planning.
- Aggressive Investors: Those seeking higher returns and willing to take on greater risk may find MYGAs too conservative, as they typically offer lower returns compared to stocks or mutual funds.
- Younger Individuals: People who are far from retirement might prefer investments with greater growth potential and flexibility rather than locking in a fixed interest rate for several years.
- Those Needing Immediate Liquidity: Individuals who anticipate needing quick access to their funds may find the liquidity restrictions and potential penalties of MYGAs unsuitable for their financial situation.
- Investors with High Inflation Concerns: Since MYGAs provide a fixed rate of return, they may not keep pace with inflation over the long term, which could erode the purchasing power of the invested funds.
What is a Lifetime Income Annuity?
A lifetime income annuity is a financial product that provides a guaranteed stream of income for the duration of the your life. In exchange for a lump-sum premium payment or a series of payments, the insurance company agrees to pay the annuitant a regular income — typically on a monthly, quarterly, or annual basis, starting immediately or at a future date — guaranteed for the rest of your life and, if you had chosen it, your spouse’s life.
In lifetime income annuity, there are two values you must understand.
- Account Value (AV) — This is the account real fund in your account. Some carriers refers to Contract Value.
- Income Account Value (IAV) — This is a virtual number to calculate your income.
For example, if the lifetime guarantees you 7% a year, it means the IAV will grow at 7% regardless of the how the actual market performs. The actual market performance will affect AV. So even if the market grows negative in the next 5 years, your account value will stay stagnant because of the 0% floor protection. However, your IAV would have grown by 50% (5 years x 7% compounded).
- Guaranteed payments until death. You cannot outlive the payouts from the annuity despite the remaining balance of the account. Example; John, 65, rolls over $1,000,000 into a lifetime income annuity and the insurance company agrees to pay John $60,000 annually till the day John passes. John is now 90 years old and has received a total of $1,500,000, $500,000 more than he initially contributed to the annuity. John is still guaranteed to receive $60,000 per year regardless of how much money he has received or how much is left from your account balance.
- Higher annual payout. Generally annuities provide a greater payout than the typical 4% withdrawal. Example; Trisha rolls over $500,000 into a lifetime income annuity, the insurance company agrees to pay her out $30,000 annually. If Trisha left her money in an IRA, her advisor may apply the 4% rule and suggest only to take out $20,000 per year to ensure Trisha doesn’t run out of money during her lifetime.
- Chronic illness or nursing care payouts. In some cases, the annuity provider may have an additional rider, for a cost, to double the annual lifetime income to pay for chronic illness and nursing care. This rider allows the annuitant to receive 2X their payout for a period of time, usually 5-10 years. Example; Bob is currently receiving $40,000 per year from his annuity. Bob suffered from a stroke and is now in need for long term care at an assisted living facility. Bob is able to receive $80,000 per year for the next 5 years, after which, he will continue receiving his initial payout of $40,000 until Bob passes.
- Market protection. Payouts are not related to market performance. The payout is set and guaranteed regardless of market conditions, positive or negative.
- Death benefit. If the annuitant passes prior to receiving the amount of money equal to the value of the annuity, the beneficiary will receive the remainder.
- Lack of Liquidity. Once you purchase a lifetime income annuity, your access to the principal amount is limited. Early withdrawals may come with significant penalties or may not be allowed at all, restricting your financial flexibility.
- Inflation Risk. Most lifetime income annuities provide a fixed payment amount, which may not keep pace with inflation. Over time, the purchasing power of your income could decrease, potentially affecting your standard of living. To mitigate this risk, some carriers give you the option to keep up inflation.
- Fees and Costs. Annuities can come with various fees, such as administrative fees, mortality and expense risk charges, and investment management fees (for variable annuities). These costs can reduce the overall value of your account.
- Complexity. Annuities can be complex financial products with various features and options. Understanding the terms, conditions, and potential risks requires careful consideration and possibly professional advice. You can mitigate this risk by working with a professional who is patient in answering all your questions and providng different options for you.
- Retirees Seeking Guaranteed Income. Individuals who want to ensure they have a steady, predictable income stream throughout their retirement, providing financial stability and peace of mind.
- Risk-Averse Investors. Those who prefer a secure, reliable source of income over the potential for higher but uncertain returns from market-based investments.
- People Concerned About Outliving Their Savings. Annuities provide a safeguard against the risk of outliving one’s financial resources, ensuring continuous income for life.
- Individuals Without Employer Pensions. Those who don’t have access to a defined benefit pension plan may find annuities an effective way to replicate a similar guaranteed income stream.
- Those Seeking to Simplify Retirement Planning. Annuities can reduce the complexity of managing investments and withdrawals, offering a straightforward financial solution for retirement income needs.
- Individuals Seeking High Returns. Investors looking for higher returns and willing to accept greater risk may find the fixed, predictable returns of a lifetime income annuity less attractive.
- Young Investors. Younger individuals with a longer time horizon might benefit more from investments with higher growth potential, such as stocks or mutual funds.
- People Needing Liquidity. If you anticipate needing access to your funds in the near future, the limited liquidity and potential penalties of an annuity could be a drawback.
- Those with Other Guaranteed Income Sources. Individuals who already have sufficient guaranteed income sources, such as pensions or Social Security, might not need the additional guaranteed income provided by an annuity.
- High Inflation Concerns. If maintaining purchasing power is a primary concern, the fixed payments from a lifetime income annuity might not keep up with inflation over the long term.
What is a Growth Annuity?
An accumulation annuity is a type of annuity designed to grow the value of your investment over a period of time before it starts paying out income. During the accumulation phase, you make contributions to the annuity, either as a lump sum or through regular payments. The money you fund is then allowed to grow on a tax-deferred basis, meaning you won’t pay taxes on the earnings until you start receiving distributions. These annuities allows index options that could provide a solid returns. The main difference from the lifetime income annuity is the distribution is not guaranteed for rest of your life. In growth annuities, you only have one value that you need to be concerned: the Account Value. You can withdraw any amount at any frequency as you wish, but your account may run of money. This annuity has benefits as well as disadvantages.
- Tax-Deferred Growth. Earnings within an growth annuity grow tax-deferred, meaning you don’t pay taxes on the investment gains until you start withdrawing the funds. This allows your investment to potentially grow faster than in a taxable account. If you had funded the annuity with ROTH IRA, then the gains will not be taxed when you take distributions.
- Guaranteed Interest Rates. Depending on the type of growth annuity, you may benefit from guaranteed minimum interest rates, providing a level of security and predictability to your investment growth.
- Diversification Options. Many accumulation annuities offer a variety of investment options, including fixed accounts and variable subaccounts tied to mutual funds, allowing you to diversify your investments within the annuity.
- Flexibility in Contributions. You can make contributions to the annuity either as a lump sum or through regular payments, providing flexibility in how you build your investment.
- Protection Against Market Volatility. Fixed accumulation annuities are not subject to market fluctuations, offering a safer investment option for conservative investors.
- Customizable Features. Some growth annuities offer riders and additional features, such as death benefits or nursing care provisions, that can be tailored to meet your specific financial needs and goals.
- Structured Withdrawals: When you transition to the payout phase, the annuity can provide a steady stream of income, which can be structured to meet your retirement income needs.
- Limited Liquidity. Access to funds in a growth annuity can be restricted, particularly during the initial years of the contract. Withdrawals may incur surrender charges, and there could be penalties for early withdrawals before age 59½.
- Fees and Expenses. Growth annuities can come with various fees, including administrative fees, mortality and expense risk charges, and investment management fees. These costs can reduce the overall growth of your funds.
- Complexity. Annuities can be complex financial products with numerous features and options, making it difficult to fully understand the terms and conditions. This complexity may require professional advice to navigate effectively.
- Inflation Risk. Fixed accumulation annuities provide a guaranteed rate of return, but this return may not keep pace with inflation over the long term, potentially eroding the purchasing power of your investment.
- Tax Treatment. While the earnings within an annuity grow tax-deferred, withdrawals are taxed as ordinary income, which can be higher than the long-term capital gains tax rate. Additionally, taking money out before age 59½ can result in a 10% early withdrawal penalty from the IRS.
- Long-Term Savers. Those who have a long-term investment horizon and are focused on building their retirement savings over time.
- Tax-Conscious Investors. Individuals who want to take advantage of the tax-deferred growth offered by annuities, deferring taxes on earnings until they begin withdrawing the funds.
- Conservative Investors. Those who prefer a more conservative approach to investing, especially with fixed growth annuities that provide guaranteed interest rates and protection from market volatility.
- People Seeking Diversification. Investors looking to diversify their retirement portfolio with a product to balance their portfolio with vehicles that is free of market-risk.
- Retirement Planners. Individuals planning for a structured and reliable income during their retirement years, ensuring a steady stream of income when they transition to the payout phase.
- Risk-Averse Individuals. Those who want to mitigate the risks associated with market fluctuations and seek stable, predictable returns.
- Individuals Seeking High Liquidity. If you need quick and easy access to your funds, the liquidity restrictions and potential penalties for early withdrawals make annuities less suitable.
- High-Risk Investors. Those aiming for high returns and willing to accept significant market risks may find the relatively conservative returns of accumulation annuities less appealing.
- Younger Investors. Individuals with a longer time horizon who may prefer investments with higher growth potential, like stocks or mutual funds, instead of the fixed or moderate returns typical of annuities.
- Those With Low Tax Concerns. If you are not significantly affected by tax-deferred growth benefits, perhaps due to being in a lower tax bracket, the tax advantages of an annuity may not be as compelling.
- High Inflation Concerns. Investors worried about inflation eroding the purchasing power of their savings might find the fixed rates of return in some accumulation annuities inadequate over the long term.
Summary
Selecting the right annuity for your portfolio can be a complex and challenging task. Given the variety of annuity options available, each with its own unique features and benefits, it is essential to make an informed decision to ensure your financial goals are met. Collaborating with a knowledgeable financial professional can be instrumental in this process. They can provide valuable insights, help you navigate the complexities of annuity products, and identify the option that aligns best with your individual retirement strategy.
By leveraging our team and expertise, you can gain a deeper understanding of how different annuities work, assess their potential impact on your financial plan, and make choices that support a secure and successful retirement. This professional guidance is crucial in tailoring a retirement strategy that optimizes your income, manages risks, and meets your long-term financial needs.
Take the first step towards a secure and successful retirement by partnering with a trusted financial professional. Reach out today to explore the annuity options that best fit your portfolio and ensure a stable financial future. Your ideal retirement strategy awaits—let’s make it happen!
Co-Founder of M&M Wealth Associates. Michael is a dedicated advocate for financial literacy, specializing in risk mitigation with the belief that addressing financial illiteracy is crucial for achieving financial success in the U.S. With only 14% of Americans on track for a successful retirement, Michael’s mission is to change that statistic. As a Certified Retirement Counselor, Michael prioritizes financial security and peace of mind for all his clients.<br>
Michael takes the time to understand his clients’ financial, emotional, and mental landscapes, allowing him to provide customized solutions tailored to their unique needs. Michael’s approach is rooted in patience, kindness, and compassion, as he firmly believe that financial health is deeply intertwined with mental well-being. Together, Michael and the M&M team create comprehensive plans that not only safeguards their client’s assets but also nurtures their overall wellness.
DOI 0N10513
Co-Founder of M&M Wealth Associates, Co. Matthew is a passionate advocate for financial security and believes in the importance of protecting people’s wealth. Matthew combines his expertise as a real estate broker with a holistic approach to financial planning, recognizing that real estate can play a vital role in a successful retirement strategy. Leveraging his MBA from UCLA, credentials as a Certified Retirement Counselor and technological background, Matthew’s mission is to provide peace of mind through personalized financial solutions. He understands that there is no one-size-fits-all approach; identifying the unique goals of his clients and crafting tailored strategies is his specialty.
Driven by commitment to helping others achieve their financial dreams, Matthew and the M&M team bring a diverse perspective to his work, guiding clients toward a secure and fulfilling future.
DRE 01881143, DOI 0M09342
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