An annuity is a contract made between a person (called a “purchaser” or “annuitant”) and an insurance company (called an “insurer”). This contract is long-term in nature where the purchaser makes either a single lump-sum contribution or a series of contributions to the insurance company over a specific period. In exchange, the insurer guarantees to give back periodic payments to the purchaser which can start immediately or at a future date.
How does it work?
Now that we know the basic definition of an annuity, let us dig deeper into detail. Individuals may purchase an annuity contract on their own. If you are an employee, it is good to check if you may purchase an annuity contract through your employer.
Think about annuity as filling up a water tank for storage. The period when you are filling up the tank or funding your annuity is called the “accumulation phase”. Once the tank is filled, it is time to get water out of it, one bucket at a time. This is called the “annuitization phase” of the contract where you, as the purchaser, will receive a steady payout for the rest of your life.
What is the purpose of an annuity?
Although individuals can set aside money for retirement, what will happen if it runs out? What will happen if you outlive your lifetime savings? That risk is exactly what an annuity contract addresses. Having an annuity contract will allow a person guaranteed payouts after retirement. It is a reliable way of having a steady cash stream without the fear of outliving your savings.
Aside from retirement purposes, a purchaser can also opt to shift a large amount of money or lump sum into a steady cash flow. Did you win the lottery? You can choose to contribute it to an annuity plan to have it paid out to you in increments.
The payout or annuitization phase is entirely up to you as the purchaser. May it be immediate or at a specific age, it will depend on your needs.
What are the common types of annuities?
As we discussed earlier, annuities can be differentiated based on when the payout begins.
Immediate Payment Annuity – the annuitant begins to receive payments immediately after contributing an initial investment. This is a useful type of annuity if the individual is approaching retirement age.
Deferred Annuity – the annuitant begins to receive payments at a future date specified by the annuitant. There are different plans with different time frames which you can choose from. Is it in 10, 15, or 20 years? Again, it will depend on your needs and when you plan to retire.
Annuities can also be structured differently.
Fixed annuity – the annuitant is paid a specific or payout.
Variable annuity – the annuitant is not paid a uniform amount. It will depend on the performance of the investment portfolio chosen by the annuitant. If it does well, the payout will be bigger. If it does not do well, then the payout will be smaller.
What is a Qualified Employee Annuity?
This is a type of annuity under an employer’s qualified employee annuity program. A qualified employee annuity is purchased by an employer for an employee as a retirement savings plan that meets Internal Revenue Code requirements. It is funded with pre-tax dollars which means that there are no taxes owed on the money that accumulates or accrues in the account provided that there is no withdrawal made.
What does the IRS require for an Employee Annuity?
According to the IRS, employee annuities can be qualified or non-qualified.
In qualified employee annuities:
These are funded with pre-tax dollars. Non-qualified annuities are funded with after-tax dollars.
If an employee makes a withdrawal before the scheduled payout or annuitization phase, part of the money withdrawn is taxable.
When the fund from a qualified annuity is distributed to the annuitant, the entire amount is taxable. This is because it was funded by pre-tax dollars and taxes have never been paid on that money.
For more detailed information, it is best to see the IRS website.
Is Annuity the same as a 401(k)?
No, they are not the same. While both annuities and 401(k) offer good retirement savings plan options, they are significantly different.
What are the major differences between Annuity and 401(k)?
Here are some key differences between an annuity and 401(k):
An annuity can be purchased by any individual independently. A person can only have a 401(k) plan if their employer has it or if that person is self-employed and can set up their own 401(k).
A person can borrow money from a 401(k) but not from an annuity.
An annuity offers regular guaranteed payouts for as long the annuitant lives. In a 401(k), it will give you only as much as you have contributed to it plus any investments earned on your fund. There is not a guarantee that it will last for as long as you will live.
There is no limit or cap on the amount of money that you can put into your annuity plan. In a 401(k), there is a contribution ceiling that increases annually. According to the IRS, the contribution limit for employees is $19,500 in 2021.
Planning for retirement and preparing for the future entails a lot of research and planning. For employers, there can be many challenges in providing employee annuities. As a result, organizations may yet be prepared to offer annuity plans to their employees.
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