Just I
If you have been outside any this summer, you know that the weather is oppressive. It’s not the heat, it’s the humidity. That was the thing we forgot about on our last camping trip.
Instead of heading to the mountains where it’s always cooler, we headed to the piedmont on the hottest, most humid weekend of the summer with our friends. I can’t remember sweating so much in one trip!
When we returned, after showers of course, we needed a nice ice-cold beer. And what’s more fun with a hoppy beer than a discussion of…annuities! Woo-hoo, right?!
*Tough crowd*
Alright, I get it…you don’t typically hear beer and annuity in the same sentence. But what if I told you that they actually have more in common than what appears on the surface?
It may come as a surprise, but these two complex products share a lot of similarities. However, the average person probably knows a lot more about picking out a good beer than they do about annuity products.
And while annuities may not be what you need right now, they could be a very important part of your financial future. So, let’s take a look at what annuities (and beer) can do for you.
First, let’s cover exactly what an this product is and an overview of the lingo that you should know before deciding if an annuity is right for you.
What is an Annuity
While many people think of an annuity as an investment, it is actually an insurance contract that ensures an outcome at a predetermined time.
Put another way, you agree to pay the insurance company a set amount of money. In return, they guarantee when and how you will get that money back (and in some cases, what interest rate your money will earn).
There are about as many variations of annuities as there are types of beer. Each one serves a particular purpose.
Because there are so many types of annuity products, there are strong arguments both for and against annuities — but the truth is that it all depends on what type of annuity you are talking about and how you plan to use it in your unique situation.
To help make sense of it all, let’s discuss a few of the terms that you may hear when discussing annuities and how they function.
Annuity Lingo to Know
When it comes to annuities, there are essentially two phases you should know about: the accumulation phase and the distribution phase. The accumulation phase is when you build up your funds. It’s like when you are throwing a party and you need to go buy beer, or maybe you tell your guests that it is BYOB (bring your own beer). Either way, you have to spend some time and effort accumulating beer.
The distribution phase is a bit different. This is when you decide where your money (or your beer) goes. In the context of your party, this is the moment when you distribute the beer to all of your guests.
In addition to these two phases, there are few more important terms that you’ll need to know before proceeding. The following terms are all vitally important for understanding how annuities function:
- Insurance Company – This is the entity that issues an annuity policy.
- Owner – The owner is generally the person who purchases an annuity policy, although you can buy an annuity for someone else.
- Annuitant – An annuitant is the person receiving payments from the annuity during the distribution phase.
- Beneficiary – This is the person who receives any death benefits from the annuity once the owner/annuitant dies.
Six Ingredients to Brew an Annuity
Much like beer, there are six primary ingredients that make up an annuity. Let’s breakdown each of these ingredients to better understand how annuities work:
Type
When it comes to annuities, the type is comparable to the grain used when brewing a beer; it is one of the main components of the final product.
All annuities are allowed to grow tax-deferred — which means any earnings on the investment are not taxed until they are paid out to the annuity holder. However, there are differences that determine if and when taxes are due on the annuity principal, the money used to purchase or fund the annuity.
These differences come down to whether the annuity is considered qualified or non-qualified.
Qualified Annuities are products purchased with pre-tax money, and are only subject to income tax upon distribution or withdrawal.
On the other hand, Non-Qualified Annuities are purchased with after-tax money and are taxed upon withdrawal.
Timing
The timing of your annuity is like the yeast in beer; the length of the fermentation process will affect the flavor.
With an Immediate Annuity, you begin to receive payments soon after you make your initial investment. For example, you might consider purchasing an immediate annuity as you approach retirement age as a way to supplement a pension or social security.
If you opt for a Deferred Annuity, your money is invested for a period of time until you are ready to begin taking withdrawals, allowing your returns to accumulate tax-free.
Purchase Method
The purchase method is kind of like the malt for brewing your beer; it gives your beer a distinct look and flavor.
The Lump-sum method is like buying a monthly pension check. You pay an annuity provider a lump sum in exchange for a guaranteed income stream. The monthly payments start immediately — usually within 30 days of handing over your money.
Alternatively, making Payments over time allow you to sock away smaller amounts of money toward your annuity. Once you reach retirement, you can withdraw it as a lump sum or as a series of payments and the money is taxed at the time of withdrawal.
Investment Type
Your investment type is a lot like the hops used in the brewing process; the hops help strengthen the flavor and bring stability to the final product. And there are several to choose from.
For example, a Fixed Annuity provides a low-risk retirement income source since you receive a fixed amount of money every month for the rest of your life. In comparison, with a Variable Annuity, the owner has access to a wide variety of investment options that each focus on one mutual fund. With this type of annuity, you receive varying rates of return depending on your portfolio’s performance.
Finally, an Index Annuity is a fixed deferred annuity that credits earnings based on the movement of an index, such as the S&P 500. The popularity of this type of annuity is due to the fact that it guarantees a certain minimum return and allows you to participate in stock market gains without assuming the full risk of losing money when the market declines.
Liquidity
Liquidity is like the water used in the brewing process; it determines the flow and consistency of the beer. Most annuities have Penalty Charges and tax penalties for withdrawing funds before the annuity has fully matured — with the penalty rate decreasing with each passing year.
On the other hand, some annuity contracts allow the owner to withdraw up to 10% of the annuity’s value each year, Penalty-Free.
Riders
Finally, riders are like all of the extra ingredients that can give beer an extra kick of flavor, like honey, bacon, citrus, etc. In the case of annuities, they have optional benefits like:
- Long-term Care – This allows owners to withdraw penalty-free funds for the costs of long-term care.
- Guaranteed Minimum Withdrawal – This allows owners to take out a set minimum each year without any penalties.
- Guaranteed Minimum Income – This ensures that owners receive a minimum income from their investment.
A Six-Pack of Examples
When you go to a bar, there will certainly be a beer for just about anyone, and annuities are no different. There are numerous options to choose from, so much so that you may come in contact with one without even realizing it.
Let’s look at six examples of annuities that fit a wide variety of needs and circumstances:
- Social Security – You may be surprised to see this on the list; however, Social Security is one type of annuity that we can all relate to. Much like a deferred annuity, you make payments toward your social security, and then start receiving an income when you retire. This of this brand as Anheuser-Busch InBev.
- Pension Plan – A pension is an employer-based annuity. Either you or your employer pay into it and you get a payment in return when you reach retirement. Similar to a Coors or Corona, they are associated with a specific place.
- Annuity Sold through an Insurance Agent – Not sure which beer is the best for you? You may want to go to a bottle shop and talk with the employees to pick one you like. Similarly, consulting an insurance agent is one of the best ways to find the right plan for you.
- Low Cost Annuity – Low cost annuities have low fees and do not require large lump-sums to invest. You can purchase these online and they tend to be simpler products than those sold through an agent. You can always go to the local grocery store and find a common craft beer that suits you.
- Annuity as a 401(k) Distribution Option – Some 401(k) plans allow you to choose an annuity option, which allows you have a steady retirement income. Sometimes, you have to brew your own beer.
- Beneficiary of an Annuity – Even if you have no interest in purchasing an annuity, you may end up inheriting one if someone you know passes away. This is when a good friend gives you a beer.
Is an Annuity Right for Me?
Everyone’s financial circumstances are different, but we all must find ways to save for retirement. These products are an option for those who want to establish a retirement income early, or bolster their Social Security funds. In any case, you will need to ask yourself the following questions to determine the best course of action for you:
- Have I maxed out my 401(k) and IRA type accounts? (Hint: Do this before purchasing an annuity.)
- Do I have money invested that I do not currently need that am paying taxes on? You may be able to defer those taxes with an annuity.
- Do I think that I will be in a lower tax bracket when I retire than I am in now? If so, you may want to take tax savings now and allow your money to grow tax-free. Then you can take it out with lower taxes in the future.
- Do I think I will need a guaranteed stream of income in the future?
Addressing these questions should help you deal with whatever annuity products you’re presented with and assess whether or not they’re a smart move for your financial portfolio.
Don’t stress about all this. If you’re confused, just sit down with your favorite cold beer and deal with it later.
Are you looking for personalized advice to improve your finances? Jumpstart your savings and retirement strategy today with Pathfinder Planning!
Pathfinder Planning LLC provides personal financial planning advice and asset management for a simple fee to young adults and working families in North and South Carolina through group classes, one-on-one planning, and ongoing advice.
Your Financial Mom blog posts are not meant to be legal, accounting or other professional service advice. Content represents the opinion of the author only. Pathfinder Planning LLC is not responsible for the accuracy or validity of content contained in third-party comments.