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What Is an Immediate Annuity and How Does it Work?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

An immediate annuity, also known as an income annuity, is a type of annuity that begins paying out right away. With an annuity, you enter into a contract with an insurance company. In exchange for your payments, the insurance company will send you disbursements for a predetermined term — sometimes for the rest of your life.

Immediate annuities are distinct from deferred annuities, which have an initial accumulation phase during which the pool of money grows, followed by a later payout phase. Both immediate and deferred annuities are good tools for funding your retirement, though they serve different purposes. A deferred annuity allows your money grow tax-deferred so you’ll have income at a future date, while an immediate annuity is useful if you need regular income right away.

What is an immediate annuity?

If you’re already in retirement or plan on retiring soon, an immediate annuity might make more sense than a deferred annuity because you may have an immediate need for steady income. If you live a long time, an immediate annuity could pay out more than it initially cost. On the other hand, the insurance company may keep the money that’s left in accounts when a contract-holder passes.

Here are some considerations to keep in mind to determine if immediate annuities are right for you:

  • Payments: With an immediate annuity, you’ll receive payments on a regular schedule, such as monthly or annually. The first payment will begin with your next scheduled payment. Immediate annuities can have either a fixed payment period, such as 10 or 20 years, or your annuity could pay out for your lifetime, or your lifetime plus the lifetime of a beneficiary (such as a spouse).
  • Interest: The principal balance in your annuity will grow at a predetermined rate (i.e., it’s a fixed annuity), based on underlying investments (a variable annuity) or based on the growth in an index, such as the S&P 500 (an indexed annuity). Your payments may either be fixed or they could go up and down depending on whether you buy a variable or indexed annuity.
  • Costs: A variety of fees can impact the growth of your annuity and your payments. Costs may include administrative fees, underlying fund fees, commissions and mortality and expense risk fees. Additionally, you’ll pay extra for riders, which are different types of add-ons that you can purchase for your annuity. For example, a cost-of-living adjustment (COLA) rider will increase your payments to keep up with inflation. Compare annuities to one another, and to other retirement options, before signing a contract.

Qualified immediate annuity vs. non-qualified: What’s the difference?

Depending on how you pay for your immediate annuity, it could be classified as either qualified or non-qualified.

“Qualified annuities refers to when the source of the funds comes from a tax-deferred account,” said Ray Caucci, chairman and CEO of Vantis Life Insurance Company. In other words, if you have money in an IRA, 401(k) or another type of tax-advantaged retirement account, and then use the money to buy an annuity, the annuity is considered qualified.

By contrast, if you use after-tax dollars (i.e., you don’t receive a deduction from putting your money into an account) to purchase an annuity, then it will be a non-qualified annuity.

In other words, the main difference between qualified and non-qualified immediate annuities is the taxes on your payments.

Immediate annuity taxation issues

Unlike when you contribute to a tax-deferred retirement account, the premiums you pay when you purchase an annuity aren’t tax deductible. But the payments you receive can be taxable.

If you have a qualified annuity — meaning you bought the annuity with money that was inside a tax-advantaged account — then the entire annuity payment is fully taxable as income. Unlike with investment distributions, the principal and interest or gains portions of your annuity payments are taxed as ordinary income rather than capital gains. And, similarly to tax-advantaged accounts, you may need to pay a 10% penalty fee if you withdraw money before you are 59½ years old.

Taxation is a bit trickier with a non-qualified annuity. “The benefit is split between a return of the principal and interest,” Caucci said. The interest or gains portion is subject to ordinary income taxes, while the principal portion isn’t taxed (because you already paid taxes on the money before you bought the annuity.)

“That’s done through the means of an exclusion ratio that’s determined by the insurance company,” Caucci said. The ratio, which depends on your life expectancy, is often shared as a percentage and indicates how much of each payment is non-taxable income from the principal. If you live beyond your life expectancy, your remaining payments will become completely taxable.

Who should invest in immediate annuities?

Immediate annuities are generally best for those who are already in retirement, or who are about to retire, and are looking for a low-risk option to boost their income. Particularly if you’re worried about outliving your savings, an annuity with a lifetime payout could ease that concern.

“It could be a foundational income source that doesn’t change,” Caucci said. “You can decide how you want to distribute your other savings and investments, but you always have a foundation of the income.”

One of the downsides is that the guarantee also means you might have to keep your money locked up in the annuity. “People who want more control over their retirement income won’t be as enamored with an immediate annuity,” Caucci said.

Immediate annuity pros and cons

While an immediate annuity could offer a secure and steady source of income during retirement, it’s not the right fit for everyone. Here are some of the pros and cons to consider:

Pros

Cons

  • You can start receiving income almost right away.
  • There’s the potential to receive a steady income stream for the rest of your life.
  • You may receive a higher interest rate than you would with other low-risk options, such as a certificate of deposit (CD) or a bond.
  • Market fluctuations generally won’t impact your payments.
  • Many immediate annuities won’t let you withdraw any of your principal once your payments start.
  • The fees associated with an annuity could make it a more costly option than other types of retirement accounts or investments.
  • If the insurance company goes under, state guaranty funds may only cover a portion of your annuity’s balance, typically $250,000.
  • Depending on the type of annuity and the riders you choose, your remaining account balance might not pass on to your estate or heirs.

The bottom line

If you’re in or nearing retirement and worried about outliving your savings, an immediate annuity could offer a solution. You can also customize annuities in many ways, to provide payment increases that keep up with inflation or payments to a spouse after you pass, for example. Before you buy a contract, learn more about the potential fees, features and annuity providers, and consider the different types of annuities that are available if you don’t need the immediate income.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Louis DeNicola
Louis DeNicola |

Louis DeNicola is a writer at MagnifyMoney. You can email Louis at [email protected]

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Banking

Understanding the Three Types of Annuities

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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Understanding how annuities work is an important first step in determining whether they fit into your retirement plans. Annuities can be customized in many ways, although they fall into three broad categories: fixed, indexed and variable.

An annuity is a contract between you and an insurance company. In exchange for giving the company money today, you receive a lump-sum payment or series of payouts in the future. For example, you could purchase an annuity with a single payment when you retire and then receive monthly payouts for the rest of your life.

Annuities offer long-term, tax-deferred savings, making them a potentially helpful tool for retirement. But because there’s such a wide-range customization available, it can be confusing to understand all your options. Our guide covers the basics on the different types of annuities: fixed, indexed and variable.

What is a fixed annuity?

A fixed annuity is one of the simplest types of annuities — it’s somewhat similar to a certificate of deposit (CD) account. You fund a fixed annuity with a single payment or a series of payments. The insurance company guarantees this principal amount, a minimum interest rate and a number of payments in the future.

The interest rate applies to your principal balance, and your account grows tax-deferred during the accumulation phase. At the end of the accumulation phase, your payout period begins. You’ll then receive a single lump-sum payout or periodic payouts, such as monthly or annually.

“When you first buy a contract for a fixed annuity, the payout amount will be specified,” according to Ken Tumin, founder of LendingTree-owed company DepositAccounts.com, so you’ll know how much income to expect later. Also, depending on your contract, the periodic payouts could be guaranteed for a certain number of years, until you die or until you and a beneficiary (such as a spouse) die.

Fixed annuity pros and cons

Fixed annuity pros

  • This type of annuity is relatively easy to understand.
  • You’ll receive a guaranteed interest rate and payouts.
  • You’ll know the payout amount and payout period when you first buy the contract.
  • There’s little risk of losing your savings.

Fixed annuity cons

  • The interest rate may be lower than what you could receive from other savings or investment products.
  • The interest rate could be lower than inflation in the future.
  • Fees may eat into your savings and decreases your payout amount.
  • You might not be able to take money out of the annuity without paying additional taxes and fees.

Who should invest in fixed annuities?

A fixed annuity may be the most attractive type of annuity if you’re looking for stability and guarantees. However, think carefully about when and why you’re buying the contract, as the interest rate you lock-in during the purchase will influence your payouts.

“If the interest rates start to bottom, it might not be the best time to get a fixed annuity,” said Tumin. “If you think rates are going up, wait for a few years until there’s a better interest rate environment.”

What is a variable annuity?

A variable annuity may feel more like a 401(k) or individual retirement account (IRA) than a certificate of deposit. When you buy a variable annuity, you can choose to invest your money in different financial products, such as mutual funds.

Your earnings during the accumulation phase depend on how well your investments do, which will impact your future payouts. The insurance company may offer optional riders that limit how low your account’s value can drop and guarantee you a minimum payout.

You may also be able to choose to receive the payout as a lump sum, over a fixed number of payouts or until you die. If you choose periodic payouts, the payout amount could either be pre-set or it may vary with your investment returns.

Variable annuity pros and cons

Variable annuity pros

  • You could earn higher returns and have larger payouts than you would with a fixed annuity.
  • Earnings are tax-deferred.
  • The SEC generally regulates variable annuities.

Variable annuity cons

  • You may have to pay higher fees than you would with other tax-deferred accounts.
  • Your payouts count as ordinary income rather than capital gains and may be taxed at a higher rate.
  • You could lose the money you put into the annuity.

Who should invest in variable annuities?

A variable annuity can offer tax-deferred investment growth and an additional source of income during retirement. “But a lot of the best variable annuities are basically a wrapper around investment options like mutual funds,” says Tumin. The wrapper analogy can apply to other tax-deferred accounts, such as 401(k)s and IRAs, although those may offer more investment options and fewer fees.

“For those who’ve maxed out their 401(k)s and IRAs, a variable annuity can be a reasonable option,” says Tumin. Until that point, you may want to focus on investing in other, lower-cost accounts instead.

What is an indexed annuity?

Indexed annuities often offer a minimum interest rate on your money, but are also tied to an investment index, such as the S&P 500. Depending on how the index performs, you may receive more interest earnings than the minimum rate. However, there are also often caps on how much you earn.

For example, if the S&P increases by 8%, you might only receive 3% of the gains — your cap — and the insurance company keeps the remainder. On the other hand, if the S&P decreases in value in a year, you might still receive a minimum interest rate gain rather than losing money.

The specifics of your annuity can also impact your earnings because the contract will dictate the cap, how much of the index’s gains your receive, the fees you’ll pay and how often the insurer reviews the index to calculate gains.

Indexed annuity pros and cons

Indexed annuity pros

  • Offers a mix of guaranteed and investment-based tax-deferred earnings.
  • Limits the potential for losses compared to variable annuities and other investments.

Indexed annuity cons

  • Although your money gets invested, the SEC and FINRA might not regulate indexed annuities.
  • Your gains are limited by the insurance company’s fees and caps.
  • Can be particularly hard to understand and compare to other savings and investment options.
  • Although there could be minimums, you might lose money on your investment.

Who should invest in indexed annuities?

Index annuities can seem like the best of both worlds — protection against investment losses with the potential to earn more than you would with a fixed annuity. But it’s not all good news, as the fees and caps can eat into your potential investment returns, particularly during high-growth periods.

“For those that are very conservative, the indexed annuity could give you a better return than a fixed annuity,” says Tumin. However, as with variable annuities, he suggested looking into other tax-deferred investment accounts, such as 401(ks) and IRAs, before an indexed annuity.

Deferred annuity vs. immediate annuity: What’s the difference?

You can purchase these three types of annuities as either deferred or immediate annuities.

With a deferred annuity, your contract begins with an accumulation phase. During this phase, the interest or investment earnings get added to your account balance, and you may be able to make additional contributions to increase your account’s value. At the end of the accumulation phase, you’ll start to receive payouts (either in a lump sum or periodically) based on the account balance and the terms of your contract.

Immediate annuities start to pay immediately based on your payment schedule. So, if you receive payments monthly, your first payment will start a month later. But if you receive annual payments, you’ll wait a year for your first payment.

Deferred annuities can be a better option if you’re planning ahead for retirement, or are in retirement but have other sources of income. An immediate annuity may be a better option if you’re in retirement and want to lock-in an income stream.

Conclusion

There are different types of annuities, payout structures and a wide range of riders that can make comparison shopping extremely difficult. Add on the fees, brokers’ commission-based sales arrangement and the possibility of losing your “guaranteed” income stream if the insurance company goes under and annuities look much less appealing.

Still, that’s not to say annuities are all bad. An annuity can offer a steady income stream during retirement, with an option to continue the income stream as long as you’re alive (or even beyond).

However, if you’re considering purchasing one, continue doing your due diligence and learning about the differences between annuity providers and contracts.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Louis DeNicola
Louis DeNicola |

Louis DeNicola is a writer at MagnifyMoney. You can email Louis at [email protected]

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Banking

A Timeline of the 2008 Financial Crisis

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

The financial crisis of 2008 was one of the worst economic disasters in recent history, and the shockwaves from the global recession it caused are still being felt today. We will outline the key developments in the 2008 financial crisis timeline on a month-by-month basis. The roots of the crisis can be found in banks making too many risky investments, especially in subprime mortgage loans. The big banks packaged risky mortgage loans into investment securities, sold the securities to each other, and then insured the investments with exotic and risky forms of insurance known as credit default swaps (CDS). These interrelated investments tied the banks to each other: If one bank went bankrupt, the problem would infect others and eventually the entire financial system. This is how banks became “too big to fail.”

By the final months of 2007, the U.S. housing market and global credit markets were under a great deal of pressure. The slowing U.S. economy lowered home values, subprime borrowers started defaulting on their loans, pushing the banks to declare huge losses from subprime mortgage investments. This negative feedback loop sparked a major liquidity shortage, as the banks reduced lending to one another because of the spiraling losses.

Interbank lending is the vital circulatory system of the global financial system. In an effort to jump-start interbank lending and ease the liquidity crisis, central banks around the world — including the U.S. Federal Reserve — began cutting interest rates and offering emergency lending for the banking sector.

January 2008 — Central banks cut rates

On Jan. 11, Bank of America announced that it would buy mortgage lending giant Countrywide Financial Corporation (the deal would be completed later in the year). Countrywide was a key subprime mortgage lender, and it was hemorrhaging money as more and more borrowers defaulted on their mortgage loans. Although the purchase looked like a deal at the time, Bank of America wound up losing over $40 billion due to the acquisition.

On Jan. 21, stock markets around experienced the largest losses since Sept. 11, 2001. The next day, the Fed lowers the key federal funds rate by 75 basis points to 3.5%, the biggest decrease in 25 years. Stock markets rebounded momentarily, but by Jan. 30th, the Fed was forced to cut rates again, this time by 50 basis points, to 3.0%.

The federal funds rate is the key benchmark for interest rates throughout the financial system. When the Fed cut rates, it was looking to drive a reduction in market rates for consumers. The hope was that lower rates would spur consumers to take out mortgages and buy homes — helping current homeowners get out of overpriced, failing mortgages rather than default on their loans.

February 2008 — Washington tries emergency stimulus

On Feb. 13, President George W. Bush signed the Economic Stimulus Act of 2008. The law included measures to boost spending by consumers and businesses, in an attempt to avoid a recession.

  • It provided a recovery rebate to individuals who filed a tax return for 2007 or 2008, effectively lowering the federal tax rate. Taxpayers received up to $600 each ($1,200 for married filing jointly taxpayers), plus an additional $300 per dependent child.
  • The law temporarily increased certain business tax write-offs to $250,000 from $125,000 for purchases of depreciable assets, and up to 50% of the cost of certain purchases in 2008.
  • To address the subprime mortgage crisis, the law allowed the Federal Housing Authority (FHA), Freddie Mac and Fannie Mae to buy up larger mortgages from lenders in certain high-cost areas.

Freddie and Fannie are known as government-sponsored enterprises (GSEs), and together with the FHA, they buy mortgages from lenders and package them into securities, which are sold to investors. The hope was that the higher loan limits would ease the mortgage crisis in hot spots where housing had become very overvalued. However, home sales continued to fall and foreclosures continued to rise.

March 2008 — Bear Stearns fails

During the first two weeks of the month, the Fed announces several programs to increase loans to banks and other organizations, with the hope of increasing liquidity (i.e., the flow of money).

Backed by financing from the Federal Reserve, JPMorgan Chase agrees to buy Bear Stearns on March 16. Bear Stearns had been one of the largest global investment banks in the US, but was failing due to its investments in subprime mortgages.

On March 18, the Fed drops the reserve rate to 2.25%.

April to June — The subprime crisis becomes a global crisis

In early April, the International Monetary Fund (IMF) warned that the financial crisis could go beyond the subprime mortgage market. It warns that the overall global losses could be higher than $1 trillion.

Then, at the end of the month, the Fed cut interest rates again, by 25 basis points to 2%. In the meantime, the Fed continued its efforts to improve liquidity by offering more loans to financial institutions and increasing the types of assets the financial institutions can use as collateral for the loans.

On June 19, it was declared that since March, the FBI had arrested 406 people that it alleged were part of mortgage fraud schemes.

July — Banks begin to fail

Federal regulators seized IndyMac Bank, a major mortgage lender, at the beginning of July, making it one of the largest bank failures in U.S. history. Customers waited in long lines, hoping to withdraw their money before the bank failed. The bank reopened after several weeks as IndyMac Federal Bank.

Denmark announced it was the first European Union country to enter recession, as its economy shrunk for two quarters in a row.

On July 13, the Fed increased credit lines to Fannie and Freddie, and authorized the Federal Reserve Bank of New York to lend the GSEs money. It also gave the Treasury department temporary authorization to buy shares of the GSEs.

President Bush signed the Housing and Economic Recovery Act of 2008 to combat the housing crisis. The act revised regulations for the GSEs, increased GSE loan limits, created a temporary tax credit for people who purchased a new principal residences and temporarily authorized the FHA to refinance mortgages for homeowners who were having trouble making payments.

September — Lehman Brothers fails, GSEs nationalized

The federal government took over the GSEs, Fannie Mae and Freddie Mac on Sept. 7 in one of the largest bailouts in U.S. history. The two companies held about half of all mortgage loans in the U.S. at that time, and their stock prices had fallen over 75% each. The fear was that their collapse could have disastrous repercussions for the economy.

On Sept. 11, Lehman Brothers, a major investment bank, reported $4 billion in quarterly losses and disclosed that it was looking for a company to buy the firm. The U.S. Department of the Treasury and private bankers worked together to make a deal that would work. However, events would overtake them:

  • Sept. 15. Lehman Brothers declared Chapter 11 bankruptcy, making for the largest bankruptcy in U.S. history. On the same day, Bank of America announced it would buy failing brokerage giant Merrill Lynch.
  • Sept. 16. The Fed bailed out insurance giant AIG by offering to loan the company up to $85 billion in exchange for nearly 80% of the company’s equity.
  • Sept. 19. U.S. Secretary of the Treasury Henry Paulson announced the Troubled Asset Relief Program (TARP), a $700 billion government bailout for the financial industry.
  • Sept. 25. JPMorgan Chase purchased failing regional bank Washington Mutual.
  • Sept. 29. Citigroup announced plans to purchase Wachovia bank, the House voted down the first draft of TARP and the Dow Jones Industrial Average drops 777.68 points, its largest single-day drop to date.

October — Congress passes TARP

After a long weekend of unrestrained panic and intense negotiations, Congress passed a revised version of TARP and President Bush signed the program into law. TARP gave the government authority to buy “troubled assets” from private companies, in yet another attempt to stabilize the U.S. financial system.

Upstaging Citigroup, Wells Fargo announced a bid to buy Wachovia on Oct. 3. Wells Fargo ends up getting Wachovia in the end, instead of Citigroup.

The government bailout of AIG is restructured on Oct. 8, giving the company access to more funds.

The week of Oct. 6-10 was the worst week ever for the Dow Jones Industrial Average. The crisis spread to the auto industry as auto sales dropped sharply.

Stock markets plunged around the world. Central banks from Britain, Canada, China, the EU, Sweden, Switzerland and the U.S. worked together to further lower interest rates. The Fed cut rates twice in October, to 1.5% on October 8 and then to 1% on October 29. By the end of October, U.S. consumer confidence had fallen to an all-time low.

November — More bailouts, TARP gets to work

The AIG bailout was restructured again on Nov. 10, reducing the loan amount, lowering the interest rate and giving the company more time to repay the money. The Treasury department agreed to purchase an additional $40 billion in AIG stock.

The Treasury department, the Federal Housing Finance Agency (FHFA), the Department of Housing and Urban Development (HUD) and HOPE NOW alliance announced a new loan modification program that could help mortgage holders who wanted to keep their homes.

On Nov. 12, Paulson announced plans to use TARP funds to ease credit markets rather than purchase troubled assets from financial institutions.

The CEOs of the Big Three auto companies, General Motors, Chrysler and Ford flew to Washington, D.C. on Nov. 18 to request TARP funds.

On Nov. 23, the government bailed out Citigroup.

Fannie Mae and Freddie Mac announced they would stop foreclosing on occupied homes from Nov. 26 to Jan. 9, 2009.

On the 25th, the Fed rolled out a plan to keep interest rates low by purchasing government bonds and mortgage-backed securities. Called quantitative easing (QE), the plan continues to this day. The Treasury and the Fed also announce the Term Asset-Backed Securities Loan Facility (TALF), which made an additional $200 billion in loans available to financial institutions with the goal of increasing consumer lending.

December — Recession finally declared

On the first of the month, the National Bureau of Economic Research confirmed that the U.S. was in a recession that had begun a year earlier, in December 2007. On Dec. 5, monthly job reports disclosed that over 500,000 jobs were lost in November — one of the largest declines in 30 years — and employment had decreased by 1.9 million jobs since August.

On Dec. 19, the Treasury department announces it would use TARP funds to bail out General Motors and Chrysler.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Louis DeNicola
Louis DeNicola |

Louis DeNicola is a writer at MagnifyMoney. You can email Louis at [email protected]